is the current equity selloff about oil?

I’m postponing my 2015 Strategy summary/conclusion on Monday.


The price of oil has been steadily declining since June  It’s now below $60 a barrel, after having moved sideways at around $100 from January through early July.

I think the drop is being caused by the fact that supply and demand for petroleum are relatively inflexible in the short term, so small changes in either can cause surprisingly large changes in price.  In 2008, for example, the oil price quickly spiked up from $100 to almost $150 a barrel.   It moved above $125 for a short period in 2011 and again in 2012.

Unlike the prior three surges–caused by fears of supply disruption–the current decline is being created by the steady increase in shale oil output from the US.  In a sense, no one needs all the oil now being brought to the surface.  No one has a place to store the excess.  No producer is willing to cut back his lifting to make room for the extra.  The only mechanism available to clear the market is that the price drops until it reaches a level where buyers are willing to take the risk of increasing their inventories.   Doubtless, commodities speculators of all stripes have been accentuating the downward trend with their shorting activity.

Bad as the price drop has been for oil-producing countries–Russia, the Middle East and Africa–it’s a big plus for the rest of the world.    …yet stock markets are falling on the news.  Why?

–Some market strategists are saying that falling oil prices are being caused by a mysterious–and as yet unseen in other data–falloff in economic activity.  In other words, lower oil is supposedly a harbinger of recession.  Other than for the oil producers, this makes no conceptual sense.  And it flies in the face, at least in the case of the US, of all the economic data we’re seeing–which indicate that the economy is accelerating.

–Others argue that falling oil presages deflation, presumably of the type that has plagued Japan for decades.  Again, other than for oil producers and their banks, I don’t see the problem.  Ex oil companies, no one is going to have less money to spend or to use to repay debt.

–There is a stock market-specific issue, though.  Take the US as an example.  In rough terms, the country produces 13 million barrels of oil a day and uses 20 million.  So it imports 7 million.  The price fall means the country as a whole is keeping about $100 billion a year that was previously going to foreign pil producers.  The loss to domestic producers/gain to domestic consumers is about $200 billion a year.  That money isn’t leaving the country.  It’s just going into different pockets.

In an $18 trillion economy, the whole thing is peanuts, even with secondary effects.

But oil stocks represent 8%+ of the S&P 500 (for the MSCI Global index the proportion is about the same).  So the effect on stocks is much more dramatic.

Energy stocks went down by 10% last month   …and they’ve declined another 5% so far in December.  This has two influences on the market.  The drop in oil stocks themselves depresses the index.  In addition, short-term traders, thinking oil shares look cheap (rightly or wrongly), will short other sectors to buy the oils in the expectation of a bounce.  This arbitrage activity drags the rest of the index down as well.  This is just the way stocks work.

–The fact that we’re close to the end of the year, when many professionals have begun closing down for the year, doesn’t help.  They’ll prefer to sit on the sidelines for now and hunt for bargains in January.

my take

I think the “expert” opinions about possible deflation and recession are silly.  The outsized representation of oils in stock market indices is an issue, but a temporary and minor one, in my opinion.  If anything, I think the oil price fall is a trigger for investors to begin discounting potentially higher interest rates next year.  Some investors may simply be taking profits after a 2014 that has been much stronger than anyone expected.  But declines in December seem to me to imply a better chance of gains in 2015.


yesterday’s OPEC meeting: no production cuts = oil below $70 a barrel

Yesterday’s OPEC meeting ended without an agreement to withdraw output from the market in an attempt to halt the recent sharp crude oil price decline.  This should have come as no surprise   …but it did, at least in the sense that oil prices–and oil-related stock quotes–fell further on the announcement.

In its earliest days, OPEC was badly understood by large oil-consuming countries.  It had greater solidarity than the garden-variety economic cartel because it was at heart a political–not an economic–entity.  It’s main goal was to end exploitation of producing countries by the big international oils, which made gigantic profits while paying the producers a pittance for their crude.

But even in those heady days for OPEC, there were significant divisions within the group.  Members who had small reserves and pressing government fiscal problems wanted the highest possible current prices.  In contrast, others, like Saudi Arabia, with long-lived reserves and better government finances, wanted to keep prices low so consumers wouldn’t start to seek out petroleum substitutes.  Often the result of these divisions was leaky agreements violated by smaller countries and made to work chiefly through greater-than-promised cutbacks by Saudi Arabia.

Today, there are many more non-OPEC oil producers, like Russia, Brazil or the US.  It’s also a generation since OPEC broke the dominating power of the big oils–plenty of time for institutional memory of past oppression to fade.  In addition, Saudi Arabia must know that the burden of enforcing any agreement would fall disproportionately on it.

Letting prices fall to the point where high-cost producers are forced out of the market is the only way any commodity prices stabilize, in my view.  In the case of oil, as far as I can see we’re nowhere near that point.

What I find odd is the negative commodities and stock market reaction.

(By the way, duinr the oil shocks of the 1970s, the US was the only developed country to fail to increase taxes on oil in order to discourage profligate consumption.  We chose instead to continue to protect a dysfunctional auto manufacturing industry.  If I’m correct about lower prices, we’ll have a chance to correct that error  Let’s hope we take it.)


shale oil and shale gas (i): oil as an investment vs. natural gas

I want to write about the changes that horizontal drilling and hydraulic fracturing have made in the economics of oil and gas by allowing drillers to tap deposits in shale.  This is the first of three posts, and contains background.

what they have in common

Oil and natural gas are both hydrocarbon energy sources.

The same exploration and development companies look for both oil and gas.  They use the same geologists, the same sub-surface mapping tools, the same drilling equipment and the same oilfield service firms to make the actual holes in the ground.

Oil and natural gas often occur in proximity.  Sometimes a single well produces a mixture of the two.

In many areas, including the US, the government provides tax subsidies to encourage exploration.

A barrel of oil is roughly equivalent in heating value to 5,800 cubic feet of natural gas.  During much of my Wall Street career (I stared out as an oil analyst), the price of natural gas and the price of oil have been tied relatively closely to one another based on this heating value relationship.  In other words, if oil were selling at a price of $36 a barrel meant that natural gas would sell at more or less $6 an Mcf (thousand cubic feet).

That’s no longer true.  The current oil price of around $100 per barrel translates, on a heating value basis, into $16.67 per Mcf for natural gas.  Gas spent most of 2013 selling at about $3.50 an Mcf.  The recent severe cold spell in many of the densely populated parts of the country has caused the spot quote for gas to spike to a bit over $5 an Mcf..  That’s an anomaly that the arrival of warmer weather will correct,  but even today’s spot price is still less than a third of the heat equivalent price of crude,

how they’re different

Crude oil reaches the surface as a liquid.  In contrast, and as the name implies, natural gas reaches the surface as a gas.  This innocuous-sounding difference has enormous economic implications.

oil is easy to transport, natural gas isn’t

The most efficient way to move large amounts of either oil or gas from the wellhead is through a pipeline.  Often, when production begins in a new area, there’s no pipeline nearby, though.  Building one  is expensive and takes time.  That’s not a huge problem for crude oil.  It can be stored in a tank by the wellhead.  Trucks will come by periodically to take the oil away, either directly to a refinery, or to the railroad or a pipeline for further transport.

Natural gas is a different matter.  There’s no practical way to store it above ground, and there are no trucks made to transport it   In the past, for wells that produce both oil and gas, drillers would “flare” or burn away the natural gas just to get rid of it if no pipeline was available.  Today, the driller is most often required to pump the gas back down below the surface rather than simply destroying it.  For natural gas-only wells, no pipeline means seal up the well and wait.

One exception:  if the amounts of natural gas in a remote location are enormous, the natural gas can be cooled until it becomes a liquid and then transported to market in special refrigerator ships.  The cost of the required cryogenic plants + special ships + unfreezing operations at the buyer’s end can run into tens of billions of dollars, however.  So this requires lots of time, operational and financial planning, as well as the creation of long-term supply contracts.

lots of buyers for oil, not so many for gas

Early in my career, I studied an offshore oil and gas financing project in New Zealand.  The oil from the field was pumped directly into oil tankers that sailed away when full.  The natural gas got pumped back underground.

Why not ues the natural gas in New Zealand?   …lots of infrastructure needed.

One thing was the cost of the required miles-long pipeline to shore.   But that wasn’t the main issue.  To get the gas to residential/commercial users, local distribution companies would need to be formed.  These firms would then have to tear up all the streets in town to lay pipelines to everyone’s doors.  Potential users would have to either replace or modify their existing oil burners  so that they could use gas.  The expense would be enormous.  So, too, the disruption to daily life.  And you couldn’t force citizens to use gas, could you?  So it would be hard to guess in advance if there would be any payoff to all this.

Another example:  in the early 1980s the US tried to promote natural gas as automotive fuel.  The effort foundered on the lack of places to refuel.  No one wanted to buy natural gas-powered cars if there were no service stations.  No company wanted to build a national chain of natural gas service stations if there were no cars.  The plans did result in the creation of fleets of natural gas-powered local delivery trucks, but little else.

the big difference

Oil can move to markets all around the world.  Natural gas generally can’t.

More tomorrow.

thoughts on the International Energy Agency release of strategic oil reserves

the IEA action

Yesterday, the International Energy Agency (IEA), an organization of oil consuming countries, announced its 28 member nations have agreed to release 60 million barrels of their collective emergency oil supplies, at the rate of 2 million barrels daily for thirty days starting early in July.  The idea is to offset upward pressure on the oil price that might arise during the summer high point in demand.

The extra oil, which represents a bit less than 4% of the total government reserves of the IEA, is ostensibly to replace crude lost to world markets by fighting in Libya.

The agency has done this twice before.  The first time was when Iraq invaded Kuwait in 1990; the second was after Hurricane Katrina.

Of the 60 million barrels, North America (read, the US) will supply half, Europe 30% and Asia the rest.  Each country will decide for itself how it will achieve its goal.  The US intends to release crude oil from the Strategic Petroleum Reserve.  Japan, in contrast, is simply going to reduce by three days the amount of refined petroleum products that refiner/marketers are legally mandated to maintain.  This presumably will ultimately lead to decreased purchases of crude by Japanese oil companies.

a stop-gap measure

The release of petroleum reserves is a stop-gap measure.  It appears to have been well-timed enough to be shaking some speculators out of their long positions in oil futures, and may therefore get the world through the summer months with lower gasoline prices.  But the move is also reminiscent of the ultimately futile attempts of the signatories to the Bretton Woods currency agreements to defend fixed exchange rates.

structural issues

In the case of oil, two structural issues stand out:

–the increasing affluence of the developing world means ever higher demand from these countries for fossil fuels for power generation and for transportation, and

–the US, the only developed country without a sensible energy conservation policy, consumes almost a quarter of the petroleum the world produces, even though it  represents just over 4% of the population of the globe.

effect on stocks

The initial reaction from financial markets is that the IEA action is bad for oil stocks and good for consumer names, especially in the US.  To some degree, I think this is the right response.  But production-sharing agreements signed between the big international oil companies and producing nations over the past twenty years call for progressively increasing percentages of oil sales revenue to go to the nation rather than the oil company as prices rise.  So the negative effect of the current price fall will likely be less than markets expect.  Also, the IEA move is more a temporary reprieve than a problem solution for hard-pressed consumers.

As a result, I think that, as it unfolds in the coming weeks, the IEA move will prove a better occasion for selling US retail stocks whose customers are ordinary Americans and buying oil names that it is to do the opposite.


crude oil production contracts: a simple overview

Financial commentators have been pointing out recently that neither the large international integrated oil companies’ profits nor their stock prices are rising in line with the upwardly spiking price of oil.  This has to do with the changing nature of production-sharing agreements in the development of sovereign oil deposits.

There’s a ton of jargon in the oil business used to describe the often complex process of deciding how revenues and costs from a project are split up among the parties involved.  This is a highly simplified outline (but still good enough, I think, for a stock market investor) of how it works:

Generally speaking, an oil company (or group of companies) leases oil and gas rights to a specified block of acreage owned by a government through a competitive auction (in the past, colonial-style political or military coercion could easily have been the real key, however) .  In some cases, the winner will pay a large up-front fee.  In all cases, he is obliged to pay for and drill a specified number of exploratory wells over a specified time period, or else forfeit the lease.

If economically viable quantities of hydrocarbons are found, the oil firm must begin commercial development, again within a certain period of time.  The company “carries” the government, that is, it pays all development expenses.  Typically it can gradually recover these costs once production begins by being allocated an extra share of output until it has been recompensed.

Sometimes, the oil company takes physical possession of some or all of the oil and can do what it wants with it, sometimes not.  This can be a big deal in times of shortage.  For companies designated as “national champions” in nations like China or Japan, and asked to find supplies that can be sent back home in a pinch, it’s always a big deal.

three frameworks

I’ve seen three major contract frameworks, one following after the other, since I began watching the international oil industry in 1978:

1.  When I became an oil analyst, the typical arrangement called for the ol company to pay a fixed fee, say, $.50 or $1 a barrel, to the government that leased the mineral rights to a major international oil firm.  The oil company owned the oil, and might resell the crude immediately or refine and market it.  Such a firm made a good profit even when oil sold for under $2 a barrel.  But when prices rose in the early Seventies and again later in that decade, reaching as high as $35, the oil companies enjoyed the entire windfall.

This was a mixed blessing.  The contracts were seen as so unfair and one-sided that many oil-producing countries nationalized their oilfields and threw the majors out.

2.  In the 1980s, new contracts retained the general form of their predecessors but were renames production sharing agreements.  They called for a sharing of production revenues in specified percentages, say 70/30, with the oil company receiving the smaller portion.  That worked for a while.  But as prices rose from $12-$15 a barrel to $25-$30, and the majors began to make huge profits relative to their invested capital once more, the same problem of perceived onesidedness arose again.  Producing nations reacted in a somewhat similar vein as earlier, but either levying new taxes or simply unilaterally mandating more favorable terms to contracts.

3.  During the past decade or so, a new type of contract has emerged.  Again, the general form of the original contract has been retained.  But the production sharing arrangements call now for the oil producing country to receive an escalating percentage of revenues as the oil price rises.  While the contract terms tend to be expressed in this manner, the intention, I think, is to cap the returns to the oil major from a given project at, say, 25%-30% yearly.  The producing country basically retains everything above that.

Are the oil companies okay with this latest development?  Well, they continue to drill.  Of course, a lot depends on the riskiness of a specific project, but I think the oil company investment conclusion is that getting a 25% annual return for the life of a twenty- or thirty-year project is better than getting a 100% return for two years and then losing the project entirely.

stock market implications

For individual stock market investors, though, it’s important to realize that professional portfolio managers, or at least the oil analysts who work for them, understand the rules of the new order.  So they won’t chase after the stocks of companies that they know have large proportions of newer contracts.

why are the Saudis raising oil output?

Saudi Arabia to the rescue

Saudi Arabia announced recently that it is upping the amount of oil it produces.  It’s doing so to replace the portion of Libya’s normal output of 1.6 million barrels a day being lost during the current political struggle there.  The Saudis will doubtless be joined by other OPEC nations who will increase their production as well, although these other countries may not choose to identify themselves.

Even assuming the total number of barrels reaching the market is unchanged, the world faces a short-term logistics issue.  The Saudi crude needs more processing than Libyan oil.  It has extra sulfur (corrosive and a pollutant) that needs to be removed, for one thing.  And it contains more large molecules that need to be “cracked,” or broken down chemically to yield higher value-added products like gasoline or jet fuel.  The quality difference is a particular problem for Italy, the traditional buyer much of Libya’s oil.  (Italy seized Libya from Turkey in a war about a century ago and held it as a colony until after World War II.)  The country’s refineries haven’t seen the need to spend money on the expensive equipment required to process lower-quality Saudi crude into stuff customers can use. Nevertheless, they’re under severe political and market pressure to deliver refined products.  The resulting scramble for easy-to-refine crude is one reason the price of high-quality North Sea oil has risen so much.

Provided governments don’t decide to “help” the process along with new regulations, oil companies should readjust the world’s refining and distribution networks to restore the flow of gasoline, naphtha and jet fuel to something akin to the pre-Libyan-revolution normal within a few months.  I think there’s a very good chance of this happening.

why add production?

That doesn’t mean I don’t see a secular upward trend in the price of oil, because I do.  In this post, however, I only want to address the narrow question of why Saudi Arabia is acting to hold down oil prices, even though a $1 a barrel rise in the cost of crude puts an extra $3 billion a year into the royal treasury.

the iron law of macroeconomics: substitutes determine pricing

The answer is pure microeconomics.  Saudi Arabia, like many OPEC countries, has enough oil underground to last for well over fifty years at its current production rate.  It could easily have a hundred years’ worth.

Most of those barrels will only have value if petroleum remains the world’s fuel of choice in 2060…and in 2100.  So Saudi Arabia certainly doesn’t want world governments worrying about the dependability of oil supply and starting programs of serious research on possible replacement fuels.  Nor does it want dramatic real (that is, inflation plus) increases in the price of oil that might cause consumers to start to conserve.  Saudi Arabia doesn’t want to make waves.  It just wants to keep taking its $800 million + check to the bank every day.

conservation potential

Conservation could be a serious threat to OPEC revenues.  Look to the United States, which is the low-hanging fruit in the conservation department.  We have 4% of the world’s population but use about a quarter of the world’s oil (we consume about 3.7 tons of the stuff yearly for each man, woman and child in the country).  We’re the only developed country without a coherent national energy policy.  We’re practically alone in not taxing oil heavily to discourage use.  True, we no longer artificially depress the price of oil as we did in the Seventies.  Nor do we have quotas that limit imports of fuel-efficient cars, as we did in the Eighties.  But that’s not much.  The Saudis have a strong economic interest in us not waking up.

history shows what sharp price increases do

We’ve seen during the oil shocks of the 1970s what happens when oil price skyrocket.  Crude oil prices, which were under $2 a barrel in the 1960s, quadrupled in the early 1970s, declined somewhat and then more than doubled during 1978-80 in the wake of the Iranian revolution.

What followed was a period of global economic stagnation and then–crucially from an oil producer’s point of view–a twenty-year period of oil price decline.  At its nadir, crude had given back in real terms virtually all its gains from the 1970s.  So OPEC had a few years of riches, followed by two decades of budget deficits.

Conditions could actually have been worse for oil producers, had it not been for Saudi Arabia.  Had the Saudis acted unilaterally to temper price increases by adding to output, prices might have otherwise stayed high enough for long enough during the late Seventies-early Eighties to force permanent changes in consumption. Those billions of barrels of oil still in the ground might have become worthless.

As it turned out, however, and especially in the US, governments quickly lost interest in substitute fuels and in conservation measures as oil prices began to slide.

Today, Saudi Arabia is just doing what it has been doing for the past thirty years +, taking the role of the “swing producer” to keep real increases in prices under control.  This behavior may have its altruistic aspects, but, given its vast amounts of untapped oil, Saudi Arabia is clearly acting in its own economic interest.