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.


–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.



Shaping a portfolio for 2015 (ii): energy

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.