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).


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.


sorting out oil-related stocks

The very large drop in oil prices over the past eight months has had negative effects on all oil-related firms.  The amount of suffering varies considerably, however, based on how a given firm is involved in the hydrocarbon business.  Here’s my take on the various sub-industries:

1.  oilfield services companies.   It’s a general rule in business that when a manufacturer slows down, its suppliers feel more pain than the manufacturer itself.  This is true in the oilfields, as well.

–Lower output prices mean some new drilling projects are cancelled.  This is bad for the contract drillers who supply and operate the rigs that do the actual drilling.  Offshore, where projects are typically larger and more expensive–therefore riskier, is a worse place to be than onshore.  Worst hit of all are the suppliers of the oilfield services firms, like the companies that manufacture new drilling rigs.

–Suppliers of goods and services, from seismic analyses of prospective acreage to drilling mud, are hurt as well.  Being in support for development of existing projects is better than being involved in new exploration.

2.  high-cost alternatives   …like liquefied natural gas (LNG) or tar sands.  Projects may no longer be economically viable.  I think LNG is more at risk.  Transporting natural gas from, say, the US to the EU or from Australia to Japan requires a multi-billion dollar investment in plant and equipment to liquefy and ship the gas to market (the alternative would be an underwater pipeline).  Because of this, I think new projects are non-starters in today’s world.  As for projects already up and running, we have no way of knowing how contracts are structured–that is, how the selling price of the gas is affected by the oil price drop.  This determines whether the pain of the oil price decline is borne by the LLNG project or by the utility customers who ultimately use the gas.

The situation for green alternatives, like solar and wind, is less clear.

3.  reserve valuations     The asset value of any oil exploration/production company depends heavily on the size and value of its oil reserves.  The lower oil price clearly hurts the value of reserves.  What’s less obvious is that reserves are defined as barrels of oil that can be brought to the surface and sold at a profit at the current price.  Some barrels that are economically viable at $100 a barrel may not be at $50.  If so, the size of reserves will also shrink.  In an extreme case, a company with a million barrels of reserves worth $50 million at an oil price of $100 might have 0 barrels worth $0 at a $50 oil price.

4.   US-based exploration companies     Smaller firms have been the leaders in shale oil production.  Generally speaking, they are hurt worse  by shrinkage in cash flow and downward revisions in reserve value than the big international firms.  To the extent they’ve borrowed to finance drilling, their problems may be magnified.  As a practical matter, however, there’s probably less scope for creditors to take action against a firm if it has issued junk bonds than if it has bank loans.

5.  international majors    The profits of these firms are more insulated against the price drop than their smaller rivals.  How so?

–They have petrochemicals and refining/marketing businesses that benefit from the lower price because they’re users of crude oil.

–They have fields they own that may have been operating for decades, and which therefore are still profitable at today’s prices.

–Also, in their deals to develop fields with national oil companies in foreign countries, they typically are paid a return on invested capital.  In other words, they don’t gain or lose much (if anything) as the oil price rises and falls.

No, they don’t escape unscathed.  They do lose from the lower price they get from production they own in the US and Europe, but their losses are much less than the pure domestic exploration and production companies.

6.   I haven’t looked at refining and marketing companies.  I assume that they aren’t fully passing along to their customers the benefits of lower crude oil costs, but I haven’t checked.

Of course, if/when the oil price begins to rise again (I don’t expect that to be any time soon), the most responsive stocks will likely be those of the oilfield services firms, with those of the international majors moving the least.

effects of lower oil prices

At $50 a barrel oil vs. $100 a barrel:

1.  High-cost alternatives hydrocarbon like liquefied natural gas (LNG), where projects require billions of dollars in spending on infrastructure–cryogenics at the wellhead, special refrigerator ships for transport–become much less compelling.  Tar sands, too.

2.  Green energy substitutes like wind and solar, which already require heavy government subsidy to encourage adoption, are less attractive, as well

3.  The real asset value of oil companies is in their proved reserves.  A lower price hurts this value in two ways.  The first is the obvious one, that the selling price of output is lower.  But there is a second.  In order to be counted as reserves, barrels of oil must be economically recoverable at present prices.  So quantities may shrink, too, as the price declines.  One can imagine, say, a tar sands company that has one hundred million barrels of reserves worth $20 billion at a $100/bbl price   …but 0 barrels worth $0 at a $40 price.

4.  The natural gas price in the US has fallen, but not by a much as oil.  This puts US petrochemical plants, which use natural gas as a raw material, at a relative disadvantage vs. their European and Asian counterparts that use naphtha, a petroleum product.  In absolute terms, the US companies are still in better shape, but to the extent that their historical price advantage has long ago been factored into stock prices, their equities have been relative underperformers.

5.  I spent six years as an oil analyst, covering both the big internationals and domestic explorers, and another while managing an Australian portfolio at a time when over half the market consisted of natural resources stocks.

Admittedly, my expertise is dated.  Nevertheless, some things don’t change.  Hearing and reading Wall Street “experts” on oil publicizing their opinions, I’m struck by how much loss of basic knowledge about the oil industry there has been within the investment community over the years.  This really shouldn’t be so surprising.  I’ve seen the same phenomenon in the mining industry.  In both cases, there have been very long stretches of time when the relevant stocks have been dormant and, consequently, it has been very hard for a sector specialist to make a living selling his analysis.

More on industry sub-sectors tomorrow.


reading the paper yesterday morning…

I’m postponing writing about my early days as an oil analyst until tomorrow.

An article in the Wall Street Journal,  “Investor Bind:  How Low Can Oil Go?,” struck my eye as I was waiting a doctor’s office yesterday morning.  Two aspects:

The article quotes a Swiss oil trader as saying the current market for petroleum is “irrational.”  He explained that the craziness consisted in the market concentrating solely on bad news and ignoring any possible ray of sunshine.

Yes, this is irrational.  But, more to the point, this is the essence of a bear market, that good news gets ignored and only bad news gets factored into prices.  (A bull market is just the opposite.  In a bull market, all the bad news goes in one ear and out the other; only the good news has an influence on prices.)  I wonder why he didn’t just say that.  Maybe he did, but the reporter didn’t understand.  On the other hand, maybe he didn’t realize.

Second, the article leads off with hedge fund Tusker Capital, LLC of Manhattan Beach, California.  The fund had been betting heavily on a decline in crude oil prices since at least the middle of last year and has just cashed in its chips after cleaning up oin a major way on the subsequent 60% fall in the oil price.

According to the article, Tusker gained 17% overall in 2014 and is up by 10% for 2015 through mid-January.  Implied, but not explicitly stated, is that the largest part of the +10% this year comes from the bet against the price of crude., with is down by 8.6%.  Why else would it be the lead in a sotry about a crashing oil quote.

The occupational disease of analysts is that they analyze.  As I sat in the waiting room–and waited–it became increasingly clear that I couldn’t make the Tusker numbers make sense.

Tusker has “roughly” $100 million under management now (I take that statement to mean the assets under management are just shy of $100 million, but let’s say $100 million is the right figure).  This means it had $91 million under management on December 31st and $78 million at the end of 2013–assuming no inflows or outflows.

Let’s say all of the $11 million gain in assets under management in early 2015 comes from the negative bet on oil.  If the same bet were maintained through the second half of 2014, it should have produced a gain of about $55 million.  But Tusker’s assets were only up by $13 million in 2014.  Either a lot of customer money left, or something really horrible happened in the rest of the portfolio, or “all” is too high a number.  My hunch is that at least the last is correct.

Let’s say half the 2015 gain comes from the negative bet on oil (regular readers will know that 1/2 is my default guess on most things).  If so, then the bet should have produced a profit of around $27 million in 2014.  Same story, although with somewhat less draconian figures–something else happened that caused $14 million in assets to disappear–disaster or withdrawals, or both–or maybe Tusker initially had a much smaller bet gainst oil that it expanded as crude began to sink.

I later Googled Tusker and found an article, from the New York Post, of all places, that said Tusker had assets of $105 million at the end of June 2013 and that the firm strongly believed that the end of quantitative easing in the US would cause a collapse in commodities prices.

To sum up: Tusker made a hugely successful bet against oil that likely made it $40 million – $70 million.  Yet it now has less money under management than it did 18 months ago (a period during which the S&P 500 went up by about 30%).  There’s certainly a story here.  It may not be about oil, though.




crude oil

starting with the basics…

A barrel of crude oil is a container filled with flammable liquid that weighs about 300 lb and occupies a volume of about 5.6 cubic feet.  A cube measuring a yard on each side would hold about 7 barrels and weigh a ton.  In other words, storing and transporting oil is a major issue.

According to OPEC, world oil demand is now about 91 million barrels daily.  That figure is likely to grow by about a million barrels daily during 2015.

World supply is just under 93 million barrels daily.  The difference between supply and demand, 2 million barrels daily, is enough each week to fill three of the largest oil tankers around.

Oil producers prefer to keep output steady,  because that optimizes the amount of oil that can be recovered through a given well.  Oil usage, on the other hand, is seasonal, with peaks in the US–the world’s largest consumer of petroleum products–during the summer driving season and the winter heating oil season.  Temporary storage, either in tanks or on the seas in oil tankers, holds the “extra” oil in the slack seasons.

…and on from there

What happens to the 2 million barrels of daily output that consumers more or less don’t want?

The standard answer is that speculators with access to storage bid a price on the spot market that they figure will allow them to cover their costs and make a profit when they eventually sell.

There have also been press reports that China has been buying large amounts of oil recently to build its strategic oil reserve.

The issue of imbalance between supply and demand has been developing for several years.  High prices prompt conservation, for one thing.  They also make high-cost shale and tar sands extraction economically feasible.  And until  relatively recently continuing instability in the Middle East has kept output from this important producing region below normal–offsetting the growth of shale oil from the US.

near-term potholes

In a few weeks, we’ll be entering the lowest-demand time of the year for oil.  It will be too late to manufacture and deliver heating oil to customers for winter use; driving doesn’t pick up until April-May.

Paradoxically, lower prices can trigger a spate of new output entering the market.  This could come from oil-producing countries trying to offset the price-related shortfall in their inflows of hard currency, or from financially leveraged private companies needing cash to service bank loans, or from companies whose oil inventories now look much too big.


More tomorrow.