The Trouble with Oil (Part Two)

Two weeks ago we wrote a post on oil (The Trouble with Oil Part 1)  – why it matters to equities these days, and how the initial market response (and pundit commentary) seemed to miss some key fundamental aspects of commodity supply and demand.

What a difference two weeks makes.  A few updates:

  • Oil is up more than 25% from the lows (below $27 per bbl ten days ago, close to $34 today).
  • The focus has shifted from near term demand hysteria to medium and longer term supply issues.
  • The first indication of a policy response – Russia essentially publicly pleading for concerted action with OPEC (or vice versa, depending on who’s talking) – hit the news yesterday.

On the medium term and longer term supply issues, here are some revealing statistics from a leading industry consultant:

  • Demand will grow by 7 mm bpd by 2020 – growth of 7-8% from today.
  • 13 mm bpd of production – 13-14% of the current total – will be eliminated due to depletion – wells are, after all, depreciating assets.
  • Yet, due to lower prices, capital expenditure estimates for 2015-2020 are now $1.8 trillion lower than they were a year ago.

The point is that, in the oil industry, supply and demand are in constant flux.  Huge capital expenditures are needed over the coming decades ($10 trillion is one estimate by mid century) in order to meet demand.  Yes, oil companies have been aggressively cutting capital expenditure budgets, but they also recognize that oil prices today may have little relationship to those in five or ten years.  Projects that look uneconomic at today’s price may result in windfall profits over time.

Predicting supply will be even more difficult going forward

Another issue covered in the news has been the difference between shale and other forms of production.  Unlike deep sea projects, which take billions of dollars invested over years before the first barrel comes out of the ground, shale wells reportedly can be drilled in 20 days with $10 million. Tons of shale companies are overleveraged and will go bankrupt.  This process, while painful, will lead to a write down in existing debt and fresh capital from the new owners.  One estimate is that $60 billion in private equity capital is waiting in the wings to scoop up assets cheaply.  In addition, distressed debt hedge funds have been buying up junk bonds in order to convert the debt to equity in a bankruptcy – called “loan to own.”

With such technological change, predicting supply will be even more difficult going forward.  Better capitalized shale companies can wait to ramp up production as prices start to rise.  Plus, if technology continues to drive down lifting costs, the breakeven price for shale and other forms of production may well continue to drop and new production may come online sooner.

In any event, because of all of these variables, we should expect extreme volatility in oil prices, which will probably be unsettling to equity markets in the near term.  Over time, equity investors are likely to realize that short term moves in oil are not good long term indicators, and daily volatility in oil will have less of an impact on other markets.

January 29, 2016