Category Archives: Energy

natural gas in the US: the “other” energy story

December 26, 2014 By in Current Market Thoughts, Energy, Industry Analysis Tags: , , , , , , Leave a comment

The US is now producing about 70 billion cubic feet of natural gas daily.  On a heat-equivalent basis, that’s equal to around 10 million barrels of oil.

When I was a starting-out energy analyst in the late 1970s, natural gas and crude oil sold for roughly the same amount per Btu.  In fact, in some instances, natural gas sold at a premium.  That hasn’t been true for a long time.  Up until July of this year, natural gas was selling for about $4.50 per thousand cubic feet (Mcf).  That’s the equivalent of $30 a barrel oil.

Why the huge price difference?

In the simplest terms:

–natural gas is a good substitute for oil as a heating fuel or for generating electricity, but it has made only small inroads in transportation, and

–because it’s in gaseous form, it’s harder to get from place to place.  Gas typically requires a pipeline, which is expensive and suffers from the NIMBY syndrome.

Even though the prices of crude and natural gas have going their separate ways for many years–with gas being consistently much cheaper than oil, natural gas, too, has had its own price collapse over the past six months.  Even at what should be a seasonal peak, natural gas is now going for $3.50 an Mcf (the equivalent of $23.50 a barrel), down by almost a quarter since summer.

The two price slides have one factor in common–an increase in production from hydraulic fracturing.  The other is mostly a gas thing–unusually warm weather in November and December  For what it’s worth, predictions are for continuation of the mild weather until spring.

The main effect of the natural gas price slide has been the obvious one–more money in the pockets of gas consumers.  But there have been several others.  Imports of natural gas from Canada are down.  Imports of high-cost liquefied natural gas (LNG) have dropped sharply.  The advantage that the EU’s petrochemical industry, which uses oil as its main feedstock, had achieved over its US counterpart, which uses gas, has abated.

my take

This is a situation where effects are asymmetrical.  The price decline is very bad for domestic natural gas producers. While it persists, demand for imported natural gas should be close to zero, although minimum “take” provisions of long-term contracts may force importers to buy at least some amount.  Bad for them, too, unless their customers ar contractually obligated to take the pricey stuff.

Because gas is hard to transport, this is a US phenomenon.

We use about 20 million barrels of oil in the US each day.  We use the equivalent of another 10 million in the form of natural gas.  On a dollar basis, though, gas amounts to only about 20% of overall hydrocarbon spending.  So the positive effect of the natural gas price decline will be much smaller than for oil and will be concentrated mostly in the Northwest and Midwest, where the weather is colder and where the pipelines terminate.

 

 

 

is the current equity selloff about oil?

December 12, 2014 By in Energy, Industry Analysis, shale oil, Strategy Tags: , , , , , , , 3 Comments

I’m postponing my 2015 Strategy summary/conclusion on Monday.

 

The price of oil has been steadily declining since June  It’s now below $60 a barrel, after having moved sideways at around $100 from January through early July.

I think the drop is being caused by the fact that supply and demand for petroleum are relatively inflexible in the short term, so small changes in either can cause surprisingly large changes in price.  In 2008, for example, the oil price quickly spiked up from $100 to almost $150 a barrel.   It moved above $125 for a short period in 2011 and again in 2012.

Unlike the prior three surges–caused by fears of supply disruption–the current decline is being created by the steady increase in shale oil output from the US.  In a sense, no one needs all the oil now being brought to the surface.  No one has a place to store the excess.  No producer is willing to cut back his lifting to make room for the extra.  The only mechanism available to clear the market is that the price drops until it reaches a level where buyers are willing to take the risk of increasing their inventories.   Doubtless, commodities speculators of all stripes have been accentuating the downward trend with their shorting activity.

Bad as the price drop has been for oil-producing countries–Russia, the Middle East and Africa–it’s a big plus for the rest of the world.    …yet stock markets are falling on the news.  Why?

–Some market strategists are saying that falling oil prices are being caused by a mysterious–and as yet unseen in other data–falloff in economic activity.  In other words, lower oil is supposedly a harbinger of recession.  Other than for the oil producers, this makes no conceptual sense.  And it flies in the face, at least in the case of the US, of all the economic data we’re seeing–which indicate that the economy is accelerating.

–Others argue that falling oil presages deflation, presumably of the type that has plagued Japan for decades.  Again, other than for oil producers and their banks, I don’t see the problem.  Ex oil companies, no one is going to have less money to spend or to use to repay debt.

–There is a stock market-specific issue, though.  Take the US as an example.  In rough terms, the country produces 13 million barrels of oil a day and uses 20 million.  So it imports 7 million.  The price fall means the country as a whole is keeping about $100 billion a year that was previously going to foreign pil producers.  The loss to domestic producers/gain to domestic consumers is about $200 billion a year.  That money isn’t leaving the country.  It’s just going into different pockets.

In an $18 trillion economy, the whole thing is peanuts, even with secondary effects.

But oil stocks represent 8%+ of the S&P 500 (for the MSCI Global index the proportion is about the same).  So the effect on stocks is much more dramatic.

Energy stocks went down by 10% last month   …and they’ve declined another 5% so far in December.  This has two influences on the market.  The drop in oil stocks themselves depresses the index.  In addition, short-term traders, thinking oil shares look cheap (rightly or wrongly), will short other sectors to buy the oils in the expectation of a bounce.  This arbitrage activity drags the rest of the index down as well.  This is just the way stocks work.

–The fact that we’re close to the end of the year, when many professionals have begun closing down for the year, doesn’t help.  They’ll prefer to sit on the sidelines for now and hunt for bargains in January.

my take

I think the “expert” opinions about possible deflation and recession are silly.  The outsized representation of oils in stock market indices is an issue, but a temporary and minor one, in my opinion.  If anything, I think the oil price fall is a trigger for investors to begin discounting potentially higher interest rates next year.  Some investors may simply be taking profits after a 2014 that has been much stronger than anyone expected.  But declines in December seem to me to imply a better chance of gains in 2015.

 

Shaping a portfolio for 2015 (ii): energy

December 4, 2014 By in Energy, Energy, Industry Analysis, Shaping a portfolio for 2015, Strategy Tags: , , , , , , Leave a comment

From 2011 through the first half of 2014, the world crude oil price averaged $110 a barrel, more or less (let’s not worry about quality differentials and stuff like that–this is the BIG (and simple) picture).  Now it’s $70.

World oil production is 90 million barels a day.  So a $40 a barrel reduction in price means $3.6 billion a day no longer leaving the pockets of oil consumers and landing in those of the oil producers.  That’s $1.3 trillion a year–or about 8% of the total GDP of the United States.

The important investment questions are:

–does oil stay at this price?, and

–who are the winners and losers.

Let’s take the second first.

oil production and consumption

net importing areas, i.e., winners

Asia         20.4 million bbl/day; of that, China accounts for 5.6 million, Japan 4.4, South Korea 2.5, India 2.3

Europe     10.5 million bbl/day

North America     4 million bbl/day;  the US imports 6.7 million, Canada and Mexico are both exporters

net exporting areas, i.e., losers

Middle East     19.2 milllion bbl/day;  Saudi Arabia is 7.1 million

Eurasia     8.8 million bbl/day; Russia is 7.2 million

Africa     5.7 million bbl/day.

The US is now the largest oil producing country in the world, at 12.3 million barrels/day.  It is followed by Saudi Arabia and Russia, both at 10+ million bbl/day.

On a net basis, Asians and Europeans get the biggest windfall from lower oil prices;  the Middle East and Russia lose the most.  The US situation is more complex.  On the one hand, the nation as a whole is a net winner from lower oil prices.  On the other, the net win is made up of large gains by drivers everywhere, airlines and heating oil users in colder areas, partly offset by substantial losses in oil-producing states like North Dakota and Texas.

second round effects

There are two varieties:

–historically, a considerable portion of the money collected by oil producing countries is not spent.  Instead, it’s saved, or “recycled” into international financial markets.  Taking the Middle East, Eurasia and Africa together, there’s now a half-trillion dollars a year being spent in dribs and drabs by consumers outside these areas rather than being parked in sovereign wealth funds, private equity or hedge funds.  Bad for fund managers and bankers, good for consumption.

–Some consumers are abandoning hybrids and starting to buy gas guzzlers again.  Some new shale oil projects may no longer be economical.  Some of the urgency is leaving the alternative energy area.  These counter-trend developments are probably too small to matter much today, but they ultimately have the potential to help reverse the price decline and therefore are worth monitoring.

the first question

My guess is that the oil price stays around where it is now.

But that’s really just a guess.

As investors, we have to deal with ambiguity and uncertainty every day.  It’s more important for me to understand that I’m using this assumption in structuring my portfolio than to be 100% sure that I’m correct.  That way I can keep my eye out for changes and plan what I’ll do when/if I see them. In any situation where a professional genuinely has no insight, the plain-vanilla strategy is to equal weight the area.  I imagine that most professionals will have less than the S&P 8% weithging in Energy going into 2015, however.

In the active portion of my holdings, I’ve had virtually no Energy for some time.  I’m going to continue that stance. But I’m going to look around for some Retail or Restaurants to add in the US or EU. I’m leaving my passive holdings alone.  I suppose I could short an oil ETF, but I’m confident in my case that that wouldn’t work out well. At some point, well ahead of any reversal in the oil price, the stocks in the Energy sector will bottom out.  We should be watching for this.  I don’t think we’re anywhere near that point yet, however.

oil: will falling prices reduce supply?

December 2, 2014 By in Current Market Thoughts, Energy, Industry Analysis, shale oil Tags: , , , , , , , , Leave a comment

Ultimately, yes   …but only at lower prices than today’s., I think.

With any mining commodity, price declines normally end only when the highest-cost firms have to pay more to produce the commodity than they can sell it for.   Even then, if a production process is hard to restart or if the producers fear losing skilled workers permanently if they shut down, production often continues for a period even though cash flow is negative.

Petroleum has been an exception to this rule.  Oil had a period in the early 1980s when Saudi Arabia reduced its oil production dramatically in a vain bid to stabilize prices.  But its efforts were undone by other members of OPEC who agreed to cut production, too, but upped it instead to fill the vpoid left by Saudi cutbacks.  It took Saudi resumption of production and a consequent plunge in prices for the others to fall into line.  This time around Saudi Arabia has made it clear it won’t repeat its production-cutting mistake.

If cartel action won’t stop the current oil price decline, then we’re left with normal commodity forces to do the job.  The most likely production to shut down for cost reasons is output generated through hydraulic fracturing in North Dakota and Texas.  Estimates of cash production costs for fracked wells ranges from $40 – $60 a barrel.  In theory, therefore, production won’t be taken off the market until prices reach $60.  Even at that level, however, only a small amount of output will probably be lost–not enough for price stabilization.

One wild card:  bank loans.  Typically, smaller oil exploration companies of the type that have been successful with fracking try to boost their returns or speed their expansion by leveraging themselves financially.   Except in times of speculative excess, bank loans.to exploration companies contain restrictive covenants.  These normally mandate that the explorer must maintain reserves with a value of, say, 3x the amount of the loan.  If the value of reserves falls below a certain minimum, say 2x the value of the loan, the borrower is required to devote most or all of its cash flow to repaying its borrowings.  In other words, it can no longer pay a dividend to shareholders nor can it spend money on new drilling.  This last is potentially a big issue for frackers, whose wells tend to have relatively short productive lives.

My guess is that borrowings of the type I’ve just described will ultimately be the reason the oil price ultimately stabilizes, by halting the growth of fracking.  Two ways to gauge whether this is happening:  dividend cuts, and reductions in the number of new wells started.

yesterday’s OPEC meeting: no production cuts = oil below $70 a barrel

November 28, 2014 By in Current Market Thoughts, Energy, Industry Analysis Tags: , , , , , , Leave a comment

Yesterday’s OPEC meeting ended without an agreement to withdraw output from the market in an attempt to halt the recent sharp crude oil price decline.  This should have come as no surprise   …but it did, at least in the sense that oil prices–and oil-related stock quotes–fell further on the announcement.

In its earliest days, OPEC was badly understood by large oil-consuming countries.  It had greater solidarity than the garden-variety economic cartel because it was at heart a political–not an economic–entity.  It’s main goal was to end exploitation of producing countries by the big international oils, which made gigantic profits while paying the producers a pittance for their crude.

But even in those heady days for OPEC, there were significant divisions within the group.  Members who had small reserves and pressing government fiscal problems wanted the highest possible current prices.  In contrast, others, like Saudi Arabia, with long-lived reserves and better government finances, wanted to keep prices low so consumers wouldn’t start to seek out petroleum substitutes.  Often the result of these divisions was leaky agreements violated by smaller countries and made to work chiefly through greater-than-promised cutbacks by Saudi Arabia.

Today, there are many more non-OPEC oil producers, like Russia, Brazil or the US.  It’s also a generation since OPEC broke the dominating power of the big oils–plenty of time for institutional memory of past oppression to fade.  In addition, Saudi Arabia must know that the burden of enforcing any agreement would fall disproportionately on it.

Letting prices fall to the point where high-cost producers are forced out of the market is the only way any commodity prices stabilize, in my view.  In the case of oil, as far as I can see we’re nowhere near that point.

What I find odd is the negative commodities and stock market reaction.

(By the way, duinr the oil shocks of the 1970s, the US was the only developed country to fail to increase taxes on oil in order to discourage profligate consumption.  We chose instead to continue to protect a dysfunctional auto manufacturing industry.  If I’m correct about lower prices, we’ll have a chance to correct that error  Let’s hope we take it.)