energy: oil

history

–oil began replacing coal as fuel of choice in the early 20th century, but that loss was mostly offset by substitution of coal for wood, until…

…at the end of WWII, Saudi Arabia, having lost its primary source of revenue, Hajj pilgrims, in the prior decade-plus, opened its oil deposits to foreign development.  

–Third-world producing countries formed OPEC in 1960 as a political organization to battle exploitation by oil-consuming countries.  In the 1970s, OPEC “shocked” the world by raising the price of crude oil in two stages from $1 barrel to $7.  In the panic that ensued after the second increase the price spiked to over $30 before collapsing and staying low for years.

–During the 1970s oil crisis, every major consuming nation other than the US acted decisively to decrease dependence on oil.  If anything, the US did the opposite.  One result of our misguided policy (to protect domestic auto firms) has been that although the US represents 6% of the world’s population it consumes 20% of global oil output.  Another, despite this + trade protection of domestic carmakers, has been loss of half the domestic auto market to better-made, more fuel-efficient imports.  (In most cases this is what happens–protection weakens the protected sector.)

supply/demand

price dynamics

Pre-pandemic, the world was producing about 100 million barrels of oil daily.  It consumed about the same.  Oil supply is relatively inflexible.  In over-simple terms, once a large underground pool of oil start to flow toward a well, it’s difficult to stop without harming its ability to start up again.  Because of this, even small supply excesses and shortfalls can induce sharp price changes.

supply

The biggest oil producers are:

US          19.5 million barrels/day (includes natural gas liquids.  crude alone = 12.7 million)

Saudi Arabia          12 million

Russia          11.5 million

Canada, China, UAE, Iraq, Iran      each 4 – 5 million

demand

The biggest oil consuming countries are:

US          20 million barrels/day

EU          15 million

China          13.5 million

India, Japan, Russia      each about 4 million

my stab at production costs (which is at least directionally correct)

Saudi Arabia        less than $5/barrel

Russia          $30/barrel

US fracking          $40/barrel

where we stand toady

The coronavirus outbreak appears to have reduced world oil demand by about 15 million barrels a day.  Enough surplus oil is building up that global storage capacity will soon be completely full.  Also, a spat broke out between Saudi Arabia and Russia over production cutbacks to support prices.  When the two couldn’t agree, the Saudis began to dump extra oil on the market.

West Texas Intermediate, which closed last year just above $60 a barrel, plunged to just above $20 a barrel in late March.  It goes for about $24 as I’m writing this late Sunday night, despite Moscow and Riyadh seemingly paving patched up their differences last week and agreeing to cut their output by 10 million barrels between them.  The market was not impresses, as the Friday WTI quote shows.

fracking

The US is in a peculiar position:

–the administration in Washington appears to have two conflicting energy goals:  to keep use of fossil fuels as high as possible; and to keep the world oil price high enough to make fracking profitable.  The first argues for lower prices, the second for higher.

–according to the Energy Information Administration, fracking accounted for 7.7 million barrels of daily crude oil liftings in the US last year, or 63% of the national crude total.   If the cost numbers above are anywhere near accurate, domestic frackers are in deep trouble at today’s oil price  

This doesn’t mean production will come to a screeching halt. 

The industry has two problems:  excessive debt and high total costs.  According to the Wall Street Journal, Whiting Petroleum, a fracker who recently declared bankruptcy, prepared for pulling the plug by drawing its full $600 million credit line, swapping stock in the reorganized company to retire $2 billion in junk bonds and paying top executives a total of $14.5 million.  That solves problem number one. 

As to number two, total costs break out into capital costs (leases, drilling…) and operating costs.  I have no idea what the split is for Whiting and I have no interest in trying to figure it out.  My guess is that the company can generate positive cash flow even at today’s prices.  Almost certainly the reorganized company can.  It may choose to shut its existing wells in the hope of higher prices down the road.  But it could equally well opt to continue to operate just to keep experienced crews together.  However, new field development is likely off the table for now.

my take

When I was an oil analyst almost (gulp!) a generation ago, the ground level misunderstanding the investment world had about OPEC was the belief that it was an economic organization, a cartel, not the political entity that it actually was.  The difference?–economic cartels invariably fail as members cheat on quotas; political groups have much more solidarity.  Today’s OPEC, I think, is much more an economic cartel than previously.  In other words, it can no longer control prices.  And despite the fact that Putin and MSB have extraordinary sway over the administration in Washington, my guess is this won’t help, either.

There’s some risk that investing in oil today is like investing in firewood in 1900 or coal in 1960.

Despite this, for experts in smaller US oil exploration companies, I think there will be a lot of money to be made after a possible wave of bankruptcies has crested.  Personally, I’d rather be making videos.

 

 

 

 

 

 

 

 

more oil production cuts announced

the news

Over the weekend, a group of non-OPEC oil producing countries, including Russia and Mexico, announced they will pare their collective crude oil output by 500,000 daily barrels.  About 60% of the total reduction will come from Russia.

On hearing that, Saudi Arabia said it would reduce its liftings by more than its already-promised 486,000 daily barrels.  The kingdom didn’t specify an amount, however–and the wording of its statement suggests the number will be small.

Nevertheless, the combined declarations have been enough to raise the price of oil in commodity trading by about 5% today, and 10% in total.

To put these figures into perspective, world crude production is around 98 million barrels per day.  So we’re talking about less than a 2% reduction in total output.

for oil producing countries

In one sense, the agreements have already been a financial success for the countries involved.  For most, they’ll reduce future output by, say, 2% and are already receiving 10% more for the 98% they are still selling.  That combination brings in 8% more dollars.

On the other hand, a $50+ price per barrel gives new life to shale oil producers in the US.  All to that that a fracking-friendly administration in Washington and the likelihood is that crude oil output from the US will begin to rise rapidly next year, offsetting at least some of the near-term output reductions now being achieved.

for investors

For us the situation is not so clear.

–Oil exploration and development companies in the US have already risen substantially on the original OPEC cutback announcement

–We’re also only about six weeks away from the beginning of the seasonally weakest part of the year for oil.  Crude oil bought in late January can’t be refined into heating oil and delivered to retail customers before the winter is over.  The driving season doesn’t begin in earnest until April.  So demand for the two principal refined products will be at a low ebb from January – March.  Soft demand usually translates into weaker crude prices.

–At some point, we’ll begin to see US crude output pickup

–The promised output cuts won’t take effect until the new year, so it’s impossible to find countries cheating on their output reduction pledges today.  The history of all commodity cartels tells us, however, that cheating will happen.  And if past is prologue, evidence of cheating will trigger a substantial price decline.

So we can reasonably expect a substantial bump in the crude-can-only-go-up-from-here road shortly.

Although I’m not doing anything at the moment, my reaction to all this is that I’m closer to being a seller of oil exploration firms than a buyer.  If I had a relatively large position (I don’t.  I only own one e&p stock), I’d be trimming it today, with an eye to possibly buying back in late January.

 

 

 

 

yesterday’s report on US crude oil supplies

the EIA

Each week the Energy Information Administration (EIA), an independent statistical agency in the Energy Department that collects, analyzes and publishes extensive amounts of energy data, releases a report on US inventories of crude oil.

background

Over the past quarter-century, the typical US crude oil inventory stock level has been around 325 million barrels (excluding the Strategic Petroleum Reserve of 700- million barrels).  The figure shows some seasonal variation in most years, peaking in late Spring – early Summer and reaching a low point in late Winter.  But these swings have usually been relatively mild.  Before the current period of oversupply, for example, the weekly figure had never come in above 375 million barrels.

Between August 2014 and May 2016, however, the inventory number rose steadily from 331 million barrels to 510 million.  Since then, the figure has been gradually declining.  That, and talk of OPEC members placing a ceiling on the cartel’s overall production, have created the belief among speculators on Wall Street that the worst of the global crude oil oversupply might be behind us.

…until now.

the November 2nd report

The November 2nd EIA report shows crude oil inventories leaping by a huge 14.4 million barrels,to a total of 483 million.  While even the 468 million barrel inventory figure of a week ago is way above normal, the shock  to financial markets is that the change–typically one or two million barrels in either direction in any given week–is so big and that it is in the direction of more oversupply.

Even though one data point doesn’t make a trend, this one appears to have let a lot of air out of the balloon of crude oil bulls.

 

I’m still on the sidelines.  I continue to think we won’t the first clear signal of the state of the crude market until the seasonally slack period in late January – early February.

 

 

 

 

last weekend’s “failed” Doha oil meeting

Representatives from a large group of national oil companies, both Opec and non-Opec, met in Doha last weekend, ostensibly to see if they could mutually agree not to raise their oil production from current levels.

From a practical economic view, the conclave made little sense.  Because all the countries involved are strapped for cash, they’re already producing flat out.  The only exception is Iran, which declined to participate.  It is ramping up its output for the first time in a long while now that sanctions are being lifted, and has no intention of stopping.

 

It was clear from the outset that the best outcome would be an agreement where the parties said they wouldn’t do what they couldn’t do anyway.  So Doha was all about optics, about satisfying internal political demands that the local oil ministries were leaving no stone unturned.  Weird, maybe, but understandable if you’re an oil functionary who wants to keep his job.

Nevertheless, there was an immediate spike down in the oil price when failure to reach agreement was announced.  To my mind this was more traders playing games in the market than an expression of dismay.

More interestingly:

–crude oil prices are higher today than they were before Doha, and

–Brent crude, a proxy for non-US demand for oil (because it can be used in older refineries), is beginning to establish its traditional premium  over West Texas Intermediate.

my thoughts

We passed the seasonal low point for oil demand in mid-February and are entering the strongest seasonal period now.  So it makes some sense that the price should be strengthening.

The Brent premium suggests US drivers aren’t the only ones consuming more oil products.  The lower price may also be stimulating usage in the rest of the OECD, where petroleum taxes are much higher.

The (crazy) period of securities trading where low oil was thought to be a harbinger of recession appears to be behind us.

My guess is that traders will continue to search for a price ceiling, which I think is around $50 a barrel.

I wonder if the major non-government owned oil companies have been holding back production on the idea that prices are too low, thereby, consciously or not, aiding the recovery process.  This wouldn’t be much different from how these firms acted during the period of oil price controls in the US in the 1970s -1980s.

 

 

 

crude oil (ii): what’s happening now

lower oil price+=less new drilling

Sharply lower oil prices have two main effects on the planning of new drilling by oil exploration companies:

–the more obvious is that they are only getting about half as much for the oil they are selling today than from output they sold half a year ago.  If production is constant, their cash flow has been cut in half

–the second is that projects on the drawing board and highly profitable at $100 a barrel may not be moneymakers at $50.

For both these reasons, less cash flow and fewer winning projects, exploration firms are cutting their capital spending budgets for 2015.

also…

–when prices are rising, oil explorer/developers tend to build up large inventories of supplies for “just in case.”  Instead of having, say, a three-month supply of the steel drill pipe that lines the walls of the wells, companies may want six months’ worth.  Now that drilling may only be half the level originally anticipated, a wildcatter could be saddled with what is now a year’s worth of pipe, or 4x what he could carry in normal times.  And he’s looking to save cash.

One of the company’s first calls is to suppliers.  It will want to cancel any outstanding orders–and to see if the supplier will take back some of what the firm already has in inventory.

It’s no surprise, then, that US Steel just announced layoffs at a big steel pipe-making plant.

–In good times, banks are happy to lend.  Wildcatters–natural optimists and not very risk averse–are eager to borrow.

I remember talking in early 1982 with the CFO of a mid-sized oil explorer that a short time later went bankrupt.  He said that over the preceding few years he routinely went to the local bank for drilling loans, which were always promptly approved.  He assumed the bank had done all the analysis needed to determine that the project was sound;  the chief loan officer assumed that because the CFO had an MBA he had done the work.  In reality, no one had.  Whoops.

During the same period, a small Oklahoma bank called Penn Square (located in one tiny office in a strip mall) originated tons of drilling loans, supposedly vetted by expert loan officers and collateralized by oil and gas assets, and sold them on to other Midwestern banks eager to participate in the late-1970s drilling boom.  Turns out no screening was done   …and documents securing the collateral were never signed.

In today’s world, a lot of drilling finance has come through junk bond issuance rather than bank loans.  That may be a plus for the exploration companies, if lenders have done their usual poor job of protecting their own interests through debt covenants.

At any rate, I think the bad debt story for drilling companies has just begun to unfold.

a price turnaround?

At some point–which I don’t think is anywhere close to today–at least a few savvy producers will begin to withhold production from the market.  This will come as/when they think oil is too cheap and likely to rebound in price within a relatively short period of time.

We’ve also already seen American car buyers adjust to lower gasoline prices by starting to favor gas guzzling cars and trucks again.

However, like any other commodity, the bottom for oil will come when the cash flow of the highest-cost firms turns negative and they cease production.   My not-very-well-informed guess is that this is between $40 and $50 a barrel.