$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.

oil inventories: rising or falling?

The most commonly used industry statistics say “rising.”

However, an article in last Thursday’s Financial Times says the opposite.

The difference?

The FT’s assertion is that official statistics emphasize what’s happening in the US, because data there are plentiful.  And in the US, thanks to the resurgence of shale oil production, inventories are indeed rising.  On the other hand, the FT reports that it has data from a startup that tracks by satellite oil tanker movements around the world, which seem to demonstrate that the international flow of oil by tanker is down by at least 16% year on year during 1Q17.

Tankers move about 40% of the 90+million barrels of crude brought to the surface globally each day.  So the startup’s data implies that worldwide shipments are down by about 6 million daily barrels.  In other words, supply is now running about 4 million daily barrels below demand–but we can’t see that because the shortfall is mostly occurring in Asia, where publicly available data are poor.

If the startup information is correct, I see two investment implications (neither of which I’m ready to bet the farm on, though developments will be interesting to watch):

–the global crude oil supply/demand situation is slowly tightening, contrary to consensus beliefs, and

–in a world where few, if any, experienced oil industry securities analysts are working for brokers, and where instead algorithms parsing public data are becoming the norm, it may take a long time for the market to realize that tightening is going on.

It will be potentially important to monitor:  (1) whether what the FT is reporting proves to be correct; (2) if so, how long a lag there will be from FT publication last week to market awareness; and (3) whether the market reaction will be ho-hum or a powerful upward movement in oil stocks.  If this is indeed a non-consensus view, and I think it is< then the latter is more likely, I think, than the former.

This situation may shed some light not only on the oil market but also on how the discounting mechanism may be changing on Wall Street.

 

 

 

why have oil production costs fallen so much?

rules for commodities

From years of analyzing oil, gas and metals mining–as well as watching agricultural commodities and high-rise real estate out of the corner of my eye–I’ve come to believe in two hard and fast rules:

–when prices begin to fall, they continue to do so until a significant amount of productive capacity becomes uneconomic and is shut down.  That’s when the selling price of output won’t cover the cash cost of production.  Even then, management often doesn’t reach for the shutoff valve immediately.  It may hope that some external force, like a big competitor shutting down, will intervene (a miracle, in other words) to improve the situation.  Nevertheless, what makes a commodity a commodity is that the selling price is determined by the cost of production.

–it’s the nature of commodities to go through boom and bust cycles, with periods of shortage/rising prices followed by over-investment that generates overcapacity/falling prices.  The length of the cycle is a function of the cost of economically viable new capacity.  If that means the the price of new seed that sprouts into salable goods in  less than a year, the cycle will be short.  If it’s $5 billion to develop a gigantic deep-water offshore hydrocarbon deposit that will last for 30 years, the cycle will be long.

boom and bust spending behavior

During a period of rising prices, cost control typically goes out the window for commodity producers.  Their total focus is on adding capacity to satisfy what appears at that moment to be insatiable demand.  Maybe this isn’t as short-sighted as it appears (a topic for another day).  But if oil is selling for, say $100 a barrel, it’s more important to pay double or triple the normal rate for drilling rigs or mud or new workers–even if that raises your out-of-pocket costs from $40 to, say, $60 a barrel lifted out of the ground.  Every barrel you don’t lift is an opportunity loss of at least $40.

When prices begin to fall, however, industry behavior toward costs shifts radically.  In the case of oil and gas, some of this is involuntary.  Declining profits can trigger loan covenants that require a firm to cease spending on new exploration and devote most or all cash flow to repaying debt instead.

In addition, though, at $50 a barrel, it makes sense for management to:  haggle with oilfield services suppliers;  do more ( or, for some firms initiate) planning of well locations, using readily available software, to optimize the flow of oil to the surface;  optimize fracking techniques, again to maintain the highest flow; streamline the workforce if needed.   From what I’ve read about the recent oil boom, during the period of ultra-high prices none of this was done.  Hard as it may be to believe, getting better pricing for services and operating more efficiently have trimmed lifting expenses by at least a third–and cut them in half for some–for independent wildcatters in the US.

 

This experience is very similar to what happened in the long-distance fiber optic cable business worldwide during the turn of the century internet boom.  As the stock market bubble burst and cheap capital to build more fiber optic networks dried up, companies found their engineers had built in incredibly high levels of redundancy into networks (meaning the cables could in practice carry way more traffic than management thought) and had also bought way to much of the highest-cost transmission equipment.  At the same time, advances in wave division multiplexing meant that each optic fiber in the cable could carry not only one transmission but 4, or 8, or 64, or 256…  The result was a swing from perceived shortage of capacity to a decade-long cable glut.

My bottom line for oil:  $40 – $60 a barrel prices are here to stay.  If they break out of that band, the much more likely direction is down.

 

how low can the crude oil price go?

This is my response to the comment of a regular reader.

There’s no easy answer to this question.  I have few qualms about putting a ceiling on the oil price.  In round terms, I’d say it’s $60 a barrel, since this is most likely the point at which an avalanche of new shale oil production will come on line.  Also, for investing in shale oil companies this number doesn’t matter than much, so long as it’s appreciably above the current price.

A floor is harder.

a first pass through the issue

We can divide the source of oil production into three types.  I’m not going to look up the numbers, but let’s say they’re all roughly equal in size:

–extremely low production cost, less than $5 a barrel, typified by production from places like Saudi Arabia

–very high production cost, like $100+ a barrel, which would be typical of exploration and production efforts of the major international oil companies over the past decade or so, and

–shale-like oil, with production costs of maybe $35 -$40 a barrel.

In practical terms, there’s never going to be an economic reason for the low-cost oil to stop flowing.

Shale oil is basically an engineering and spreadsheet exercise.  The deposits are relatively small and the cost of extraction is almost all variable.  So shale will switch on and off as prices dictate.  We know that at the recent lows of $25 or so, all this production was shut in.

The very high production cost is the most difficult to figure out.  Of, say, $100 in production expense, maybe $70 is the writeoff of exploration efforts + building elaborate hostile-environment production and delivery platforms.  This is money that was spent years ago just to get oil flowing in the first place.  What’s key is that for oil like this is that the out-of-pocket cost of production–money being spent today to get the oil–may be $30 a barrel.  From an economic perspective, the up-front $70 a barrel should play no role in the decision to produce oil or not.  So, dealing purely economically, this oil should continue to flow no matter what.

second pass

First pass says $30 – $35 a barrel is the low;  $60 is the best the price gets.

Many OPEC countries (think:  Saudi Arabia again) have economies that are completely dependent on oil and which are running deep government deficits.  Their primary goal has to be to generate maximum revenue; the number of barrels they produce is secondary.  If so, they will increase production as long as that gives them higher revenue.  Their tendency will be to make a mistake on the side of producing too much, however.  Their activity will make it very hard to get to a $60 price, I think.

On the other hand, shale oil producers who can make a small profit at, say, $35 a barrel may tend to shut in production at $38 – $40, on the idea that if they exercise a little patience they’ll be able to sell at $45, doubling or tripling their per barrel profit.

third pass

Second pass argues for a band between, say, $40 and $55.

Bank creditors don’t care about anything except getting their money back.  They will force debtors–here we’re talking about shale oil companies–to produce flat out, regardless of price, until their loans are repaid.  This was an issue last year, and what I think caused the crude price to break below $30 a barrel.  I don’t think this is an issue today.

There’s a seasonal pattern to oil consumption, driven by the heating season and the driving season in the northern hemisphere.  The driving season runs from April through September, the heating season from September through January.  February-April is the weakest point of the year, the one that typically has the lowest prices.

If the financial press isn’t totally inaccurate, there are a bunch of what appear to be poorly -informed speculators trading crude oil.  Who knows what they’re thinking?

my bottom line

This is still much more of a guessing game than I would prefer.  I see three positives with shale oil companies today, however.  Industry debt seems more under control.  Operating costs are coming down (more on this on Monday).  And seasonality should soon be providing support to prices.

 

 

 

the wobbly crude oil price

Over the past week or so, the world crude oil price has dropped by about 10%–although it is rebounding a bit as I’m writing on Wednesday morning.

I have several thoughts:

–this is the weakest part of the year for crude oil demand, since the winter heating season is over and the spring driving season is yet to begin

–the surprising aspect of recent crude oil prices is not that they are weak, but rather how strong they have been in January and February in the face of a rising rig count in the US and a milder than average winter in heavily populated areas around the world

–hard as this may be to believe, the price drop suggests to me that many traders in the crude oil market are new to the game, and for some reason haven’t filled themselves in beforehand on the basic characteristics of the commodity

–since there’s a direct relationship between the price of oil and the price of oil exploration and development stocks, the current odd price action in the crude market makes evaluating and trading in the equities more difficult

–I’ve built a small position in e&p stocks over the past couple of months, so I’m sitting on my hands.  If I owned nothing, I’d be tempted to buy something–although I’d be more comfortable if crude had been gradually declining in price over the past month, rather than exhibiting the panicky behavior of the past week.  This is also predicated on the idea that what’s driving crude is thoughts #2 & #3.