Shaping a Portfolio for 2016: a data dump on oil

This time last year I was embarrassingly silent about oil, which I considered to have poor prospects–and still do.  So naturally I’m going to go overboard in the other direction now.

If there’s a method to my madness, it’s that  an interesting buying opportunity may emerge at some point during next year.  Especially so, if the current imbalance between supply and demand causes the price to fall significantly again.  That could happen as early as 1Q16.

seasonality

Because many large oilfields are multi-decade projects that depend on a steady flow of output to the surface to maximize recovery of the underground oil, and because producers need the money to fund national spending or (in the case of small wildcatters) to service debt, the supply of oil into the market is relatively steady.

Not so demand.  We’re now in the high season for buyers, as the winter heating season in the northern hemisphere unfolds.  Late January through March are the lowest points of the year for demand.  Heating fuel has already been delivered to customers and driving is in its winter lull.  From April on, demand beings to build into the summer.  It plateaus from there until autumn heating demand causes the price to reach its yearly high point.

In a normal year, the oil price should be rising today.  But it’s falling instead–suggesting that the market could get ugly once the peak heating oil season is over.

arbitrage

What happens to the excess oil that’s now being produced?  It’s bought by arbitrageurs who store the stuff for future sale, while simultaneously entering into futures contracts to lock in a price.  The trouble is that, although no one has good numbers, global onshore storage appears to be getting close to being completely full.

There’s lots of offshore storage available–in oil tankers–but current rental rates imply crude would have to fall by $5 – $10 a barrel to make arbitrage trades economic.

the slow convergence of supply and demand

Ignoring seasonality, there’s probably on average 2 million barrels of excess crude oil now being produced each day.  That may rise by another 500,000 – 1,000,000 once Iranian sanctions are lifted next year.  Then there’s the temptation for government-owned producers to put a little extra on the market to help close the national budget deficit.  And there’s the creditor pressure on independent producers to continue to service their debt.

Demand is probably rising by about 1.2 million daily barrels annually.  The gradual removal of supply by high-cost producers is shrinking supply by maybe 500,000 – 1,000,000 daily barrels a year.  This would imply that we’d come back into supply-demand balance at the end of next year or in 2017.  Given all the moving parts–especially seasonality and Iran–it’s possible that there’ll be another price spike downward before we come back into equilibrium.  That’s where the buying opportunity thing comes in.

sensitivity to oil price changes

from low to high…

big international integrateds

smaller independent explorers

service companies–development and maintenance

service companies–new drilling

service companies–new drilling, offshore or hostile environments

Refiners don’t fit on this table.  They’re currently enjoying a field day because they’re not passing on all of the benefit of lower input prices to customers.  There are also non-energy companies, like steel producers, who may have important subsidiaries that make oilfield tools and supplies.

Two other important notes:

–integrateds aren’t quite in the favorable defensive positions that my table would imply.  That’s because for years they’ve been devoting large chunks of their massive cash flows to developing gigantic high-cost oil projects that may no longer have any economic justification

–some independents have enormous debt burdens.  While the most speculative may arguably have the highest return potential during a future selloff, that’s no good if they go into Chapter 11 before that potential can be realized.

 

 

nearing crunch time for the oil price

recap

By allowing/encouraging the oil price to stay over $100 a barrel, OPEC unwittingly created a pricing umbrella that spawned a significant new, relatively high cost, shale oil industry in the US that, at its peak last year, was pumping an extra 5 million barrels of crude a day onto the world market.  At that point, world supply rose above demand, with the natural consequence that prices began to fall.

The OPEC response ot lower prices has been to increase its production, with the intention of spurring new demand and of forcing shale oil producers out of business.  Since for most OPEC countries, oil is the principal source of GDP and of hard currency, more barrels out the door also eased revenue shortfalls somewhat.  Nevertheless, OPEC is generally experiencing a significant cash squeeze.

The plan has worked, to some degree.  American consumers have lost their taste for compact cars and are buying gas-guzzling trucks in huge numbers.  Shale oil production is gradually fading.  Overall world demand continues to rise at 1.5+ million barrels per day.

where we stand now

The excess of supply over demand is still about two million barrels per day, according to the International Energy Agency, (whose latest monthly report can be found in financial newspapaers).

The end to economic sanctions on Iran is likely to free 500,000 barrels of Persian oil for sale sometime next year, however–and that figure might be as high as a million.  And China has been using the fall in prices to increase its strategic petroleum reserve.  Some reports say that this process is close to an end.

storage is a key 

The most important near-term factor to watch, in my view, is overall world inventories–which are at extremely high levels.

Petroleum storage is of two types:

–storage of crude, normally in tank farms, but also in rented oil tankers

–refined products storage, both in tank farms owned by refiners and (the thing we know least about) in customers’ hands–from industry to the gas tanks in individuals’ automobiles.

We do know that crude tank farms in Asia and Europe are full, and that refiners’ output storage tanks are bursting at the seams.  In addition, the cost of renting a crude oil tanker to store barrels for future delivery is now higher than the profit an arbitrageur would make by buying oil now and entering a futures contract for later delivery.

On top of all that, warm weather has meant that the usual seasonal buying surge for heating oil has not yet happened.

to summarize

At the current rate of adjustment, oil supply and demand may not come into balance until late 2016–and maybe early 2017.

The world is running out of places to stash the extra crude.  The globe already appears to have run out of places to do so at a profit.

Therefore, it’s possible that, at the very least, the oil price will decline again–even in a period of seasonal strength like the present–to a level where the arbitrage of buying now and storing for future delivery makes money.  But when stuff like this happens, the world is rarely rational.  The Goldman scenario in which the crude price falls to $20 no longer seems like a footnote.  It’s something that has–I don’t know–say, a one in three chance of occurring.

If that happens, I think it would be a great chance to sift through the rubble for medium-sized US shale oil firms that will survive until better days arrive in maybe 18 months.

 

 

sorting out oil-related stocks

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.

lower oil prices: stock market implications

falling crude oil prices

It late February, the West Texas Intermediate oil price was $110 a barrel.  Now it’s $80.

North Sea Brent crude, which is much easier to refine and therefore sells at a premium, was at $120 four months ago.  Now it’s at $92.

That’s a price drop of around 25%, even though June is seasonally stronger period for demand than late winter.

That’s good news for consumers, especially in the US.

Here’s why.

a thumbnail sketch of the oil market

Petroleum is a peculiar commodity, for several reasons:

–huge size.   The world uses around 80 million barrels daily.  At the current $80 each, that’s $6.4 billion a day in value, or $2.3 trillion a year.

–disproportionately large consumption by the US.  The US makes up about 4.5% of the world’s population–but uses over 20% of the global oil output.  How so?  It’s partly because the US is a rich country.  But it’s mostly, in my view, the result of long-standing (and misguided) policy in Washington to subsidize an inefficient domestic auto industry.  (We’re the only industrialized country without an effective energy policy, and we’ve been like this for forty years–but that’s a topic for another day).

–supply is very inflexible.  Most pools of oil are buried under great pressure deep beneath the earth.  Draining these reservoirs without drilling a gazillion wells in each is a complex process that involves starting–and keeping for years and years–a steady flow of crude from all parts of the field toward the surface.  In almost all cases, stopping, or even trying to slow down, the flow can be disastrous.

As a result, when demand slows, as it is now, the only way producers can sell their surplus output is to lower the price–sometimes by a lot.

implications of falling prices

There are two major ones for stocks:

1.  Most oil (and natural gas) companies make the bulk of their money from developing oilfields and selling the output.  Lower prices translate directly into lower profits.  There may be different shades of bad, depending on whether the producers own the oilfields outright or have production-sharing agreements with third parties.  But it’s not good.

The one exception is companies that whose business is completely “downstream, ” that is, who refine and sell petroleum products, especially gasoline.  They’re buyers of crude oil, so their margins may expand as prices fall.  Ultimately, though, competition forces them to pass on almost all their lower costs to customers.

2.  Falling oil prices are a boon for consumers, particularly in the US.  Sustained over a year, a $30 per barrel reduction in the oil price means an extra $1,700 in spendable income for the typical US household.  That’s the equivalent of a 6%-7% pay raise.

think modest

That’s not enough for the Porsche or the Tiffany tiara you’ve been eyeing.  And the extra income won’t be particularly noticeable to the affluent.  But it will be an important boost, I think, to the everyday buying of ordinary Americans.  So Wal-Mart and Disney (I own DIS) should benefit.  Generally speaking, average citizens should continue to feel better about their economic circumstances, even as the economy shifts into a lower gear (is there one?) and job growth slows.  So retailers who sell low-ticket items should have the wind at their backs.

why are the Saudis raising oil output?

Saudi Arabia to the rescue

Saudi Arabia announced recently that it is upping the amount of oil it produces.  It’s doing so to replace the portion of Libya’s normal output of 1.6 million barrels a day being lost during the current political struggle there.  The Saudis will doubtless be joined by other OPEC nations who will increase their production as well, although these other countries may not choose to identify themselves.

Even assuming the total number of barrels reaching the market is unchanged, the world faces a short-term logistics issue.  The Saudi crude needs more processing than Libyan oil.  It has extra sulfur (corrosive and a pollutant) that needs to be removed, for one thing.  And it contains more large molecules that need to be “cracked,” or broken down chemically to yield higher value-added products like gasoline or jet fuel.  The quality difference is a particular problem for Italy, the traditional buyer much of Libya’s oil.  (Italy seized Libya from Turkey in a war about a century ago and held it as a colony until after World War II.)  The country’s refineries haven’t seen the need to spend money on the expensive equipment required to process lower-quality Saudi crude into stuff customers can use. Nevertheless, they’re under severe political and market pressure to deliver refined products.  The resulting scramble for easy-to-refine crude is one reason the price of high-quality North Sea oil has risen so much.

Provided governments don’t decide to “help” the process along with new regulations, oil companies should readjust the world’s refining and distribution networks to restore the flow of gasoline, naphtha and jet fuel to something akin to the pre-Libyan-revolution normal within a few months.  I think there’s a very good chance of this happening.

why add production?

That doesn’t mean I don’t see a secular upward trend in the price of oil, because I do.  In this post, however, I only want to address the narrow question of why Saudi Arabia is acting to hold down oil prices, even though a $1 a barrel rise in the cost of crude puts an extra $3 billion a year into the royal treasury.

the iron law of macroeconomics: substitutes determine pricing

The answer is pure microeconomics.  Saudi Arabia, like many OPEC countries, has enough oil underground to last for well over fifty years at its current production rate.  It could easily have a hundred years’ worth.

Most of those barrels will only have value if petroleum remains the world’s fuel of choice in 2060…and in 2100.  So Saudi Arabia certainly doesn’t want world governments worrying about the dependability of oil supply and starting programs of serious research on possible replacement fuels.  Nor does it want dramatic real (that is, inflation plus) increases in the price of oil that might cause consumers to start to conserve.  Saudi Arabia doesn’t want to make waves.  It just wants to keep taking its $800 million + check to the bank every day.

conservation potential

Conservation could be a serious threat to OPEC revenues.  Look to the United States, which is the low-hanging fruit in the conservation department.  We have 4% of the world’s population but use about a quarter of the world’s oil (we consume about 3.7 tons of the stuff yearly for each man, woman and child in the country).  We’re the only developed country without a coherent national energy policy.  We’re practically alone in not taxing oil heavily to discourage use.  True, we no longer artificially depress the price of oil as we did in the Seventies.  Nor do we have quotas that limit imports of fuel-efficient cars, as we did in the Eighties.  But that’s not much.  The Saudis have a strong economic interest in us not waking up.

history shows what sharp price increases do

We’ve seen during the oil shocks of the 1970s what happens when oil price skyrocket.  Crude oil prices, which were under $2 a barrel in the 1960s, quadrupled in the early 1970s, declined somewhat and then more than doubled during 1978-80 in the wake of the Iranian revolution.

What followed was a period of global economic stagnation and then–crucially from an oil producer’s point of view–a twenty-year period of oil price decline.  At its nadir, crude had given back in real terms virtually all its gains from the 1970s.  So OPEC had a few years of riches, followed by two decades of budget deficits.

Conditions could actually have been worse for oil producers, had it not been for Saudi Arabia.  Had the Saudis acted unilaterally to temper price increases by adding to output, prices might have otherwise stayed high enough for long enough during the late Seventies-early Eighties to force permanent changes in consumption. Those billions of barrels of oil still in the ground might have become worthless.

As it turned out, however, and especially in the US, governments quickly lost interest in substitute fuels and in conservation measures as oil prices began to slide.

Today, Saudi Arabia is just doing what it has been doing for the past thirty years +, taking the role of the “swing producer” to keep real increases in prices under control.  This behavior may have its altruistic aspects, but, given its vast amounts of untapped oil, Saudi Arabia is clearly acting in its own economic interest.

oil refining basics: why countries like Libya are important to the world economy–plus a thought on the markets

Political upheaval in Libya is causing much more turmoil in world stock markets than the popular overthrow of the government in Egypt–even though Egypt is a much larger country with much more influence in Middle East politics.  The obvious difference between the two is that Libya is an oil producer and Egypt is not.  But when we look at the amount of oil Libya brings to the surface every day, it’s pretty small–1.6 million barrels, or less than 2% of the world’s daily usage.  How can that be so important?

The answer is that a lot depends on two factors:  the kind of oil Libya has (light, sweet crude) and the ability of the world’s processing capacity to turn different types of oil into usable products.

refinery basics

Wikipedia has a chart that diagrams the structure of a typical oil refinery.  It’s complicated.  Luckily, six years as an oil analyst taught me that you don’t need to know all the ins and outs. The Cliffnotes version:

1.  The primary refining process consists in putting the crude oil in a big metal cylinder and boiling it.  Heat causes the crude to break up into three parts:

—the lightest molecules, basically gasoline, that rise to the top of the tube

—medium-weight molecules, jet fuel, diesel fuel, home heating oil, naphtha, that settle in the middle

—the heaviest, industrial boiler fuel or “residual” oil, tar, asphalt and other junk, at the bottom.

The top two parts, or “fractions,” contain most of the value.  The third might be hard to give away.

2.   An increasing proportion of the oil available for refining is what industry jargon calls “sour” instead of “sweet. ”  That is, it contains sulfur, a corrosive element and a pollutant.  So most refineries have expensive desulfurization machinery that remove the sulfur from refined products.

3.  An increasing proportion of the available oil is also “heavy” instead of “light.” That is, it’s rich in bigger molecules and contains few small ones.  Therefore, the primary heating process yields large amounts of the junky stuff at the bottom of the column and very little of the more valuable gasoline and middle distillates.

As a result, most modern refineries also have (again, very expensive) machinery to “crack,” or break up, the large molecules at the bottom of the distilling column into smaller-molecule, more valuable output, like diesel or gasoline.

That’s all you need to know.  Light, sweet crude:  boil it and you’re done.  Heavy, sour crude:  spend billions on a “back end” to your refinery so you can make it into stuff people will buy.  Why do this?  …heavy, sour crude is a lot cheaper.

world refinery capacity:  a mixed bag

Building, or even upgrading, a refinery is a pain in the neck.  It’s a multi-billion dollar, several year project.  It requires educated guesses about what kinds of crude oil, sweet or sour, light or heavy, will be available on the market when the refinery is finished, as well as whether there will be more or less demand from competing refineries for the kinds of crude your plant is optimized for. In addition, in most developed countries, it may be next to impossible to get local government permission for any kind of building.  Do you want a refinery in your back yard?

As a result of all this, there’s still a substantial amount of refining capacity, particularly in Europe, where the owners have opted to do nothing.  So these plants can’t process anything else except the lightest, sweetest crude.

why Libya matters

That’s where Libya comes in.  Yes, Libya is only a small factor in the world oil market (the country may have huge reserves, but that’s irrelevant if they’re not being developed).  And it has a reputation as an unreliable supplier.  But the 1.6 million barrels it churns out is all easy/cheap to refine light, sweet crude that’s rich in the gasoline and diesel fuel that the US and Europe consume.

There may be lots of “extra” crude oil available on the market.  But that’s predominantly heavier and sulfur-laden.  These are only substitutes if the refineries that have contracted for Libyan crude can process these lower grade oils as well.  The frantic bidding we’re seeing in the market for similar light sweet crude argues that they can’t.

The refiners affected are in a no-win situation.  They can scramble to get the crude they need, so they can produce fuel for their retail outlets, in which case they get blamed for higher prices.  Or they can simply shut down until Libyan crude is available again, in which case they’d take the political heat for supply shortages.

In the short term, then, the mismatch between the capabilities of the world’s oil refining plants and the “slate” of crudes available to refiners will translate into higher retail prices.  Because of the unusually pure nature of Libyan crude, withdrawal of even that country’s small contribution to world crude production can cause this.

stock market effects

I don’t have any idea how the Libyan situation will play out politically.  My guess is that virtually none of the “experts” talking or writing about Libya do either.  The least favorable outcome for the world ex Libya would be a years-long cessation of that country’s oil production–sort of a mini-Iraq.  World refined products prices might be, say, 5% higher than they would otherwise be.  Consumers in the US, where taxes on gasoline are very low by world standards, would be disproportionately hurt.

Even in this case, though, I think there are much more powerful currents affecting the US economy–like the pace of recovery, mobile broadband, internet-enabled erosion of brick-and-mortar retailing.  Yes, the US would be hurt, yet again, by Washington’s failure to have a coherent energy policy.  But we deliberately haven’t had one for thirty-five years, so that’s not real news.  And somewhat higher oil prices could get lost in the welter of other, structural things going on.

To my mind, the current downdraft in world stock markets has very little to do with Libya. It has more to do with how high the markets have gone in the past six months.

The S&P 500, for example, has been steadily rising since September and is up by 28% since then.  Time for a correction?

Looking at the market from another perspective, the S&P was up more than 7% year to date as of mid-day last Friday.  Assume we could have closed out the month that way.  If 7% were an average two-month return on stocks, then the yearly return would be 42%–or 4x what history tells us is the norm for stocks.  In year one of a bull market, this might be possible.  But approaching year three?   …no way.

To my mind, Libya is more a trigger than a cause for investors to take profits after this run.  If it hadn’t been Libya, it would have been something else.

One interesting characteristic of world equities over the past few months has been–until this week–the unwillingness of stocks to go down.  I’ve been reading this as being the result of an asset allocation shift to equities and away from cash and bonds.  If so, it will be important to watch for how deep this correction is and how long it goes on. Continuation of flows into stocks would argue that the correction will be shallow and brief.  Looking at the charts, the first line of defense for the S&P is around 1300.

In short, I’m reading this downdraft as a natural part of the two-steps- forward, one-step-back character of equity markets.

Most investors simply don’t look at prices during a period like this.  That’s ok with me.  I’ve always found these times to be good for upgrading your portfolio.  Stocks that have done poorly over the past year probably won’t go down much in a correction (after all, they didn’t go up), while strong-performing stocks can be hurt badly as nervous investors “lock in” profits.  So you may be able to switch to better companies at a 10%-20% cheaper price than you would have been able to last week.  The fewer investors doing this, the better bargains for those who are.