Tag Archives: oil and gas

oil …again

December 18, 2015 By in oil and natural gas, Uncategorized Tags: , , , , 4 Comments

After a long period of the stock market thinking that lower oil prices are a good thing (for all sectors except Energy), the market now appears to have adopted the opposite view.

Over the past short while, when the spot price, a mere shadow of its June 2014 self, moves down, so too does the S&P 500.  Economically sensitive stocks get clunked more than the average equity.   And vice versa.

To me, this seems so obviously wrong   …and yet it’s happening.

This wouldn’t be the first time that the market got a crazy idea into its head and ran with it for a while.  Remember in 2009 when a number of prominent hedge fund managers proclaimed that the Fed’s decision to lower interest rates would quickly cause runaway inflation and that the only protection against this government folly was to stockpile gold?

Here we are six years later, with still no inflation to speak of.  Gold had an amazing two-year run, which had nothing to do with the Fed, and everything to do with demand for the yellow metal in India and China.  The gold price has since lost 40% of its value as new mine supplies have come into the market and as domestic developments in Indian and China have lessened their ardor for money-like stuff they can bury in the backyard.

It’s tempting to think that the reversal of view about oil is only occurring because most big market participants have closed their books for the year and are drinking egg nog on the sidelines.  But I think it’s a dangerous habit to cultivate–the idea that I’m right, the market’s wrong and it will soon come to its senses.  The reality is that I’m wrong maybe 40% of the time.  Also, it could be that soon is the operative word.

At times like this, I go through this mental checklist:

  1.  How dependent is my portfolio on this one idea?  The riskiest situation is one where my holdings end up being an all-or-nothing bet on a falling oil price being good, without my realizing it.
  2. How likely is it that, contrary to my view, the market turns out to be right?
  3. If I wanted to rearrange my holdings to neutralize the effect of lower oil–meaning, in this case, becoming more defensive–how would I do it?  Would these changes make any difference to my performance expectations?  If not, why don’t I make them?
  4. If I were managing professionally, I’d ask if I should do some of this in any event, to guard against falling behind my peers (and ultimately getting fired–even worse, maintaining a portfolio that would pay off spectacularly for my replacement).

Most often, when I go through this process I find something in my portfolio that I don’t like and change it.  Invariably the move improves my performance.  But most often it has nothing to do with my original worry.

As to the market’s current fixation on oil, I have three thoughts:

–for now I’m content with what I hold and hope to ride out the craziness,

–I think this latest market kerfluffle brings us closer to the day when we’ll want to add oil exposure, and

–downward pressure on the market in December will translate into somewhat higher returns in 2016.

 

oil: confusing correlation and causation

December 15, 2015 By in oil and natural gas, shale oil, shale oil and gas, Uncategorized Tags: , Leave a comment

This is about the current state of the oil market.

The fact that two things occur together (correlation) does not always mean that one causes the other.

For example, every morning the rooster crows and the sun comes up.  But killing the rooster won’t plunge the world into eternal darkness.

Birds fly south and winter begins: birds fly north and winter ends.  Same story.

 

Some commentators are arguing that the sharp decline in the price of oil is a harbinger of recession, using the argument that low prices and recession are very often linked.  I don’t think this is correct.

The causal connection between lower demand and price works something like this:

When aggregate global demand begins to contract, sellers of end products see their businesses begin to slow down.  They may cut their prices to sell stuff they have on hand and they certainly begin to shrink their inventories to a level that matches the lower demand they are experiencing.  They do so by cutting back new orders sharply.  Middlemen do the same.  This process typically hits producers with a very sharp decrease in new orders.  Producers respond in the only way they can, by cutting prices.

In the case of oil today, none of this is true.  Yes, prices are only a third of what they were eighteen months ago.  But aggregate demand is steadily rising.  So too world inventories.  The majority of oil producers are increasing their output, as well.

What’s happening with oil is that years of very high prices established a pricing umbrella that encouraged new entrants (shale oil), previously uneconomical, to invest tons of money and enter the business.

Established producers, meaning OPEC, have started a massive price war to force the new guys into bankruptcy.  The producers are learning the basic, but bitter, lesson that it’s much easier to keep new entrants out (by keeping prices low) than it is to deal with them once they have invested in plant and equipment and have begun production.

Shaping a Portfolio for 2016: dealing with oil

December 14, 2015 By in oil and natural gas, Shaping a Portfolio for 2016, Uncategorized Tags: , , , Leave a comment

Energy stocks now make up about 7% of the market capitalization of the S&P 500.  That’s not much.  They make up about 14% of the junk bond universe, however.  And they’re a huge chunk of emerging markets.  To my mind, it’s the spillover effect from these latter two areas where the price of energy may have an effect on the stock market.

forecasting earnings

I think it’s impossible to know what the earnings of oil and gas stocks will be for 2016.

If an exploration company spends $10 million to find 1 million barrels of oil, oil and gas accounting rules call for it to expense $10 of finding costs every time it produces a barrel.  On top of that, it expenses the out of pocket costs of extraction.

A complication:  suppose the extraction costs exceed the selling price of the oil.  If so, the oil company won’t produce any.  It won’t have revenue, but it won’t have a loss on its income statement, either.

If, however, the oil company decides the field is permanently impaired, it could write part of all of the cost of the field off at the end of this year.  That would allow it to show an accounting profit on output from that field in 2016.

This kind of housecleaning has already begun with Royal Dutch Shell, which has written off a number of high cost projects.

To the extent that the industry as a whole has large, non-recurring writeoffs this December, 2016 earnings will look better than we now think.  We won’t know this for a while, however.

reported earnings probably don’t matter that much

It seems to me that the stocks are no longer trading on reported earnings, but on the spot price of oil and gas instead.

It strikes me, too, that we’re now entering some sort of capitulation phase with oil and gas stocks, where panicky investors tend to throw the baby out with the bathwater.  This phase could last a considerable amount of time, especially if energy prices continue to slide during what is supposed to be the strongest season for demand.  So there’s plenty of scope for near-term bad news.

We’ll know that the capitulation is over only when the stocks stop reacting negatively to oil/gas price declines.

the energy sector is now a small part of the S&P 500

At today’s size, it would take a 15% fall in the Energy sector to clip one percentage point off the return on the S&P 500.  One could argue that in this sense, oil and gas no longer have a large bearing on the fate of the index.

one worry

It seems very clear to me that the current decline in energy prices is similar to what happened during 1982-86.  That is, a period of very high prices leads to the creation of supply overcapacity that causes the price to subsequently plunge.

I don’t think there are wider macroeconomic implications.   It’s all about the microeconomics of benefit to oil consumers and hurt to oil producers.  For the S&P 500, that ends up being a net plus.  For emerging markets, especially for OPEC, it’s a net minus.

I find it hard to follow the logic of the argument that if very high oil prices are bad for the world economy, then low ones are also bad.  Yet that’s what I’m beginning to read and hear in the financial media.  It’s taking the form of a claim that the price decline is not being caused by oversupply–which it clearly is–but by a recessionary falloff in demand.  The low oil price, these commentators say, is the first evidence that the world is entering a business cycle decline.

If investors in general begin to believe this, we could talk ourselves into a period of stock market weakness.

For long-term investors, this shouldn’t have any effect on investment strategy.  For more trading oriented, a stock market selloff based on false premises could provide a buying opportunity.  When?  My guess is as we enter the seasonal energy lull early next year.

 

 

 

 

 

 

 

Shaping a Portfolio for 2016: a data dump on oil

December 3, 2015 By in oil and natural gas, Refining, shale oil, shale oil and gas, Uncategorized Tags: , , , , , Leave a comment

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.

 

 

what would $20 a barrel oil mean for stocks?

September 17, 2015 By in Energy, oil and natural gas, Portfolio management, stock market, Strategy Tags: , , , , , Leave a comment

Yesterday I wrote about the recent Goldman report speculating that oil might fall to $20 a barrel.

What would this mean for stocks?

a $40 ceiling…

To my mind, the most important observation is the simplest–the potential price fall would be caused by more oil being supplied than the world wants or needs or is able to store profitably for future use.  The price would decline to force marginal production off the market.

In other words, there’s significant oversupply at $40 a barrel.  Therefore, $40 becomes the new ceiling for oil, which would presumably bounce between it and the floor of $20.  The $60-$70 a barrel level, which markets now believe to be the near-term price ceiling, becomes a pipe dream.

…that would be hard to break through

Yes, demand for oil has been showing a trend rise of about 1% per year, and a lower price will encourage higher use but since the extent of oversupply is hard to know for sure, the safest assumption, I think, is that it would take a looong time to break through the $40 ceiling.

substitutes are hurt

A lower oil price makes substitute forms of energy–from coal and natural gas to nuclear to wind and solar–relatively less attractive.  In the US, we’ve already seen demand for automobiles is shifting away from fuel efficiency to gas guzzling because of $40 a barrel oil.  This trend to would likely accelerate if oil falls more.  Of course, by spurring more profligate use of oil, this trend should sow the seeds for future oil price increases.  Still, my guess is that upward price pressure takes a long time to develop.

producers vs. consumers

countries

Lower prices would be a boon for oil-consuming nations.  For developing countries dependent on oil production for economic growth, however, lower prices would force significant–and possibly very politically messy–structural change.  We’re already seeing this in Saudi Arabia, for instance.

industries (in the US)

Financially strapped oil producers would be in worse trouble than they are now.  Bad, too, for oil-related junk bonds.  The same for regional lenders specializing in oil and gas loans.

Seen from 30,000 feet, the US is a complex economic case.  Shale oil has allowed the country to displace Saudi Arabia as the #1 oil producer in the world.  On the other hand, the US is nevertheless a huge importer of foreign oil (per capita, we use twice as much oil as anyone else on earth).  While oil-producing regions–Alaska, Texas, Oklahoma, North Dakota…–would suffer from lower oil prices, the rest of the country would have its already low oil bills cut in half.

stocks

the minus column

oil producers

producers of other forms of energy

companies located in oil-producing regions

the plus side

US auto firms

oil refiners

transport companies, like airlines and truckers

consumer companies, helped by the boost to disposable income from less spent on petroleum products

??strip malls, Wal-Mart, resort destinations, other firms consumers typically drive to

businesses serving less affluent customers, who would have the greatest percentage boost to disposable income