nearing crunch time for the oil price

recap

By allowing/encouraging the oil price to stay over $100 a barrel, OPEC unwittingly created a pricing umbrella that spawned a significant new, relatively high cost, shale oil industry in the US that, at its peak last year, was pumping an extra 5 million barrels of crude a day onto the world market.  At that point, world supply rose above demand, with the natural consequence that prices began to fall.

The OPEC response ot lower prices has been to increase its production, with the intention of spurring new demand and of forcing shale oil producers out of business.  Since for most OPEC countries, oil is the principal source of GDP and of hard currency, more barrels out the door also eased revenue shortfalls somewhat.  Nevertheless, OPEC is generally experiencing a significant cash squeeze.

The plan has worked, to some degree.  American consumers have lost their taste for compact cars and are buying gas-guzzling trucks in huge numbers.  Shale oil production is gradually fading.  Overall world demand continues to rise at 1.5+ million barrels per day.

where we stand now

The excess of supply over demand is still about two million barrels per day, according to the International Energy Agency, (whose latest monthly report can be found in financial newspapaers).

The end to economic sanctions on Iran is likely to free 500,000 barrels of Persian oil for sale sometime next year, however–and that figure might be as high as a million.  And China has been using the fall in prices to increase its strategic petroleum reserve.  Some reports say that this process is close to an end.

storage is a key 

The most important near-term factor to watch, in my view, is overall world inventories–which are at extremely high levels.

Petroleum storage is of two types:

–storage of crude, normally in tank farms, but also in rented oil tankers

–refined products storage, both in tank farms owned by refiners and (the thing we know least about) in customers’ hands–from industry to the gas tanks in individuals’ automobiles.

We do know that crude tank farms in Asia and Europe are full, and that refiners’ output storage tanks are bursting at the seams.  In addition, the cost of renting a crude oil tanker to store barrels for future delivery is now higher than the profit an arbitrageur would make by buying oil now and entering a futures contract for later delivery.

On top of all that, warm weather has meant that the usual seasonal buying surge for heating oil has not yet happened.

to summarize

At the current rate of adjustment, oil supply and demand may not come into balance until late 2016–and maybe early 2017.

The world is running out of places to stash the extra crude.  The globe already appears to have run out of places to do so at a profit.

Therefore, it’s possible that, at the very least, the oil price will decline again–even in a period of seasonal strength like the present–to a level where the arbitrage of buying now and storing for future delivery makes money.  But when stuff like this happens, the world is rarely rational.  The Goldman scenario in which the crude price falls to $20 no longer seems like a footnote.  It’s something that has–I don’t know–say, a one in three chance of occurring.

If that happens, I think it would be a great chance to sift through the rubble for medium-sized US shale oil firms that will survive until better days arrive in maybe 18 months.

 

 

$20 a barrel oil?

Last week, Goldman Sachs released a research report to clients in which it observed that if the world oil market develops in a less favorable way (to oil producers) than it currently anticipates, the crude oil price might plunge to as low as $20 a barrel before enough production is removed from the market for prices to stabilize.

This “doomsday” scenario has, naturally enough, captured all the press headlines.  I haven’t seen the GS report, but I do know the factors involved.  They are:

forces for price stability around $40 a barrel

  1.  Under normal conditions in a commodity market, when oversupply develops prices fall to a level below the out-of-pocket production expenses of the highest-cost producers.  This eventually causes them to stop generating output.  The reduction in supply stabilizes prices.  If producers mothball their operations and fire their workers, that itself may be enough to start prices rising again.
  2. Even for producers who are still profitable at lower prices, decreased cash flow leaves them less money to invest in project expansion.  Price uncertainty may cause them to hesitate, as well.  For those who have borrowed heavily, contracts with their lenders may force them to divert cash away from operations toward debt repayment.

forces against stability

  1. Many members of OPEC, which accounts for about a third of world oil production, have relatively simple economies that are heavily dependent on oil to fund government spending and to provide money to ordinary citizens.  Where the textbook economic response to lower prices may be to produce less, in order to maintain government plans and services (keeping citizens happy) the only response from OPEC is to produce more to generate more income.  This is arguably self-defeating   …and makes the problem worse.  Still, OPEC has raised production by about 2 million barrels a day over the past months.  And Iran is saying that once sanctions are lifted, it will begin to sell 100,000 barrels of oil a day, with presumably more in the offing.
  2. At, say, $100 a barrel, producers of petroleum from oil sands or shale have had no pressing incentives to hone their techniques.  At $40 a barrel and facing potential shutdown, they’re becoming much more inventive.  So they are finding ways to lower their costs to keep delivering output to market.

oil storage

We know that the world is now being supplied with more oil than it needs because oil inventories are rising.  Middlemen continue to be content to buy from producers because they can immediately sell for future delivery at a profit through derivatives and store the stuff in the mean time.

My experience is that although the markets have a rough idea of how much storage capacity there is–in giant storage tanks, barges, tanker ships…,  the reality is that there’s always more capacity than the consensus suspects.

What happens when every storage container is full?    …no one buys oil that comes on the market because there’s no place to put it.

the doomsday scenario

Three parts:

–shale oil producers lower their costs so that their production doesn’t fall by the 500,000 barrels/day that the market expects

–storage gets all filled up

–OPEC keeps on increasing production because it needs the money.

Middlemen turn the stuff away.  Prices plummet.

probability?

I’m not worried, so I guess I think it’s low.  In reality, no one knows.

Goldman has credibility in this field not only because it has strong commodity trading operations, but also because years ago it predicted $100+ per barrel oil when no one else thought it was possible.

Tomorrow, consequences of doomsday, were it to happen.

 

more on oil

As I was thinking about this post, I knew that oil is a complicated subject and that there’s a risk of getting lost in the details.  So I decided to sketch out the structure of the post carefully on paper before I began to write.  Several pages of notes later, I abandoned the attempt, in favor of extreme simplicity (I hope).

oil

Like any other mineral commodity, oil is subject to boom and bust cycles.  We’re now in bust, meaning that supply is structurally higher than demand, exerting continuous downward pressure on prices.

As with any other commodity, prices will stay low until supply and demand come back into balance.  The slow way for this to happen is for demand, now at about 93 million barrels per day and growing at 1%+ per year, to expand.  The fast way is for prices to stay low enough, long enough for high-cost producers to go out of business.  As I see it, adjustment will primarily come the fast way.

Oil is peculiar, though, in two respects, both of which argue that prices will stay low for a considerable time:

–many major oil producing countries (e.g., the Middle East, Russia) have relatively simple economies that are radically dependent on exports of oil for government income.  Over the past year, OPEC oil output has actually risen by about 1.5 million barrels per day, despite the expanding glut.  This indicates that, unlike prior periods of oversupply, the group has no desire to try to moderate the downturn.

–the long-term geological damage to a big oilfield from turning the taps off and on can be great.  So producers are more hesitant than in other industries to do so.

the catalyst

Arguably, what has upset the pricing applecart is the unanticipated surge in oil production in the US, which was 5.6 million barrels per day this time in 2011 and is 9.5 million today.  Hydraulic fracturing is the reason for this.

where to from here?

US oil production is still averaging more than a million barrels per day higher than in 2014.  However, the steady month by month march upward of output figures may have been broken in May, when liftings were about 200,000 barrels a day less than in April.

My guess (and I’m doing little more than plucking numbers out of the air) is that at $50 a barrel or below, new fracking projects won’t get started. Under $40 a barrel, some wells may be shut in.  If a production falloff comes solely through the former mechanism, we’re probably a year away from a meaningful (translation:  more than a million barrels, but after that, who knows) decline in fracking output.

That would likely mean a higher oil price then than now, IF (…a big “if”) OPEC nations desperate for cash don’t up their production further.

what I’m doing

I have no desire to buy oil stocks today, because I think we’re not that far along in getting supply and demand back into balance.  In the early 1980s, for example, the entire process from top to bottom took about half a decade.  I’m also thinking that there might either be another sharp price decline, or simply a further sharp selloff in oil stocks before the current oversupply is over.  I’ve just started to think about what I might buy if either were to happen.  One thing is certain, though.  It won’t be the big oils, or tar sands, or LNG.

more than you ever wanted to know

When I started on Wall Street as an oil analyst, oil and natural gas sold for roughly the same price per unit of heating power.  Natural gas has been less than half the cost of oil on a heating equivalent basis for many years, however, because it isn’t in widespread use as a transportation fuel and because it takes a pipeline to deliver it to customers.  Natural gas is already being substituted for coal in power generation.  Will it ever have a dampening effect on the ability of the oil price to rise?

oil and gold: finding the commodity cycle bottom

I got my first couple of portfolio manager jobs in the 1980s because one of my industry specializations as  a securities analyst was natural resources.  Back then, there were an enormous number of mining analysts in an information industry based in London.  The large size and vitality of the analyst community were partly because there had been an enormous spike in the prices of gold and oil in the late 1970s-early 1980s. So investors were willing to pay handsomely for information and interpretation.  Also, the prevalent economic theory of the day, since proved to be woefully incorrect, held that a necessary condition for global economic growth was a continuously expanding supply of mineral resources.

When the Chinese economic expansion-driven commodities boom began a decade and a half later, I found that, unsurprisingly after 15 years of no one being interested, the entire stock market information infrastructure for metals had disappeared.  There were still the odd steel or oil analyst around eking out a living and staggering toward retirement, but little else, either in London or New York.

As far as I can see, from an information perspective the situation is at least as bad today.  In the perverse way that Wall Street works, however, that lack itself is the basis of the positive thesis for mining in general.

industry characteristics

Mineral extraction industries are very capital-intensive.  This means that projects typically require large amounts of up-front money. But they can often continue, once up and running, for long periods without new funds being put in.

Mining projects often have very long lives.

Very often, projects are also huge.  This is partly the nature of the beast, partly a function of the temperament of the people who run minerals companies.  This means that new supply is often added in gigantic chunks.  New supply almost invariably arrives in amounts way above the increase in demand and typically, therefore, marks the high water mark in terms of price.  Boom and bust, boom and bust–the rhythm of these markets.

finding the bottom

Falling prices indicates that there’s more supply than demand.  In theory, that situation can be reversed either by demand expanding or by supply contracting.  In practice, the first rarely happens.

What establishes the bottom for these markets, in my experience, is a price decline that’s deep enough to force high-cost capacity to close.  This does not mean the price at which companies stop earning a financial reporting profit.  That price is too high.  That’s because it includes as an expense a non-cash allowance for recovering the money spent to open the project.  A company can also be compelled to sell at unfavorable prices by creditors.

What actually matters is the point at which the out-of-pocket cash cost of getting output out of the ground is less than what it can be sold for.  That’s the point at which projects begin to shut themselves down.  They may not do so immediately.  They may continue to bleed in the hope of an imminent turnaround.

For gold, the relevant figure is around $850 an ounce, I think.  Oil is a bit more complicated, but the magic number is likely about $40 a barrel.

More tomorrow.

 

 

off to a very slow start today…

…so I’m not going to write very much.

During the first world oil shock (1971 – 74), the US was unique among developed countries in enacting a byzantine system of oil price and distribution controls aimed at preventing the ipact of higher prices from affecting the country (don’t ask for details).

One facet was to price oil from already producing wells substantially below world market level.  The idea, I guess, was to prevent owners of oil from enjoying a profit windfall from the upward spike in oil that was occurring at that time.  One unintended effect of the legislation was that the supply of such “old” oil began to shrink rather rapidly.

After controls were abolished during the Reagan administration, curious as always, I asked executives of a number of big oils whether the falloff in  “old” was due to lack of new investment or to a deliberate decision to shut the wells down to await for higher prices.  The answer was uniformly the latter.

I think something similar is beginning to happen in the US today–not the price controls, shutting wells in.

More tomorrow.