$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.

 

 

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.

 

the future of oil mega-projects

My friend Bruce pointed out in a comment last Friday that the shale oil explosion in the US has come very quickly, and as a surprise to most.  Could there be a similar resurgence of the mega-projects that the big international oil companies have typically launched–and are the cause of the huge cost writeoffs they are now making?

My thoughts:

oil

–I assume the current administration in Washington will encourage domestic pipeline construction and reduce/eliminate support for renewables.  This would push further into the future the time when renewables will be price competitive with, and begin to replace, fossil fuels in a widespread way.  At the same time, increased availability of fossil fuels would tend to keep a cap on their price–which pushes the changeover to renewables even further into the future.

–if the chief oil exporting nations think this way (and I believe they do), there won’t be the panicky sense of urgency to produce oil as fast as possible that would prevail if they thought renewables would begin to substitute for fossil fuels in, say, ten years.

–I have friends in the Endless Mountains of Pennsylvania (the Marcellus Shale) who sold the mineral rights to their land to an oil company several years ago.  They tell me there are seven or eight oil- or gas-bearing strata below the one being tapped now.  If this is any indication, profitable shale drilling can go on for much longer than the consensus expects.

–the onshore shale oil/gas wells that smaller independent firms drill tend to use simple equipment, take a short time to get up and running and play out in, say, two years.  If I had to make up an oil price breakeven point for the typical fracked well, I’d say $30 a barrel.

–the offshore megaprojects that the big integrateds specialize in tend to involve very deep wells that take a long time to drill, use quarter-billion dollar+ floating drilling rigs to do so, and which tend to be located in remote, inhospitable, infrastructure-poor areas controlled by potentially unstable governments.  On the other hand, they tend to produce oil/gas for twenty years or more.  Breakeven?  …a gross generalization would be $60 a barrel.

–onshore shale wells in the US tend to cost around $12 million and to produce $35 million in output before they play out.   Fields, say, in deep water offshore Africa or in the Arctic, can require billions of dollars in upfront investment.  In addition, it’s possible that terms will be renegotiated in its favor by the owning government if the wells turn out to be more prolific than expected.  So the risk profile for this type of project is far higher, and the payback period far longer, than from the type of domestic onshore drilling done by independents.  It’s also at best marginally profitable at today’s oil price.  This suggests to me that the big oils will continue to prioritize their lowest risk, but also lowest potential, projects.

–can costs for big integrateds fall from here?  Maybe.  But those for frackers would likely fall in line, too.  And the political risks + the substantial upfront costs caused by challenging physical environments will likely remain for Big Oil projects in spite of future breakthroughs in technology.  So my guess is that the barriers to greenfield mega-projects will remain high.

Of course, neither frackers nor the large integrateds can match the lifting costs for established wells in Saudi Arabia of around $2 a barrel.

Middle East

–Many Middle Eastern oil-producing countries have young, growing populations and economies that are fundamentally dependent on sales of oil.  The government is typically the main employer.  Over the past decade, government spending will typically have expanded in line with oil revenues, to the point where now, with the oil price more than 50% off its highs, substantial government budget deficits are common.  Reorientation of these economies is urgently needed, but is also, like anywhere else, typically opposed by beneficiaries of the status quo.  This is a recipe for political instability.

–the US is likely going to be energy self-sufficient within a few years.   This will lessen the economic motivation for the country to intrude into, ore even maintain an interest in, Middle Eastern politics.  Other motives for doing so will remain, but my guess is that political willingness will wane, as well.

 

 

 

 

 

 

BP Energy Outlook 2016

BP just released its annual Energy Outlook.  

The company is projecting faster development of shale oil, coming mostly over the next few years from the US, than it previously thought.  Renewable energy supply will rise more quickly; (heavily polluting) coal usage will fall faster.  Most of the action will be in developing nations like China and India.  The US will attain energy self-sufficiency in a handful of years, oil self-sufficiency shortly after that.

 

To me, the most interesting topic the release brings up is not actually contained in the report.  It comes from comments by Spencer Dale, BP’s chief economist, during a press conference promoting the new Outlook.

According to the Financial Times, Mr. Dale said that there’s twice as much technically recoverable oil available as the world is expected to need between now and 2050.”

First, “technically recoverable” means only that all of this oil can be extracted from the ground using current oilfield methods.  It does not mean it can be done profitably.  In fact, the choice of the word “technically” suggests BP believes that a significant portion is uneconomical at today’s prices.

Second, according to BP, much of this oil is unlikely to see the light of day…ever.    That’s because global demand for energy is likely to grow by less than 2% yearly.  Most of that will be supplied by renewables and natural gas; oil demand increases by less than 1% annually.

At some point, as the price of renewable energy continues to fall, and absent a decline in the oil price, demand for oil begins to shrink.   Since one might imagine that this drop might not take place thirty years, it may be of little practical concern to you and me.  However, for OPEC countries like Saudi Arabia, which holds perhaps 100 years worth of economically viable oil, and whose economy is radically dependent on petroleum, this is a significant worry.

Investment implications (assuming BP is correct):

–the oil price is unlikely to go up

–OPEC + shale oil will squeeze out higher cost oil production from the rest of the world

–future shale oil company profits will come as much from lowering production costs as from new finds

–big oil firms probably still have plenty of stranded assets (meaning oilfield investments that have become uneconomical and where recovery of the money already spent is unlikely) on their balance sheets.

 

 

 

 

firming oil prices: seasonal strength or something more?

September through mid-January is the period of greatest seasonal strength in oil prices.  Early in this period, refineries shift from making gasoline to supply drivers to manufacturing heating oil in advance of winter in the northern hemisphere.  There’s normally some friction in the supply chain as this takes place.  But the key reason for current oil price strength, I think, is the typical behavior of wholesalers, retailers and end users accumulating supplies of heating oil for winter use as autumn commences.

This period of strength usually ends in late January–after which there’s be no time to get newly-refined heating fuel to users before the weather warms.

What follows from February through April is the period of greatest seasonal weakness for oil.

 

What to make of current firmness in crude.  Is there any evidence that the proposed OPEC production limiting agreement is exerting upward pressure on the price?

My private hunch is that, yes, there is.  At the same time, I also think there will be little lasting (meaning over six months or a year) collective discipline to keep to promised quotas once they’re seen to be having an effect.  Budget deficits are too large and the third world us-against-them cohesiveness that enabled OPEC’s remarkable past cartel success is no longer present.

 

Still, I think that prices will be strong seasonally for a while in any event, so there’s no need to have a view on whether a production agreement will stick.  That time will come early in the new year.

At that point, for 2017 investment success, having a (correct) opinion about oil will be crucial, I think.  I’m hoping–and anticipating–that I’ll be able to make that decision on other grounds, i.e., the innate cheapness (or not) of shale-related exploration stocks, even without price increases.  In the meantime, I’m content to be on the sidelines.