$80 a barrel oil

cartel activity

About a week ago, Saudi Arabia and Russia, two of the three largest oil producers in the world (the US is #1), announced they were discussing the mechanics of restoring half of the 1.8 million barrels of daily output foreign companies have been withholding from the market since 2016.

the objective? 

…to stop the price from advancing above $80.

To be honest, I’m a bit surprised that oil has gotten this high.  But producing countries have held to their cutback pledges to a far greater degree than they have in the past, with the result that the mammoth glut of oil in temporary storage a couple of years ago is mostly gone.  In addition, the economy of Venezuela is melting away, turning down that country’s output of heavy crude favored by US refiners.   Also, the world is worried that unilateral US withdrawal from the Iranian nuclear agreement may mean the loss of 500,000 daily barrels from that source.

On the other hand, short-term demand for oil is relatively inflexible.  Because of this, even small changes in supply or demand can result in large swings in price.   An extra 1% -2% in production drove the price from $100+ to $24 in 2014-15, for example.  The same amount of underproduction caused the current rebound.  So in hindsight, $80 shouldn’t have been so shocking.

Why $80?

Two factors, I think.  There must be significant internal pressure among producing countries to get even a small amount more foreign exchange by cheating on quotas.  Letting everyone get something may make it harder for one rogue nation to break ranks.

More importantly, a $100 price seems to trigger significant global conservation efforts, as well as to shift the search for petroleum substitutes into a higher gear.  So somewhere around $80 may be as good as it gets for producers.  And it leaves some headroom if efforts to hold the price at $80 fail.

the stocks

My guess is that most of the upward move for the oils is over.  I think there’s still some reason to be interested in financially leveraged shale oil producers in the US as they unwind the restrictions their lenders have placed on them.

 

 

 

thinking about the oil price

I’ve been reading lately that many US oil companies are continuing to drill for shale oil, despite the fall in the price of crude.  However, while they are finishing drilling holes in the ground, they’re not yet “completing” the wells.  That is, they’re not fracking the underground deposits by pumping in water/sand/chemicals to create a path for the hydrocarbons to get to the well.  Nor are they installing the equipment a working well requires.

There’s even a name for these already drilled but not completed wells–fracklog.

The decision not to complete is easy to understand.  There’s already too much oil sloshing around in the world.  Why spend money to add to the problem–maybe even pushing prices down enough to make your own efforts unprofitable.

Why continue to drill, though?

Lots of potential reasons.

A drilling rig may be under contract, so the oil explorer has to pay for it whether used or not.  Drilling a certain number of wells may be necessary to keep mineral rights to specific acreage.  In the case of companies with too much debt, the bankers may be calling the shots (although such wells will surely be completed as fast as possible).  Some exploration firms have also made it clear that they consider today’s oil price to be a purely temporary dip.  So they’re going to continue to drill no matter what.

What’s important for investors, though, is how the fracklog may affect any rebound in the oil price.

My picture is that oil is bouncing along at or near the bottom, waiting for high cost production to leave the market.  As/when that happens, and as world GDP growth gradually increases demand for petroleum, the oil price will begin to rise again.

I think the fracklog creates a ceiling above which oil will find it difficult to rise.  It implies that when these backlogged wells become profitable enough, a rush of new output will hit the market.  Maybe the appropriate price is $70 a barrel.  $60, anyone?  It’s almost certainly below $100.

If I’m correct, an eventual oil price rise will be unpleasant for consumers but not devastating.  Also, the buy/sell decision for any oil producer becomes much more a sharp pencil exercise than a thematic call on the possibility of boundless price increases for output.

 

 

oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.

 

 

 

oil: the view at 30,000 feet

Oil is either a very complex subject or a very simple one.

There’s a wide variation among various types of oil, the kinds of input a given refinery can process, the politics/stability of the countries that provide the different grades of oil to the market, and the regulatory regimes in different countries where refined oil products are used.

Nevertheless, there are general patterns that can be of investment significance.

In particular, I think it’s at least possible that we’re entering a period of extended oil price weakness, due to slow economic growth in the US, and to a lesser extent in the EU, plus the sharp rise in unconventional oil production in the US.

Here’s why:

supply/demand

In the short run, oil supply is relatively invariant.  Major oilfields are very expensive long-term projects designed to bring large deposits of subterranean oil to the surface.  Once the oil starts flowing, it can’t be stopped without risking major damage to the oil reservoirs.  This could mean a lot of extra drilling to reach now-isolated pockets of crude.  So capping wells to reduce supply generally isn’t done.

Same with oil demand.  In the absence of large price moves,  people will continue to use transportation fuel in the same way.  Industrial processes won’t change.  So this major portion of demand is pretty much locked in.  And until a shockingly large heating bill comes in the mail, people won’t turn the thermostat down.

Because both supply and demand are relatively inflexible, small changes in either can result in large changes in price.  We saw this a few years ago when oil spiked above $150 a barrel as desperate users bid up the price of scanty supplies.  But the opposite could equally well occur:  panicked producers, running out of storage space to put barrels of crude customers don’t want, offering large discounts to get someone to take them off their hands.

On the supply side, OPEC is the largest factor, accounting for about a third of world output.

On the demand side, the US is the world’s largest, and most profligate, petroleum consumer.  We use 20% of the world’s oil while representing less than 4% of the globe’s population.  As I invariably try to work into the conversation, the US is also the only developed country not to have an energy policy that promotes conservation.   The intent has been to protect an inefficient domestic auto industry that ended up imploding in the last recession anyway.  One unintended effect has been to help preserve OPEC’s immense economic power.

shale oil

What’s new in the supply/demand story is coming out of the US.  It’s the rapid rise in production of shale oil, which has lifted total US crude output from 5 million barrels a day in 2008 to just shy of 9 million now–with at least another one million b/d gain likely over the next year.

Arguably (read: this is what I think, but have no definitive evidence for), the main reason oil prices haven’t been spiking up despite turmoil in the Middle East is the steady new flow of US crude from places like North Dakota.

The International Energy Agency has just pared a bit from its estimate of oil demand over the coming year, based on slowdown in the EU.  Large-scale purchases of new, more fuel-efficient cars in the US may begin to put a lid on domestic gasoline consumption, which is the biggest part of US oil usage.  China, the #2 world oil user, with about half the consumption of the US, is also growing a bit more slowly than anticipated.

Will all this be enough to tip the world oil supply/demand balance in favor of oversupply (and significantly lower prices)?  Who knows?   …but maybe.

effects?

…a shot in the arm for stocks generally (other than the oils).  Lower gasoline prices would mean higher discretionary income for ordinary Americans, which would be a plus for mass-market consumer stocks.

Bet on this?   …no.  Just something to think about, to consider what we’d buy if signs of a weakening oil price began to emerge.