will OPEC cap its oil output?

…maybe, for a short while anyway.   Ultimately, no.

Will this move shore up oil prices?

…probably not.

Yesterday OPEC announced a provisionary agreement according to which the oil cartel’s members will limit aggregate output to between 32.5 million barrels per day and 33.0 million.  At the lower end, that would remove 750,000 daily barrels (or 2.3%) from OPEC production.  According to the Financial Timesvirtually all of the reduction would be by Saudi Arabia; other OPEC members promise only not to increase theirs.

Saudi Arabia has previously been dead set against any agreement of this type.  Why?   During the early 1980s oil glut, the Saudis sliced oil liftings from 13 million barrels daily to 3 million in a vain attempt to stabilize prices.  That effort failed because everyone else in OPEC cheated, boosting their output to fill the void.

That such cheating happens shouldn’t come as a shock.  It’s standard cartel behavior–and the reason most cartels fail.  The truly startling development in the modern history of commodity-producing cartels was the solidarity of OPEC in its formative years, when it was a political cartel opposing exploitation of third world countries.  It has lost its power as it evolved into the current economic one.

So, as I see it, there’s no reason not to expect widespread cheating again.

Another factor arguing against this agreement actually stabilizing crude oil prices is that OPEC doesn’t dominate world oil production as it did in the 1980s.  Four of today’s top six oil-producing countries (Russia, US, China, Canada) are not members of OPEC.  There’s every reason to expect that all of the four would boost output as/when prices start to rise.

 

To my mind, the real news the OPEC accord signals is the changed attitude of Saudi Arabia.  I think this must mean that Riyadh is in worse financial shape than is commonly believed.

Certainly, the country is radially dependent on oil   …and has become accustomed to the revenue from  $100+ per barrel prices.  So it is now running a large government budget deficit.  My guess is that it is also having a much harder time than expected in borrowing to bridge the gap between revenue and spending, and that efforts to develop other facets of the economy are not moving forward smoothly.  Saudi Arabia has just announced a salary cut for government workers, which can’t imply greater political stability.

If there is a valid reason for oil to have risen on the OPEC announcement–and I don’t think there is–it would be worries of political developments in Saudia Arabia that disrupt oil production there.

Personally, not owning any oil stocks at present, I’m thinking that the seasonal low point for demand, that is, January/February, would be a better entry time than right now.

crude oil: from shortage to surplus

Until very recently, petroleum industry thinking about crude oil supplies has been dominated by what has been called “peak oil theory.”  Developed by geologist and Shell Oil researcher M. King Hubbert in the 1950s, the simplest statement of the theory is that world production of crude oil would peak shortly after the year 2000, and then begin an inevitable decline.  The reason?   …all the world’s oilfields would have been discovered and fully exploited by that time.

We now know that Dr. Hubbert’s hypothesis is incorrect.  In fact, it’s wildly–even directionally–wrong, done in by the incentive of high prices and the development of hydraulic fracturing.

 

Peak oil is of more than academic interest, since strong belief that the world is facing an inevitable decline in oil production has informed the capital spending budgets of all the major oil companies for the past generation.  For them, the present situation of abundant supply at around $50 – $60 a barrel was unthinkable.  As a result, the majors have poured billions and billions of dollars into locating very high-cost hazardous-environment oil prospects that may now be not economically viable.

What happens now?

 

My mind keeps going back to the late 1990s and the mad rush to lay fiber optic cable around the world to support the internet.  Corning and a few Asian suppliers made the highest-quality glass cable.  Global Crossing and others spent immense amounts of money as they raced to complete undersea cables to connect the US to the rest of the world.  Internet traffic was expanding at such a fantastic rate that, in these firms’ minds, the fact that a whole bunch of firms were all doing so made no difference.

In hindsight, a key assumption these companies all made was that each optic fiber in a cable would be able to handle only one transmission at a time.

Then came dense wavelength division multiplexing.   DWDM amounted to putting a prism at each end of a fiber, breaking the light into a number of different wavelengths and sending a separate communication over each wavelength.   First it was two wavelengths, then four, then 256…

Suddenly the looming fiber optic shortage was an actual fiber optic glut.

What happened beak then?    The fiber optic cable business fell apart.  So too equipment suppliers like JDS Uniphase.  The most aggressive fiber optic cable layers went into bankruptcy.

 

I’ve been thinking that it’s time to poke around in the wreckage of smaller US oil exploration firms, although I suspect we may not see oil price lows until the end of the winter heating season (assuming there is one) next February.  But I also continue to think that the DWDM analogy is a reasonable one.  It suggests that there’s still lots of trouble ahead for the biggest and best-known names in the oil industry.

 

 

oil at $50 a barrel

It has been a wild ride.

Crude began to run up in early 2007.  It went from $50 a barrel to a peak of around $150 in mid-2008.  Recession caused the price to plunge to $30 a barrel late that year.  From there it began a second, slower climb that saw it break back above $100 in early 2011. Crude meandered between $100 and $125 until mid-2014, when increasing shale oil production from the US caused supply to outstrip demand by about 1% – 2% a year.  That was enough to cause a second slide, again to $30, that appears to have ended this February.

Since then, the price has rebounded to $50 a barrel, where it sits now.

To recap:  $50, then $150, then $30, then $125, then $30, now $50.

Where to from here?

We know that supply remains relatively steady, with additions to output from the Middle East offsetting falls in US shale oil liftings caused by lower prices.  We also know that lower prices have stimulated consumption.

The past eight years have also shown us that crude can have exaggerated reactions to small shifts in supply and/or demand.  So, in one sense, no knows what the crude oil market will do next.

On the other hand, we can set some parameters.

–the first is psychological.  The oil price has fallen to $30 a barrel twice in the last eight years.  The first was in the depths of the worst recession since the Great Depression.  The second was during a period of general market craziness earlier this year (caused, I think, by algorithms run amok).  I think it’s a reasonable assumption that prices will have a difficult time getting that low again–and if they do that they won’t stay there for long.

–the second is physical, and is about shale oil.  Overall shale oil output in the US is now shrinking.  Firms still pumping out shale oil are of two types:  companies being forced by their banks to sell oil to repay loans; and companies whose costs are low enough that they’re making a reasonable profit at today’s prices.  Cash flow from the first group is by and large going to creditors, so this output will diminish as existing wells are tapped out.  That’s probably happening right now, since shale oil wells typically have very short lives. This means, I think, the question about when new supply comes to market–putting a cap on prices, and perhaps causing them to weaken–comes down to when healthy shale oil firms will uncap existing, non-producing wells, and/or begin to drill new ones in large enough amounts to reverse the current output shrinkage.

I’m guessing–and that’s all it is, a guess–the magic number is $60 a barrel.

My personal conclusion, therefore, is that the crude price may still have a gentle upward bias, but that most of the bounce up from $30 is behind us.

 

 

 

can the oil cartel raise prices by cutting back production

cartel action in the offing?

That’s the rumor that has been supporting the oil price over the past week or so, despite this being the weakest season of the year for petroleum demand.  The story is that OPEC and Russia are having discussions right now about withholding output from the market in order to push prices up.

How likely is this to happen?

How likely is it that prices will rise if OPEC and others take action?

Supply/demand data

–world oil demand is about 95 million barrels a day, according to the International Energy Agency.  That figure has been growing at about a 1.5 million daily barrel clip over the past few years.  The IEA forecasts growth in demand to drop to a gain of 1.2 million in 2016, due to economic slowdown in China and the EU.  But demand will still likely be 96 million barrels/day by December.

–world oil supply is about 97 million barrels daily, according to the IEA.  That’s about 3 million barrels higher than at the end of 2014, due to increases in output from the US (2 million), Iraq (1 million) and Saudi Arabia (1 million-), partly offset by a bunch of production declines elsewhere.

–of the 97 million barrels of output, 39 million come from OPEC and about 14 from the former Soviet Union (11 million from Russia).  The rest come from oil consuming areas like the US, the EU and China.  These producers are, in my view, highly unlikely to cut output except when the selling price falls below the out-of-pocket costs of getting oil to the surface.

 

What I find fascinating about oil–and maybe this is just me–is the figures above show the gigantic fall in price since mid-2014 has been caused by a difference between supply and demand of only about 2%.  In fact, the IEA is forecasting continuing downward pressure on the oil price even though it thinks that the excess supply will be reduced to about 300,000 barrels daily, about 0.3%, by yearend.

It’s also important to note that demand for oil is relatively insensitive to changes in price over periods of a year or two or three.  Greater fuel efficiency of cars, substitution of natural gas or alternative energy, better insulation against heat and cold in construction, high taxes on fossil fuels in most developed countries (ex the US), are among the reasons.  What’s key for this discussion is that higher prices are very unlikely to make a dent in demand.  That’s a strong reason in favor of cartel action.

So, what would OPEC + Russia have to do to create a supply deficit?

…remove 2 million barrels of oil daily from world supply.  Let’s say 3 million, just to be on the safe side.  Given that OPEC + R control output of 53 million, that would mean each member reducing production by about 6%.  Assuming that increasing supply from US shale oil would only become economic at $40 a barrel, implying that’s the highest sustainable level prices are likely to achieve, OPEC + R could reap an almost immediate 25% increase in revenue by trimming output by 6%.  That’s a powerful incentive for economies radically dependent on oil sales and running short of cash.

Could this happen?

More tomorrow.

 

 

the Obama $10 per barrel oil tax

Last week, the Obama administration said its upcoming budget will contain a proposal for a $1o a barrel tax on oil.  Its purpose would be to fund infrastructure, as well as to use price as a tool to redirect Americans toward other forms of energy.

Anything more than these bare bones is still a puzzle.

Clues:

–the adminstration says the tax would not be collected from oil producers at the wellhead, i.e., it isn’t a tax on crude oil

–nevertheless, the tax would be collected by oil companies

–the levy would not apply to oil products refined in the US and then exported

–it would apply to oil products refined abroad and imported, though.

Effect:

A barrel (42 gallons) of crude oil refined in the US ends up on average as 19 gallons of gasoline, 12 of diesel/heating oil and 10 of other stuff.

If passed on to end users completely and evenly by the as yet unspecified collectors, a $20 a barrel ta would mean a $.24 per gallon increase in the retail price of each product.

This would be a baby step along the road to lessening dependence on OPEC already traveled by every other country in the developed world in the 1970s.  Better late than never, in my view.

My take:

We’ll hear more later this week, I guess.  But it strikes me from what has been said so far that the proposal has been defined more by what Mr. Obama doesn’t want to do than by anything positive he intends to accomplish.

–I think collecting the $10 at the wellhead from producers would likely tip some shaky shale oil producers into bankruptcy and discourage others from doing any development.  After all, in a world awash in extra crude oil being stored in bunkers and even on ships tethered off the shores of producing countries, how is any independent US producer going to be able to pass on any part of the $10 to its refinery customers?

The waning of US shale would also have the disastrous consequence of handing control of the crude oil market back to OPEC and Russia.

–adding $.25 to the federal tax on gasoline and diesel fuel, which I think would be the simplest and most economically sound alternative, would upset the US auto companies, who are now raking in money from selling gas-guzzling SUVs.  Autos are a traditional Democratic constituency and a perennial problem-child industry that the government rescued from bankruptcy less than a decade ago.  So a gas tax is likely off the table.

In addition, a Republican congressman already raised the gasoline tax issue last year.  He got a lot of grief and no support from anyone on either side of the aisle.

–This leaves refiners and/or distributors is most likely to be the parties taxed.  To me, this implies that the $10 cost would be shared among producers, refiners and end users according to who has the most market clout.  2015 results from refiners and distributors tell us that they have already been keeping a substantial portion of the benefits of lower crude oil prices for themselves, rather than passing them on to customers.  My guess is that shrinking margins for refiners and middlemen would be the primary effect of the proposed new levy.

Also, if the past is any guide, the issue of tracking and differentiating between refined products for export and those for domestic use would be a regulatory/compliance–and a fertile field for fraud.

 

As we get more details, we’ll be able to decide whether the oil tax is something concrete or just wishful thinking.

 

 

 

oil …again

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.

 

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.