Investment Opportunities in the New World of Low Oil Prices
The Current Situation
In the simplest of economic terms, the price for any commodity is set at the equilibrium where supply equals demand. However for oil, whose supply and demand is tied to an incredible amount of worldwide factors, this relationship becomes incredibly more complex.
Complicating matters are the facts that demand for oil is inelastic (price rises have little effect on drivers’ habit of using their cars) and supply for oil is inelastic (long lead times and giant investment costs mean both that new supply can be slow in arriving and that uneconomic supply can be slow to shut off). Meanwhile, prices tend not to respond to reality, but to perceptions of reality.
So instead of simply matching supply to demand, oil prices are determined by an extremely volatile mixture of speculation, oil production, weather, government policies, the global economy, the number of miles the average American is driving in any given week, etc.. In addition, the underlying assumptions used for these inputs can be inaccurate.
For the past ~3 years, oil has more or less consistently maintained a price above $100 a barrel (Brent crude oil), even occasionally trading for over $125/bbl. This elevated price level was supported by apparently ever-increasing demand as the world’s economies continued to recover from the 2008 global financial crisis. As late as mid-June 2014, Wall Street traders feared that oil prices would continue to increase even further as violence in Iraq flared up again, endangering the supply of 3 million barrels a day that are produced there.
But then, merely weeks later, oil prices began their freefall. The collapse in oil prices seems to have come to the forefront of attention on July 11, when several media outlets reported that Libya’s largest oil field resumed production after protesters ended a four-month strike, which would bring the country’s output close to one million barrels a day, three times the then current level.
This information, combined with U.S. government data revealing an increase in the amount of oil stored at Cushing, Oklahoma (the delivery point for the Nymex crude contract) and more certainty over Iraq’s oil output added to the concern that there was a vast oversupply in the market. Oil prices plummeted.
Prices continued a steady march downward then, as traders began to absorb the reality of a glut in supply and a lower level of demand. Each new piece of news added fuel to the fire, especially statements from Saudi Arabia and OPEC that they would not cut output to bolster prices.
Throughout this entire time, no one knew (or knows now) where the price would find support and bottom out. Analysts’ predictions were blown away as oil prices dropped below $70, then $60, and then $50.
As the chart below illustrates, both WTI and Brent crude oil spot prices have dropped nearly 60% from their most recent highs of $108 and $115, respectively, in June.
Note: Natural gas prices have been slightly more insulated, falling ~35% since July (natural gas is often found alongside shale oil and produces many of the same petrochemical products as crude oil).
Analysts (the same ones that said that oil would absolutely not drop below $70/bll) have since scrambled to revise their predictions, with the price for oil now expected to bottom out in the first half of 2015 at anywhere between $30 and $40, before rebounding to as high as $80. Goldman Sachs and J.P. Morgan now forecast an average price of $46-47/bll in 2015.
Meanwhile Iran’s Oil Minister recently said that the oil industry could withstand prices as low as $25 a barrel and does not expect OPEC to cut production anytime soon (in fact, it costs many of the OPEC member countries as little as $5-15 to produce a barrel of oil, although the price level needed to balance their national budgets are anywhere from $60-$120/bll).
A Crude Awakening
In hindsight, it would appear that the oil market was overdue for a correction, as investors finally began to realize the truth of the following factors:
Oil demand in the West and Japan has been stagnant or falling since the 2008 financial crisis, especially as the recovery in the United States had been slow and Europe continues to battle the threat of a continent-wide recession. Additionally, alternative fuels (including natural gas) have eroded oil demand, particularly demand for automotive fuel in the West.
Exasperating these problems is the slowdown in Chinese growth, which too many people had assumed would forever continue on its steep upward curve. Over the past four years, the YoY rise in oil imports to China has averaged 6.2%, down from an average of 16.1% from 2003 to 2010. China had become an even more important market for African, Latin American, and even Middle Eastern oil producers as North American oil imports declined, as detailed in the next section.
At the same time, rising oil prices throughout the 2000’s and newly introduced technology opened up the opportunity for exploration and production of more expensive reserves, such as the mining of Canada’s tar oil sands and hydraulic fracturing (fracking) in U.S. shales. This led to an enormous amount of oil and natural gas being produced in North America. From 2008 to 2014, U.S. crude oil production increased from approximately 5 million barrels a day to 9 million. Likewise, crude oil imports to North America fell from above 8 million barrels a day to less than 4.5 million over the same time period.
Meanwhile, Saudi Arabia and other oil producing nations continued to produce as normal, leading to a worldwide buildup of oil stocks (see the chart below). OPEC has announced that it will not cut oil production in order to support higher prices (partly perhaps for fear that some members would not adhere to the policy and partly due to the prospect that the new American shale oil producers would simply step in to fill the demand), creating a first-to-blink staring contest with North American producers.
The strengthening U.S. dollar has also contributed to the drop in oil prices. The U.S. Dollar Index (DXY), which measures the buck against a basket of six major western currencies, has risen over 15% since August. The index recently hit a 12-year high and the 7.1% rise in 3Q14 was the biggest quarterly rise since the 2008 crisis. The dollar has also hit highs against several other currencies not included in the index.
The rise of the dollar has occurred because the U.S. Fed is nearing the end of its Quantitative Easing program, while Japan continues its own QE program and Europe contemplates following suit. Additionally, the U.S. economy continues to grow faster than the economies of Europe and Japan. This combination has led to an increased demand for dollars versus other world currencies, and a stronger buck.
Since crude oil is priced in dollars, a higher dollar translates to a lower oil price.
Other macroeconomic influences include continued concerns about the stability and growth prospects of China’s slowing economy and the price ratio between oil and natural gas, which had become largely distorted in oil’s favor since the late 2000’s.
There Will Be Blood
It appears that fear has so far ruled Mr. Market, with investors fleeing any stock tied to the oil industry. From July 1, 2014 to January 20, 2015, the S&P 500 (^GSPC) has risen 2.5%. But over the same time period, the Energy Select Sector SPDR ETF (NYSEARCA: XLE) has dropped 24.8% and the SPDR S&P Oil & Gas E&P ETF (NYSEARCA: XOP) has dropped 46.7%. Even the Alerian MLP ETF (NYSEARCA: AMLP), which tracks an index of energy infrastructure companies – companies which largely should be unaffected by changes in oil prices, has fallen 10.8%.
For sure, the high oil prices that we experienced before the crash were clearly untenable and it’s still uncertain where the trough will be. But it’s neither wise nor financially-fattening to treat all companies in the oil industry the same way. Indeed, there will be some clear losers, but there will also be winners in this new world of low oil prices. The wisest course of action, therefore, is an intelligent analysis of the individual sub-sectors and companies within the broader oil industry.
Finding Liquid Gold
Because no one really knows what the future holds for oil prices, I would deem any investment in oil as a commodity as mere speculation (unless you’re attempting to profit from the current contango market conditions, in which case you probably wouldn’t listen to my advice anyways). Oil prices could drop even further or could very possibly remain at the current low levels for several years. Furthermore, prices have become extremely volatile, with the CBOE/NYMEX crude-oil volatility index nearly tripling since June (while volatility isn’t fundamentally negative, volatility while engaged in a short position or in a derivatives contract like a futures contract can be dangerous). Finally, owning oil or an oil futures contract confers now real economic benefit besides the opportunity to eventually sell at a higher price. As a consequence, your fortunes are entirely tied to the whims of the market.
Verdict: Red (avoid, unless you have a spare oil supertanker)
Upstream companies are engaged in the exploration for oil and natural gas reserves (i.e., prospecting, seismic, and drilling activities that take place before the development of a field is finally decided) and the production and stabilization of oil and natural gas (i.e., bringing oil or natural gas to the surface).
A potential oil field will be explored if the cost to explore it is less than the value of the reserves there. Similarly, an oil site will remain operational if oil prices are above the break-even price for that particular rig. The general analyst consensus has been that the break-even price for most U.S. shale producers is in the $50-70/bbl range.
With prices nearly 60% lower than six months ago, starting production in the most difficult and expensive oil fields no longer makes economic sense. Consequently, the number of U.S. oil and gas rigs has been declining as the most expensive sites drop below break-even and stop operation, and are not replaced with new wells. The total number of rigs in use is at its lowest level since October 2010, with last week (Jan 10th-16th) seeing the biggest weekly drop in rig use since January 2009 and the third-biggest drop since 2000.
So far the number of oil rigs in use has declined ~20% from the peak of 1,609 during the last cycle (June 2014). This number could decline an additional 20-40% before hitting a trough (the U.S. oil rig count fell 40-60% during the last 3 down cycles).
With their margins being squeezed, energy producers, service providers, and suppliers (such as steel companies) are cutting back on capital spending and expenses by delaying projects and eliminating jobs (although most plan to continue high production rates).
Avoid exploration companies and exploration-services companies that focus on unconventional sources of oil, such as oil sands, shale oil, and extra heavy crude. Avoid highly leveraged companies with huge debt servicing requirements. And avoid production companies that are not diversified and that have high break-even price requirements (generally those operating in the oil shale basins).
It should be noted that the the exact pinpointing of break-even prices is a little murky and can be misleading. For example, the oil sands in Canada require(d) huge initial upfront investments, but are cheap to operate once running and have lengthy production lives (unlike shale oil, which requires constant drilling of new wells to maintain output levels, once an oil-sands site is developed it will produce tens or hundreds of thousands of barrels a day, steadily, for up to three decades). Consequently, existing oil sand surface mines can make money at $30-35/bll, which is higher than traditional wells but still much lower than other unconventional sources of crude.
Verdict: Red (avoid exploration companies and most shale oil producers) / Yellow (opportunity to find undervalued oil sand producers like Suncor and traditional oil producers, or integrated producers that are partially protected through midstream and downstream operations like Exxon and Chevron; potential for future merger arbitrage opportunities as larger producers acquire smaller struggling ones and the sector consolidates).
The midstream sector involves the transportation (by pipeline, rail, barge, oil tanker, or truck), storage, and wholesale marketing of crude or refined petroleum products. Pipelines and other transport systems can be used to move crude oil from production sites to refineries and deliver the various refined products to downstream distributors. Natural gas pipeline networks aggregate gas from natural gas purification plants and deliver it to downstream customers, such as local utilities.
Midstream also often includes gas treatment (purification) and liquid natural gas (“LNG”) production and regasification plants (natural gas is sometimes liquified to facilitate transportation where pipelines are unavailable).
Most of these “energy infrastructure” companies are structured as Energy Master Limited Partnerships (“MLPs”), which are a type of limited partnership that is publicly traded and that derives at least 90% of its revenue from pipelines, natural gas, gasoline, oil, storage, terminals, and processing plants. MLPs distribute their earnings through quarterly required dividends.
Investors, worried that drillers would/will cut production and that high-yielding MLPs could suffer once the Fed increases interest rates, have been selling MLPs along with other energy stocks. As mentioned above, the benchmark Alerian MLP Index has fallen ~11% since July as oil prices have tumbled.
While the above concerns may be warranted, MLPs have probably been oversold at this point. The great thing about these these oil transportation and infrastructure companies is that they aren’t reliant on oil prices – they are paid based on volume, and in fact stand to benefit as lower prices lead to higher demand. Additionally, the hesitance of many producers to cut production combined with the current excess of supply should lead to continued high volumes.
Verdict: Green (there may be several opportunities in this sector, whether it’s a pipeline MLP like Magellan Midstream Partners, a midstream sector ETF like the previously mentioned Alerian MLP ETF, or another related energy infrastructure or energy infrastructure-services company).
Downstream refers to the refining of crude oil and natural gas into marketable end-products, such as gasoline, kerosene, jet fuel, diesel oil, heating oil, fuel oils, lubricants, waxes, asphalt, natural gas, and liquefied petroleum gas (LPG), as well as hundreds of petrochemicals such as ethylene, propylene, benzene, ammonia, etc.
Profits in this sector depend on the “crack spread” (the price difference between crude oil futures and refined products futures) or the “refinery margin” (the difference between the cost to produced refined products and the price at which they are sold). Prices for refined products typically don’t fall as quickly as crude oil prices, so downstream operators could see a short-term boost from falling oil prices. Eventually, however, end-product prices will fall, too.
Still, this isn’t necessarily negative. Even if margins compress, refiners can make up the difference with higher overall volumes as lower refined product prices drive up demand.
Verdict: Yellow (the integrated production companies (e.g., Exxon, Chevron) that also produce petroleum products stand to benefit from their refining operations; additionally, look to U.S. refiners, which have an advantage over their foreign competitors because domestic producers can only sell their oil inside the U.S. (most U.S. crude oil cannot be exported) – this means U.S. refiners enjoy higher margins than their foreign counterparts because they can buy their raw material for less and sell their products abroad at the same cost as everyone else).
Stay tuned for several specific oil & gas stock recommendations, which I will detail in a new post within the next few days.
Meanwhile, are you investing in the energy industry? Where have you found value opportunities so far? Let’s hear it in the comments box!
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Before you jump headfirst into oil & gas stocks, take time to make sure that you truly understand the industry. Here are a couple of resources to help you:
ABB – Oil & Gas Production Handbook [An excellent, comprehensive yet understandable guide to the oil & gas industry. The first 20 page provides a great introduction to the entire industry and the rest of the text goes into more specific details. H/t to Jae Jun from Old School Value]
YouTube – How petroleum exploration and refining process [It’s always nice to have a visual representation of what you’re reading about]
YouTube – Oil Drilling | Oil & Gas Animations [A more detailed look into oil drilling specifically, you may want to skip around in the video as the pace is a little slow]
ICIS – The Oil Price Crash and What It Means for the Petrochemical Industry [Provided much of the basis for this post’s description of the events causing the crash in oil prices]