Category Archives: Energy

which is the better question: where is the oil price floor or where is the ceiling?

February 19, 2015 By in Current Market Thoughts, Energy, Industry Analysis, shale oil Tags: , , , , , , Leave a comment

I read sports for a radio station for the blind each Thursday.  I was listening, as usual, to Bloomberg radio in my car while on the way.  I caught the tail end of a conversation in which a guest was apparently trying to explain the difference between a copper mine (a multi-billion dollar, multi-year project) and a shale oil well ( up and drilling for cheap in a month or two).  This came as a revelation to the show’s hosts.  Part was probably showmanship, but it also underlined to me how little knowledge about mining and basic materials industries survives on Wall Street.

A basic rule of any commodities business (regular readers will know I spent six years as an oil and mining analyst and another couple managing money in stock markets with large commodity exposure) is that in times of oversupply the price only stabilizes when it falls (and remains) below the out-of-pocket costs of the most expensive producers.  The bottoming process may take a surprisingly long time.  That’s because producers may choose to operate at a loss for a while, if the costs of starting up again are high (think:  blast furnace steel) and the oversupply is perceived to be temporary.

–In the case of oil, Saudi Arabia is doing all it can to convince the world that the oversupply is not temporary.  That’s one worry out of the way.

–The consensus belief is that the floor is around $40.

Presumably this information is being factored into today’s stock prices.  Therefore, it isn’t so interesting.

the ceiling

The better question, I think, is how high the oil price might go once high-cost supply has left the market.

base metals

For a base metals mining project, reassembling a crew + machinery to restart a shuttered mine is expensive and may take half a year.  And certainly no one is going to begin to develop a new mine until price visibility is very high.

shale oil

For shale oil, on the other hand, startup might only require a handful of people and maybe a month.  In addition, if I thought I could get, say, $70 a barrel for my oil a year or two down the road instead of $45 today, I’d deliberately pull at least some of my wells out of production and wait–assuming I had my debt repayments under control.  For that portion of my output, I’d be ready to turn the spigot instantly.

I don’t know exactly what price level triggers a return of shale oil to the market, creating potential oversupply again.  But production will return very quickly.

The trigger is clearly not as high as $100.  If I were analyzing oil companies for their rebound potential, I’d hope for $70 but base my figures on $60.  The analysis itself would tell me whether $60 is high enough.

My general conclusion, though, is that oil isn’t going back to the levels of a year ago for a long time.

an aside

The best petroleum economists in the world are in OPEC.  It’s impossible that Saudi Arabia doesn’t know with much greater precision what I’ve been writing about.  Why should it be talking of oil at $100 or $200 in the near future?

Maybe for public consumption at home.  A more devious mind would suggest it’s to persuade lawmakers in the US, the most profligate user of oil, not to take the sensible course of raising gasoline taxes and thereby tempering future demand increases.  The country’s lobbyists are doubtless hard at work in Washington, as well.

sorting out oil-related stocks

February 9, 2015 By in Energy, Industry Analysis, Mining, offshore contract drilling, oil and natural gas, Refining, shale oil, shale oil and gas Tags: , , , , , 1 Comment

The very large drop in oil prices over the past eight months has had negative effects on all oil-related firms.  The amount of suffering varies considerably, however, based on how a given firm is involved in the hydrocarbon business.  Here’s my take on the various sub-industries:

1.  oilfield services companies.   It’s a general rule in business that when a manufacturer slows down, its suppliers feel more pain than the manufacturer itself.  This is true in the oilfields, as well.

–Lower output prices mean some new drilling projects are cancelled.  This is bad for the contract drillers who supply and operate the rigs that do the actual drilling.  Offshore, where projects are typically larger and more expensive–therefore riskier, is a worse place to be than onshore.  Worst hit of all are the suppliers of the oilfield services firms, like the companies that manufacture new drilling rigs.

–Suppliers of goods and services, from seismic analyses of prospective acreage to drilling mud, are hurt as well.  Being in support for development of existing projects is better than being involved in new exploration.

2.  high-cost alternatives   …like liquefied natural gas (LNG) or tar sands.  Projects may no longer be economically viable.  I think LNG is more at risk.  Transporting natural gas from, say, the US to the EU or from Australia to Japan requires a multi-billion dollar investment in plant and equipment to liquefy and ship the gas to market (the alternative would be an underwater pipeline).  Because of this, I think new projects are non-starters in today’s world.  As for projects already up and running, we have no way of knowing how contracts are structured–that is, how the selling price of the gas is affected by the oil price drop.  This determines whether the pain of the oil price decline is borne by the LLNG project or by the utility customers who ultimately use the gas.

The situation for green alternatives, like solar and wind, is less clear.

3.  reserve valuations     The asset value of any oil exploration/production company depends heavily on the size and value of its oil reserves.  The lower oil price clearly hurts the value of reserves.  What’s less obvious is that reserves are defined as barrels of oil that can be brought to the surface and sold at a profit at the current price.  Some barrels that are economically viable at $100 a barrel may not be at $50.  If so, the size of reserves will also shrink.  In an extreme case, a company with a million barrels of reserves worth $50 million at an oil price of $100 might have 0 barrels worth $0 at a $50 oil price.

4.   US-based exploration companies     Smaller firms have been the leaders in shale oil production.  Generally speaking, they are hurt worse  by shrinkage in cash flow and downward revisions in reserve value than the big international firms.  To the extent they’ve borrowed to finance drilling, their problems may be magnified.  As a practical matter, however, there’s probably less scope for creditors to take action against a firm if it has issued junk bonds than if it has bank loans.

5.  international majors    The profits of these firms are more insulated against the price drop than their smaller rivals.  How so?

–They have petrochemicals and refining/marketing businesses that benefit from the lower price because they’re users of crude oil.

–They have fields they own that may have been operating for decades, and which therefore are still profitable at today’s prices.

–Also, in their deals to develop fields with national oil companies in foreign countries, they typically are paid a return on invested capital.  In other words, they don’t gain or lose much (if anything) as the oil price rises and falls.

No, they don’t escape unscathed.  They do lose from the lower price they get from production they own in the US and Europe, but their losses are much less than the pure domestic exploration and production companies.

6.   I haven’t looked at refining and marketing companies.  I assume that they aren’t fully passing along to their customers the benefits of lower crude oil costs, but I haven’t checked.

Of course, if/when the oil price begins to rise again (I don’t expect that to be any time soon), the most responsive stocks will likely be those of the oilfield services firms, with those of the international majors moving the least.

effects of lower oil prices

February 5, 2015 By in Energy, Industry Analysis, Mining, oil and natural gas, shale oil, shale oil and gas, Strategy Tags: , , , , , , , 2 Comments

At $50 a barrel oil vs. $100 a barrel:

1.  High-cost alternatives hydrocarbon like liquefied natural gas (LNG), where projects require billions of dollars in spending on infrastructure–cryogenics at the wellhead, special refrigerator ships for transport–become much less compelling.  Tar sands, too.

2.  Green energy substitutes like wind and solar, which already require heavy government subsidy to encourage adoption, are less attractive, as well

3.  The real asset value of oil companies is in their proved reserves.  A lower price hurts this value in two ways.  The first is the obvious one, that the selling price of output is lower.  But there is a second.  In order to be counted as reserves, barrels of oil must be economically recoverable at present prices.  So quantities may shrink, too, as the price declines.  One can imagine, say, a tar sands company that has one hundred million barrels of reserves worth $20 billion at a $100/bbl price   …but 0 barrels worth $0 at a $40 price.

4.  The natural gas price in the US has fallen, but not by a much as oil.  This puts US petrochemical plants, which use natural gas as a raw material, at a relative disadvantage vs. their European and Asian counterparts that use naphtha, a petroleum product.  In absolute terms, the US companies are still in better shape, but to the extent that their historical price advantage has long ago been factored into stock prices, their equities have been relative underperformers.

5.  I spent six years as an oil analyst, covering both the big internationals and domestic explorers, and another while managing an Australian portfolio at a time when over half the market consisted of natural resources stocks.

Admittedly, my expertise is dated.  Nevertheless, some things don’t change.  Hearing and reading Wall Street “experts” on oil publicizing their opinions, I’m struck by how much loss of basic knowledge about the oil industry there has been within the investment community over the years.  This really shouldn’t be so surprising.  I’ve seen the same phenomenon in the mining industry.  In both cases, there have been very long stretches of time when the relevant stocks have been dormant and, consequently, it has been very hard for a sector specialist to make a living selling his analysis.

More on industry sub-sectors tomorrow.

 

oil: how the price dynamic has changed

February 4, 2015 By in Current Market Thoughts, Energy, Industry Analysis, oil and natural gas, shale oil, Strategy Tags: , , , , , , , Leave a comment

Value Line vs. O”Neil

My first Wall Street job was with Value Line, a firm which has seen better days but which dominated the retail market for investment information in the 1970s – 1980s.  It still publishes the Value Line Investment Survey, a newsprint weekly that over a 13-week cycle provides historical data, analyst commentary (generally not good nowadays) and a computer-generated comparison of relative investment attractiveness (based on PE and earnings growth) for a universe of around 1800 stocks.  As I recall, the Survey cost about $250 a year back then and had about 80,000 subscribers.

Analysts and portfolio managers who worked for the company couldn’t understand why the price was so low.  We all thought the publication should sell for at least double the going price.  Since the main costs of publication were for printing and postage (sadly, not for salaries), the company could triple or quadruple its profits by charging $500.  The publication was surely worth it.  Yet the firm’s owner adamantly refused to budge.  A real head scratcher.

Then we found out why.

A rival emerged in the form of William O’Neil and Company, a suppliers of very detailed price charts and other technical information to individuals and institutions. O’Neil launched a chart-based weekly service covering the same universe of stocks, cpriced at $125 a year.  No analysis, but similar historical data, loads of technical information and highly detailed charts that put Value Line’s to shame.

The publication lasted about a year and then folded (I Googled O’Neil just before writing this.  The firm appears to have revived the idea and to now be selling a similar service.  I didn’t investigate, though.)

Why?

I remember figuring at the time that O’Neil needed at least 5,000 subscribers to be cash flow positive (this was a long time ago, so my numbers may be way off.  Their accuracy isn’t necessary for my point, though.).  If it got there, it could gradually add features and increase marketing   …and start to grow itself into a serious competitor to Value Line.  O’Neil couldn’t get north of 2,000 with its service, however, and quickly got tired of bleeding red ink.

Suppose the VLIS had been priced at $500 instead of $250?  O’Neil could have priced his service at, say, $250   …or even $350 and still offered a generous discount.  At 2,000 subscribers he would have been in the black–and growing into an increasingly sharp thorn in Value Line’s side.

The clear economic response to this development would have been for VL to cut its price to $250 to make O’Neil unviable.  But that would have been psychologically very hard to do.  It would have created internal morale problems as belt-tightening took hold.   And it might also draw the attention of the Justice Department.  Waiting two or three years, hoping (in vain) for the competitive dynamic to change, would only compound the problem.

pricing umbrella

That was my introduction to the concept of a pricing umbrella, the idea that high margins creates a fertile, sheltered environment in which competition can grow.

why it’s bad

Two negative consequences:

–competition can gain critical mass, and

–even if it can’t, if newcomers have made significant capital investment they will continue to operate–at a loss–to extract whatever cash they can from their failing businesses.

OPEC’s umbrella

More or less, this is the messy situation that OPEC has created in the oil market.

Under the protection of a $100 a barrel price, unconventional, technology-based competitors have emerged, mostly in the US so far.  This happened about half a decade ago.  The newcomers were initially able to extract oil profitably at $80 a barrel (as opposed to less than $10 for Saudi Arabia).  But they’ve improved their techniques to the point that many can make money at $40.

results of the oil price halving

In the near term, highly financially leveraged high-cost oil producers will be forced by their creditors to stop spending on new projects.  They will continue to produce from existing wells until they run dry, however.  It’s just that all their cash flow will be devoted to repaying debt.

The long-term problem for OPEC is that the new technology–whose development high prices stimulated–won’t go away.  As/when prices rebound to, say, $60 a barrel, hydraulic fracturing will begin to expand aggressively again.  I think shale oil output will rise relatively quickly, as solvent oil development firms take over in-the-ground infrastructure left idle by their bankrupt brethren.

At some point, the oil price will bottom.  I don’t know whether that point is now or not, but I’ve been thinking that something like $40 a barrel will be the floor.  On the other hand, I don’t see the market returning to the status quo ante within any reasonable amount of time.

How this affects oil stocks tomorrow.

the view from Canada

January 22, 2015 By in Current Market Thoughts, Energy, Industry Analysis, Mining, oil and natural gas, Strategy Tags: , , , , Leave a comment

Yesterday the Governor of the Bank of Canada, that country’s central bank, announced it was lowering short-term interest rates from 1% to .75% as an “insurance” measure to help the Canadian economy adjust to lower oil and gas prices.  The move doesn’t come as a huge surprise, given that the oil and gas industry is close to 10% of the Canadian economy and has been accounting for about a third of its GDP growth.

In the words of Governor Stephen Poloz, “The drop in oil prices is unambiguously negative for the Canadian economy.  Canada’s income from oil exports will be reduced, and investment and employment in the energy sector are already being cut.”

To me, more interesting is the bank’s quarterly Monetary Policy Report, released at the same time, which deals with the global effects of lower oil.  It says:

1.  the Bank is assuming the oil price ultimately recovers to US$60 a barrel–no $100 oil anywhere in sight

2.  Canada gradually shifts focus to non-energy industries of the type which have been in decline during the energy boom years

3.  the net effect on world GDP growth of the oil price fall is zero, both in 2015 and 2016.  On an area by area basis, however:

–the US is a net winner.  It grows at a real rate of  +3.2% in 2015 (rather than the previously projected +2.9%) and +2.8% )+2.7%) in 2016

–China is, too.  It expands at +7.2% (+7.0%) and +7.0% (+6.9%)

–the EU, as well.  It advances at +0.9% (+0.8%) and +1.2% (+1.0%)

–Japan is up by +0.6% (+0.7%) and +1.6% (+0.8%)

–the rest of the world is a mild net loser, growing at +3.1% (+3.2%) in 2015 and reounding to +3.4% (+3.4%) the following year.

In the last category, Canada grows at +2.1% (+2.4%) this year before rebounding in mid-2015.