OPEC and $80 oil: last week’s meeting

$80 per barrel oil

Over the past year the price of a barrel of crude oil has risen from $50 to $80.  The latter figure is substantially below the $100+ that “black gold” averaged during 2011-2014, but hugely higher than the low of $25-minus thee years ago.

conventional wisdom upended

Two pieces of conventional wisdom about oil have changed during the past half-decade:

–effective shale oil production technology has shelved the previous, nearly religious, belief in the near-term peaking of world oil productive capacity.  More than that,

–the development of viable electric cars has won the world over to the idea that a substantial amount of future transportation demand is going to be met by non-petroleum vehicles.

new meaning for “peak oil”

The “peak oil” worry used to be about the day when demand would outstrip supply (as emerging economies switch from bicycles/motorcycles to several cars per household–just as conventional oil deposits would begin to give up the ghost).  The term now means the day (in 2040?) when demand hits a permanent peak, and then begins to fall as renewable energy supplants fossil fuels.

new OPEC solidarity

When Saudi Arabia, the most influential member of OPEC, said during the recent supply glut that its target for the oil price was $80 a barrel, I thought the figure was much too high.  Why?  I expected that the cartel wouldn’t stick to mutually-agreed output restrictions (totaling 1.8 million daily barrels) for the years needed for oversupply to dry up and the price of output to rise.  That was wrong.

I think the main reason for OPEC’s uncharacteristic sticktoitiveness (first time I ever typed that word) is the realization that petroleum is going to yield to renewables as firewood was supplanted by coal in the mid-nineteenth century and coal was replaced by oil in the mid-twentieth.

There are other factors, though.  The collapse of the Venezuelan government means that country now produces about a million barrels a day less than two years ago.  Also, Mr. Trump’s aversion to all things Obama has prompted him to pull the US out of the Iranian nuclear agreement and reinstate an embargo.  This likely means some fall in Iranian output from its current 4.5 million or so daily barrels, as sanctions go back into effect.  Anticipation of this last has upped today’s oil price by something like $10 a barrel.

adding 600,000 barrels to OPEC daily output

Just prior to the Trump decision on Iran, Russia and Saudi Arabia were suggesting publicly that the coalition of oil producers eventually restore as much as 1.5 million barrels of daily production, as a way of keeping prices from rising further.  Mr. Trump has reportedly asked the two to make any current increase large enough to offset the $10 rise his Iran action has sparked.

Unsurprisingly, his plea appears to have fallen on deaf ears.  Last Friday the cartel announced plans to put 600,000 barrels of daily output back on the market–subject, I think, to the condition that the amount will be adjusted, up or down, so that the price remains in the $75 – $80 range.

optimizing revenue

The old OPEC dynamic was Saudi Arabia, which had perhaps a century’s worth of oil reserves and therefore wanted to keep prices steady and low vs. everyone else, whose reserve life was much shorter and who wanted the highest possible current price, even if that hastened consumers’ move to alternatives.

Today’s dynamic is different, chiefly because the Saudis now realize that the age of renewable energy is imminent.  Today all parties want the highest possible current price, provided it is not so high that it accelerates the trend to renewables.  The consensus belief is that the tipping point is around $100 a barrel.  $80 seems to give enough safety margin that it has become the Saudi target.

 

 

 

 

 

 

$80 a barrel oil

cartel activity

About a week ago, Saudi Arabia and Russia, two of the three largest oil producers in the world (the US is #1), announced they were discussing the mechanics of restoring half of the 1.8 million barrels of daily output foreign companies have been withholding from the market since 2016.

the objective? 

…to stop the price from advancing above $80.

To be honest, I’m a bit surprised that oil has gotten this high.  But producing countries have held to their cutback pledges to a far greater degree than they have in the past, with the result that the mammoth glut of oil in temporary storage a couple of years ago is mostly gone.  In addition, the economy of Venezuela is melting away, turning down that country’s output of heavy crude favored by US refiners.   Also, the world is worried that unilateral US withdrawal from the Iranian nuclear agreement may mean the loss of 500,000 daily barrels from that source.

On the other hand, short-term demand for oil is relatively inflexible.  Because of this, even small changes in supply or demand can result in large swings in price.   An extra 1% -2% in production drove the price from $100+ to $24 in 2014-15, for example.  The same amount of underproduction caused the current rebound.  So in hindsight, $80 shouldn’t have been so shocking.

Why $80?

Two factors, I think.  There must be significant internal pressure among producing countries to get even a small amount more foreign exchange by cheating on quotas.  Letting everyone get something may make it harder for one rogue nation to break ranks.

More importantly, a $100 price seems to trigger significant global conservation efforts, as well as to shift the search for petroleum substitutes into a higher gear.  So somewhere around $80 may be as good as it gets for producers.  And it leaves some headroom if efforts to hold the price at $80 fail.

the stocks

My guess is that most of the upward move for the oils is over.  I think there’s still some reason to be interested in financially leveraged shale oil producers in the US as they unwind the restrictions their lenders have placed on them.

 

 

 

oil right now–the Iran situation

For almost a year I’ve owned domestic shale-related oil stocks, for several reasons:

–the dire condition of the oil market, oversupplied and with inventories overflowing, had pushed prices down to what I thought were unsustainable lows

–other than crude from large parts of the Middle East, shale oil is the cheapest to bring to the surface.  The big integrateds, in contrast, continue to face the consequences of their huge mistaken bet on the continuance of $100+ per barrel oil

–there was some chance that despite the sorry history of economic cartels (someone always sells more than his allotted quota) the major oil-producing countries, ex the US, would be able to hold output below the level of demand.  This would allow excess inventories to be worked off, creating the possibility of rising price

–the outperformance of the IT sector had raised its S&P 500 weighting to 25%, historically a high point for a single sector.  This suggested professional investors would be casting about for other places to invest new money.  Oil looked like a plausible alternative.

 

I’d been thinking that HES and WPX, the names I chose, wouldn’t necessarily be permanent fixtures in my portfolio.  But I thought I’d be safe at least until July because valuations are reasonable, news would generally be good and I was guessing that the possibility of a warm winter (bad for sales of home heating oil) would be too far in the future to become a market concern before Labor Day.

 

Iranian sanctions

Now comes the reimposition of Iranian sanctions by the US.

Here’s the problem I see:

the US imposed unilateral sanctions like this after the Iranian Revolution in 1979.  As far as oil production was concerned, they were totally ineffective.  Why?  Oil companies with access to Iranian crude simply redirected elsewhere supplies they had earmarked for US customers and replaced those barrels with non-Iranian output.  Since neither Europe nor Asia had agreed to the embargo, and were indifferent to where the oil came from, the embargo had no effect on the oil price.

I don’t see how the current situation is different.  This suggests to me that the seasonal peak for the oil price–and therefore for oil producers–could occur in the next week or so if trading algorithms get carried away, assuming it hasn’t already.

 

 

~$70 a barrel crude (ii)

Two factors are moving the Energy sector higher.  The obvious one is the higher oil price during a normally seasonally weak time.  In addition, though, the market is actively looking for alternatives to IT.  It isn’t that the bright long-term future for this sector has dimmed.  It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher.  With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.”  It can go on for months.

 

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff.  In particular, all but the least adept shale oil drillers must now be making money.  This is where investment activity will be centered, I think.

 

–refiners and marketers, who have benefitted from lower costs are now facing higher prices.  So they’re net losers.  Long/short investors will be reversing their positions to now be short refiners and long e&p.

 

–the biggest multinational integrateds are a puzzle.  On the one hand, they traditionally make most of their money from finding and producing crude.  On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil.  This has been a horrible mistake.  Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects.  But, in theory at least, writeoffs aren’t supposed to create future profits.  They can only eliminate capital costs that there’s no chance of recovering.  As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow.  As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation.  Small companies in this situation would likely be acquired by larger rivals.  But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that.  Will they turn themselves into quasi-bonds by paying out most of this cash in dividends?  I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over.  So watch them.

~$70 a barrel crude oil

prices equity investors watch

Investors who are not oil specialists typically use (at most) two crude oil prices as benchmarks:

Brent, a light crude from under the North Sea.  Today it is selling at just about $70 a barrel.  “Light” means just what it says.  Brent is rich in smaller, less-heavy molecules that are easily turned into high-value products like gasoline, diesel or jet fuel.  It contains few large, denser molecules that require specialized refinery equipment to be turned into anything except low-value boiler fuel or asphalt.  Because it can be used in older refinery equipment that’s still hanging around in bunches in the EU, it typically trades at a premium

West Texas intermediate, which is somewhat heavier and produced, as the name suggests, onshore in the US.  It is going for just under $64 a barrel this morning.

 

What’s remarkable about this is that we’re currently nearing the yearly low point for crude oil demand.  The driving season–April through September–is long since over.  And for crude bought, say three weeks from now, it’s not clear it can be refined into heating oil and delivered to retail customers before the winter heating season is over.

Yet WTI is up from its 2017 low of $45 a barrel last July and from $57 a barrel in early December.  The corresponding figures for Brent are $45 and $65. (Note that there was no premium for Brent in July.  I really don’t know why–some combination of traders’ despair and weak end user demand in Europe.)

 

why the current price strength?

Several factors, most important first:

–OPEC oil producers continue to restrain output to create a floor under the price

–they’re being successful at their objective, as the gradual reduction of up-to-the-eyeballs world inventories–and the current price, of course–show

–the $US is weakening somewhat.

 

 

My Lighting class is calling, so I’ll finish this tomorrow.  The bottom line for me, though:  I think relative strength in oil exploration and production companies will continue.

 

the revamped Google Finance

I hadn’t realized how dependent I’ve become over the past ten years on the Google Finance page.  Google Finance’s debut coincided closely with my retirement from my job as a global equity portfolio manager.  I found that GF met enough of my personal money management needs that I didn’t miss my $26,000/year Bloomberg terminal much at all.  (The ability to see a company income statement dissected in a way that revealed major customers and suppliers–and their relative importance–came to
Bloomberg later.  Assuming it’s still there, that’s a really useful feature for a securities analyst.)

 

What I liked about the old GF:

–everything was on one page, so I could take in a lot of information at a single glance

–it contained information about stocks, bonds and currencies, so I could see the main variables affecting my investment performance grouped together

–there was a sector breakout of that day’s equity performance on Wall Street

–I could add new stocks to a portfolio list easily, and thereby be able to see what was going up/down for a large group of stocks I was interested in

–I could compare several stocks/indices on a single chart, and vary the contents of that chart–and its timeframe–easily.

 

The charts themselves were not so hot.  But I could either live with that or use Yahoo Finance.  (I have a love/hate relationship with charts, in any event.  My issue is that stretching the price and/or time axes can change a bump in the road into a crisis and vice versa.)

 

The new Google Finance?

well…

–All of the stuff on my “likes” list has disappeared.

–The Dow Jones Industrials–a wacky, irrelevant index whose main positive point is that it’s easy to calculate–features prominently in coverage of the US.

–The Sensex has been consistently listed as a top-five world index, even though India is an insiders market that’s extremely difficult for foreigners to access.  Same for Germany, where there’s no equity culture and little of the economy is publicly listed.  No mention of Hong Kong or Shanghai or Japan or (most days) the UK.  Yes, the UK economy is smaller than Germany’s.  But London’s significance comes from its being the listing hub for many European-based multinationals.

 

My conclusion:  the new page has been put together by people who, whatever their tech smarts, have no clue at all about what an investor needs/wants.  Its overall tone seems to be to provide information that an investor will like to hear, based on browsing history.  Put a different way, the new page strives to turn users into the prototypical “dumb money.”  Actually, now that I’ve come to this realization, maybe the new page isn’t so counterproductive after all.  Just don’t use it.

 

 

deferred taxes and corporate tax reform

I wrote a couple of posts several years ago explaining in some detail what deferred taxes are.  The short version: when a company makes a gigantic loss, the loss itself has an economic value.  That’s because the firm can almost always use it to shield future earnings from income tax.

 

The IRS and the Financial Accounting Standards Board have different ways of accounting for deferred taxes.  For the IRS, they only appear on a return when the company has sufficient otherwise taxable income to use them.  At the other extreme, financial accounting rules allow the company to recognize the entire value of these potential savings immediately.  That’s even though the actual use of tax losses may be far in the future.

An example:

A company has pre-tax income of $1,000,000 from ordinary operations.  It also closes down a subsidiary, incurring a pre-tax loss of $11,000,000.  For IRS purposes, the firm has a total pre-tax loss of $10,000,000.  Ignoring the possibility of carrybacks (recovery of previous years’ tax payments because of the current loss), the company has no taxable income.  It also has a loss in the current year of $10,000,000, which it can potentially use to shield future income from taxes.

Financial accounting presents a much rosier picture.  The pre-tax loss of $10,000,000 is the same.  But financial accounting allows the company to recognize the possibility of future tax recovery right away, as a reduction of the current loss.

The financial accounting income statement reads like this:

pre-tax loss        ($10,000,000)

deferred taxes    +$3,500,000

net loss                 ($6,500,000).

The $3.5 million is carried as a deferred tax asset on the balance sheet until used.

Auditors are supposed to certify that it’s actually possible for the company to generate enough future income to use up the tax losses during the limited period of years tax law allows.  I can’t think of a company where auditors have held a firm’s feet to the fire on this point, though.

Where does the  tax bill come in?  The tax rate assumed in writeoffs up until now is 35%.  However, from now on, the top tax rate in the US is going to be 21%.  Therefore, deferred tax assets now being held on corporate balance sheets are only worth 21/35ths (about 57%) of their current carrying value.  Because they’re clearly, and significantly,  overvalued, they must be written down.

This may well throw algorithmic value investors for a loop, since the writeoff of deferred taxes will be reductions to book value.

What sector does this change affect the most?

Major banks.

Banks took major writeoffs in 2008-09 because of speculative trading and lending losses piled up after the Glass Steagall Act was repealed in the late 1990s. These losses were gigantic enough to require a huge government bailout of the industry in 2009.

Note:  Glass-Steagall was passed in the 1930s to prevent a recurrence of the financial meltdown that triggered the Great Depression.  Banks claimed in the 1990s that they were too mature to do anything like this again.  In this instance, it took over a half-century for Washington to forget why the law was in place.  However–and oddly–Washington already appears eager to to dismantle Dodd-Frank.