how low can the crude oil price go?

This is my response to the comment of a regular reader.

There’s no easy answer to this question.  I have few qualms about putting a ceiling on the oil price.  In round terms, I’d say it’s $60 a barrel, since this is most likely the point at which an avalanche of new shale oil production will come on line.  Also, for investing in shale oil companies this number doesn’t matter than much, so long as it’s appreciably above the current price.

A floor is harder.

a first pass through the issue

We can divide the source of oil production into three types.  I’m not going to look up the numbers, but let’s say they’re all roughly equal in size:

–extremely low production cost, less than $5 a barrel, typified by production from places like Saudi Arabia

–very high production cost, like $100+ a barrel, which would be typical of exploration and production efforts of the major international oil companies over the past decade or so, and

–shale-like oil, with production costs of maybe $35 -$40 a barrel.

In practical terms, there’s never going to be an economic reason for the low-cost oil to stop flowing.

Shale oil is basically an engineering and spreadsheet exercise.  The deposits are relatively small and the cost of extraction is almost all variable.  So shale will switch on and off as prices dictate.  We know that at the recent lows of $25 or so, all this production was shut in.

The very high production cost is the most difficult to figure out.  Of, say, $100 in production expense, maybe $70 is the writeoff of exploration efforts + building elaborate hostile-environment production and delivery platforms.  This is money that was spent years ago just to get oil flowing in the first place.  What’s key is that for oil like this is that the out-of-pocket cost of production–money being spent today to get the oil–may be $30 a barrel.  From an economic perspective, the up-front $70 a barrel should play no role in the decision to produce oil or not.  So, dealing purely economically, this oil should continue to flow no matter what.

second pass

First pass says $30 – $35 a barrel is the low;  $60 is the best the price gets.

Many OPEC countries (think:  Saudi Arabia again) have economies that are completely dependent on oil and which are running deep government deficits.  Their primary goal has to be to generate maximum revenue; the number of barrels they produce is secondary.  If so, they will increase production as long as that gives them higher revenue.  Their tendency will be to make a mistake on the side of producing too much, however.  Their activity will make it very hard to get to a $60 price, I think.

On the other hand, shale oil producers who can make a small profit at, say, $35 a barrel may tend to shut in production at $38 – $40, on the idea that if they exercise a little patience they’ll be able to sell at $45, doubling or tripling their per barrel profit.

third pass

Second pass argues for a band between, say, $40 and $55.

Bank creditors don’t care about anything except getting their money back.  They will force debtors–here we’re talking about shale oil companies–to produce flat out, regardless of price, until their loans are repaid.  This was an issue last year, and what I think caused the crude price to break below $30 a barrel.  I don’t think this is an issue today.

There’s a seasonal pattern to oil consumption, driven by the heating season and the driving season in the northern hemisphere.  The driving season runs from April through September, the heating season from September through January.  February-April is the weakest point of the year, the one that typically has the lowest prices.

If the financial press isn’t totally inaccurate, there are a bunch of what appear to be poorly -informed speculators trading crude oil.  Who knows what they’re thinking?

my bottom line

This is still much more of a guessing game than I would prefer.  I see three positives with shale oil companies today, however.  Industry debt seems more under control.  Operating costs are coming down (more on this on Monday).  And seasonality should soon be providing support to prices.

 

 

 

BP Energy Outlook 2016

BP just released its annual Energy Outlook.  

The company is projecting faster development of shale oil, coming mostly over the next few years from the US, than it previously thought.  Renewable energy supply will rise more quickly; (heavily polluting) coal usage will fall faster.  Most of the action will be in developing nations like China and India.  The US will attain energy self-sufficiency in a handful of years, oil self-sufficiency shortly after that.

 

To me, the most interesting topic the release brings up is not actually contained in the report.  It comes from comments by Spencer Dale, BP’s chief economist, during a press conference promoting the new Outlook.

According to the Financial Times, Mr. Dale said that there’s twice as much technically recoverable oil available as the world is expected to need between now and 2050.”

First, “technically recoverable” means only that all of this oil can be extracted from the ground using current oilfield methods.  It does not mean it can be done profitably.  In fact, the choice of the word “technically” suggests BP believes that a significant portion is uneconomical at today’s prices.

Second, according to BP, much of this oil is unlikely to see the light of day…ever.    That’s because global demand for energy is likely to grow by less than 2% yearly.  Most of that will be supplied by renewables and natural gas; oil demand increases by less than 1% annually.

At some point, as the price of renewable energy continues to fall, and absent a decline in the oil price, demand for oil begins to shrink.   Since one might imagine that this drop might not take place thirty years, it may be of little practical concern to you and me.  However, for OPEC countries like Saudi Arabia, which holds perhaps 100 years worth of economically viable oil, and whose economy is radically dependent on petroleum, this is a significant worry.

Investment implications (assuming BP is correct):

–the oil price is unlikely to go up

–OPEC + shale oil will squeeze out higher cost oil production from the rest of the world

–future shale oil company profits will come as much from lowering production costs as from new finds

–big oil firms probably still have plenty of stranded assets (meaning oilfield investments that have become uneconomical and where recovery of the money already spent is unlikely) on their balance sheets.

 

 

 

 

Saudi Arabia’s about-face

About a week ago, Saudi Arabia brokered an agreement among oil producing countries to cap their aggregate output of crude at 32.5 million barrels daily.  This will require daily liftings to be reduced by 1.2 million barrels.  Of that 1.2 million barrels in cuts, the Saudis themselves will account for 486,000, or just over 40%.

This Saudi decision flies in the face of the kingdom’s previous policy and its experience in the 1980s, when it repeatedly reduced production in a vain attempt to stabilize prices.  What happened back then?   …other OPEC countries, with more pressing needs for cash and with relatively short-lived reserve bases (so playing a long game made little sense, just as today), failed to make the output reductions they agreed to.  More than that, they boosted their liftings instead in amounts that more than offset the Saudi cutbacks.  So prices continued to fall, and for years afterward Saudi Arabia lost access to long-time customers.

Over the past two years, because of the bitter experience of the 1980s, Saudi Arabia has refused to reduce its output despite pleas from other OPEC members.  It  has even increased production a bit.

…until now.

What should we make of this about-face?

The superficial arithmetic for Riyadh is clear–reduce output by 5%; the price per barrel rises by 10% as a result; total revenue rises by 5%.  That’s assuming no cheating by other parties.  But in the case of every economically-driven commodities cartel, cheating always happens.  And the Saudis know that OPEC proved itself no different from other cartels 35 years ago.

 

What’s interesting about this case is that for us as investors situations like these, where we have imperfect information, arise more often than we would like to believe.  Rather than obsessing about what we don’t know in these cases, it’s important to see what conclusions we can draw from what we do know.

In particular:

–Saudi Arabia simply can’t have forgotten about its experience in the first half of the 1980s.  It must believe that eventually some parties will fail adhere to their production quotas.  But it must have some reason to believe that this won’t happen immediately

–it’s possible the kingdom thinks that with supply and demand are almost evenly matched, output reductions will cause the crude oil price to rise substantially.  The price rise will ward off cheating

–the Saudis must also think that what they’re doing now is a better strategy for them than that of pumping full-out and keeping prices low.  Why should this be?  My first thought is that Riyadh’s finances are not in strong enough shape to continue to endure $40 a barrel oil

–the Saudis must realize as well that $50+ a barrel will reinvigorate the shale oil industry in the US, capping any possible price rise.  On the other hand, keeping prices at, say, $40 a barrel won’t make shale oil go away.  The industry will simply lie dormant for a while, ready to spring to life again when prices are higher.  On the other hand, they may no longer believe that they can destroy the shale oil business forever by keeping prices low.  they may even fear that technological advances and cost-cutting will make shale viable at $40 if they are allowed to take place.  So, counterintuitively, the best strategy for combating the threat of shale may be to discourage the development of such new techniques by keeping prices higher

my take

Buy shale oil and monitor OPEC closely.

 

 

 

 

 

firming oil prices: seasonal strength or something more?

September through mid-January is the period of greatest seasonal strength in oil prices.  Early in this period, refineries shift from making gasoline to supply drivers to manufacturing heating oil in advance of winter in the northern hemisphere.  There’s normally some friction in the supply chain as this takes place.  But the key reason for current oil price strength, I think, is the typical behavior of wholesalers, retailers and end users accumulating supplies of heating oil for winter use as autumn commences.

This period of strength usually ends in late January–after which there’s be no time to get newly-refined heating fuel to users before the weather warms.

What follows from February through April is the period of greatest seasonal weakness for oil.

 

What to make of current firmness in crude.  Is there any evidence that the proposed OPEC production limiting agreement is exerting upward pressure on the price?

My private hunch is that, yes, there is.  At the same time, I also think there will be little lasting (meaning over six months or a year) collective discipline to keep to promised quotas once they’re seen to be having an effect.  Budget deficits are too large and the third world us-against-them cohesiveness that enabled OPEC’s remarkable past cartel success is no longer present.

 

Still, I think that prices will be strong seasonally for a while in any event, so there’s no need to have a view on whether a production agreement will stick.  That time will come early in the new year.

At that point, for 2017 investment success, having a (correct) opinion about oil will be crucial, I think.  I’m hoping–and anticipating–that I’ll be able to make that decision on other grounds, i.e., the innate cheapness (or not) of shale-related exploration stocks, even without price increases.  In the meantime, I’m content to be on the sidelines.

 

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.

 

 

 

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.

 

 

 

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?