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?

which is the better question: where is the oil price floor or where is the ceiling?

I read sports for a radio station for the blind each Thursday.  I was listening, as usual, to Bloomberg radio in my car while on the way.  I caught the tail end of a conversation in which a guest was apparently trying to explain the difference between a copper mine (a multi-billion dollar, multi-year project) and a shale oil well ( up and drilling for cheap in a month or two).  This came as a revelation to the show’s hosts.  Part was probably showmanship, but it also underlined to me how little knowledge about mining and basic materials industries survives on Wall Street.

A basic rule of any commodities business (regular readers will know I spent six years as an oil and mining analyst and another couple managing money in stock markets with large commodity exposure) is that in times of oversupply the price only stabilizes when it falls (and remains) below the out-of-pocket costs of the most expensive producers.  The bottoming process may take a surprisingly long time.  That’s because producers may choose to operate at a loss for a while, if the costs of starting up again are high (think:  blast furnace steel) and the oversupply is perceived to be temporary.

–In the case of oil, Saudi Arabia is doing all it can to convince the world that the oversupply is not temporary.  That’s one worry out of the way.

–The consensus belief is that the floor is around $40.

Presumably this information is being factored into today’s stock prices.  Therefore, it isn’t so interesting.

the ceiling

The better question, I think, is how high the oil price might go once high-cost supply has left the market.

base metals

For a base metals mining project, reassembling a crew + machinery to restart a shuttered mine is expensive and may take half a year.  And certainly no one is going to begin to develop a new mine until price visibility is very high.

shale oil

For shale oil, on the other hand, startup might only require a handful of people and maybe a month.  In addition, if I thought I could get, say, $70 a barrel for my oil a year or two down the road instead of $45 today, I’d deliberately pull at least some of my wells out of production and wait–assuming I had my debt repayments under control.  For that portion of my output, I’d be ready to turn the spigot instantly.

I don’t know exactly what price level triggers a return of shale oil to the market, creating potential oversupply again.  But production will return very quickly.

The trigger is clearly not as high as $100.  If I were analyzing oil companies for their rebound potential, I’d hope for $70 but base my figures on $60.  The analysis itself would tell me whether $60 is high enough.

My general conclusion, though, is that oil isn’t going back to the levels of a year ago for a long time.

an aside

The best petroleum economists in the world are in OPEC.  It’s impossible that Saudi Arabia doesn’t know with much greater precision what I’ve been writing about.  Why should it be talking of oil at $100 or $200 in the near future?

Maybe for public consumption at home.  A more devious mind would suggest it’s to persuade lawmakers in the US, the most profligate user of oil, not to take the sensible course of raising gasoline taxes and thereby tempering future demand increases.  The country’s lobbyists are doubtless hard at work in Washington, as well.

oil: how the price dynamic has changed

Value Line vs. O”Neil

My first Wall Street job was with Value Line, a firm which has seen better days but which dominated the retail market for investment information in the 1970s – 1980s.  It still publishes the Value Line Investment Survey, a newsprint weekly that over a 13-week cycle provides historical data, analyst commentary (generally not good nowadays) and a computer-generated comparison of relative investment attractiveness (based on PE and earnings growth) for a universe of around 1800 stocks.  As I recall, the Survey cost about $250 a year back then and had about 80,000 subscribers.

Analysts and portfolio managers who worked for the company couldn’t understand why the price was so low.  We all thought the publication should sell for at least double the going price.  Since the main costs of publication were for printing and postage (sadly, not for salaries), the company could triple or quadruple its profits by charging $500.  The publication was surely worth it.  Yet the firm’s owner adamantly refused to budge.  A real head scratcher.

Then we found out why.

A rival emerged in the form of William O’Neil and Company, a suppliers of very detailed price charts and other technical information to individuals and institutions. O’Neil launched a chart-based weekly service covering the same universe of stocks, cpriced at $125 a year.  No analysis, but similar historical data, loads of technical information and highly detailed charts that put Value Line’s to shame.

The publication lasted about a year and then folded (I Googled O’Neil just before writing this.  The firm appears to have revived the idea and to now be selling a similar service.  I didn’t investigate, though.)

Why?

I remember figuring at the time that O’Neil needed at least 5,000 subscribers to be cash flow positive (this was a long time ago, so my numbers may be way off.  Their accuracy isn’t necessary for my point, though.).  If it got there, it could gradually add features and increase marketing   …and start to grow itself into a serious competitor to Value Line.  O’Neil couldn’t get north of 2,000 with its service, however, and quickly got tired of bleeding red ink.

Suppose the VLIS had been priced at $500 instead of $250?  O’Neil could have priced his service at, say, $250   …or even $350 and still offered a generous discount.  At 2,000 subscribers he would have been in the black–and growing into an increasingly sharp thorn in Value Line’s side.

The clear economic response to this development would have been for VL to cut its price to $250 to make O’Neil unviable.  But that would have been psychologically very hard to do.  It would have created internal morale problems as belt-tightening took hold.   And it might also draw the attention of the Justice Department.  Waiting two or three years, hoping (in vain) for the competitive dynamic to change, would only compound the problem.

pricing umbrella

That was my introduction to the concept of a pricing umbrella, the idea that high margins creates a fertile, sheltered environment in which competition can grow.

why it’s bad

Two negative consequences:

–competition can gain critical mass, and

–even if it can’t, if newcomers have made significant capital investment they will continue to operate–at a loss–to extract whatever cash they can from their failing businesses.

OPEC’s umbrella

More or less, this is the messy situation that OPEC has created in the oil market.

Under the protection of a $100 a barrel price, unconventional, technology-based competitors have emerged, mostly in the US so far.  This happened about half a decade ago.  The newcomers were initially able to extract oil profitably at $80 a barrel (as opposed to less than $10 for Saudi Arabia).  But they’ve improved their techniques to the point that many can make money at $40.

results of the oil price halving

In the near term, highly financially leveraged high-cost oil producers will be forced by their creditors to stop spending on new projects.  They will continue to produce from existing wells until they run dry, however.  It’s just that all their cash flow will be devoted to repaying debt.

The long-term problem for OPEC is that the new technology–whose development high prices stimulated–won’t go away.  As/when prices rebound to, say, $60 a barrel, hydraulic fracturing will begin to expand aggressively again.  I think shale oil output will rise relatively quickly, as solvent oil development firms take over in-the-ground infrastructure left idle by their bankrupt brethren.

At some point, the oil price will bottom.  I don’t know whether that point is now or not, but I’ve been thinking that something like $40 a barrel will be the floor.  On the other hand, I don’t see the market returning to the status quo ante within any reasonable amount of time.

How this affects oil stocks tomorrow.

oil: will falling prices reduce supply?

Ultimately, yes   …but only at lower prices than today’s., I think.

With any mining commodity, price declines normally end only when the highest-cost firms have to pay more to produce the commodity than they can sell it for.   Even then, if a production process is hard to restart or if the producers fear losing skilled workers permanently if they shut down, production often continues for a period even though cash flow is negative.

Petroleum has been an exception to this rule.  Oil had a period in the early 1980s when Saudi Arabia reduced its oil production dramatically in a vain bid to stabilize prices.  But its efforts were undone by other members of OPEC who agreed to cut production, too, but upped it instead to fill the vpoid left by Saudi cutbacks.  It took Saudi resumption of production and a consequent plunge in prices for the others to fall into line.  This time around Saudi Arabia has made it clear it won’t repeat its production-cutting mistake.

If cartel action won’t stop the current oil price decline, then we’re left with normal commodity forces to do the job.  The most likely production to shut down for cost reasons is output generated through hydraulic fracturing in North Dakota and Texas.  Estimates of cash production costs for fracked wells ranges from $40 – $60 a barrel.  In theory, therefore, production won’t be taken off the market until prices reach $60.  Even at that level, however, only a small amount of output will probably be lost–not enough for price stabilization.

One wild card:  bank loans.  Typically, smaller oil exploration companies of the type that have been successful with fracking try to boost their returns or speed their expansion by leveraging themselves financially.   Except in times of speculative excess, bank loans.to exploration companies contain restrictive covenants.  These normally mandate that the explorer must maintain reserves with a value of, say, 3x the amount of the loan.  If the value of reserves falls below a certain minimum, say 2x the value of the loan, the borrower is required to devote most or all of its cash flow to repaying its borrowings.  In other words, it can no longer pay a dividend to shareholders nor can it spend money on new drilling.  This last is potentially a big issue for frackers, whose wells tend to have relatively short productive lives.

My guess is that borrowings of the type I’ve just described will ultimately be the reason the oil price ultimately stabilizes, by halting the growth of fracking.  Two ways to gauge whether this is happening:  dividend cuts, and reductions in the number of new wells started.

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.