The Trouble with Oil

In an earlier post, we talked about market volatility when new risks move to center stage.

Well, crude oil is center stage, to say the least.  Why?  Oil at $30 per barrel for a few years would lead to (literally) a world of hurt:  widespread bankruptcies in the oil patch, massive write-downs in bank loans and high yield debt, plummeting capital expenditures and further job losses.  Some emerging market nations would default.  This satisfies the “big downside” criterion.

In late 2014, pundits generally thought the decline was a good thing:  every dollar lost by an oil company was a gift to airlines and consumers – an “oil tax cut.”  Today, low oil is now “too low oil,” and fears of the above scenario have some commentators using terms like “unprecedented” and “2008 all over again.”

Now let’s do a reality check.  The market clearly is oversupplied today.  In the third quarter of last year, the International Energy Association pegged the excess at around 1.5 mm barrels per day.  But note that 1.5 mm bpd is only 1.5% oversupplied.  In early 2014, when the market was 1.1% oversupplied, oil was trading above $100 per barrel.

Did an increase in 0.4% in excess supply really cause prices to collapse by 70% or more?

In part, but it’s a bit more complicated.  Over the past decade, trillions of dollars of capital investment in new oil production boosted supply; in the US alone, production doubled to over 9 mm bpd.  Most of the new production, though, is high cost:  it’s a lot easier to get oil out of the ground in Saudi Arabia than in shale formations or deep water wells.

In 2014, the Saudis and OPEC decided to keep pumping oil despite signs of oversupply in order to drive higher cost producers out of the market.  Prices might drop, but if even a small percentage of high cost producers shut production and with global demand rising at 1% per annum, balance between supply and demand would be restored.  To the surprise of the Saudis, frackers kept fracking and prices plunged more than expected.  Why?  For one thing, many frackers had bought hedges, so they effectively were selling their production at 2014-like prices.  Plus, when you hear about “high cost” wells, that usually includes cap ex – the marginal cost of pumping is much lower.

Will this continue?  In the near term, almost certainly.  There’s an industry-wide game of chicken underway.  Debt-laden frackers and others are pumping frantically to stay solvent.  State run oil companies, which subsidize bloated government budgets, are flooding the market.  Iran is re-entering the market at precisely the wrong time.  Add in political factors like a desire to weaken Russia and ISIS, and many swing producers will accept short term economic pain rather than allow prices to rise.

But in terms of the scary “2008 like” scenario above, prices need to be low not for days or weeks, but years.  Will oil be closer to $20 or $120 in 2017?  There are too many variables to estimate it with accuracy, and many of the players in the commodity markets are not known for rational economic decision making.  That said, low prices today do lead to less supply over time, so there is a self-regulating feature, as in any market.

The longer prices stay low, the deeper the cuts.

Over the medium term, though, it won’t take much for oil prices to rebound from here.  Capital expenditure budgets are being cut.  The longer prices stay low, the deeper the cuts.  Financing has dried up for high cost producers – in contrast to the billions of fresh equity and debt raised in early 2015 (and most of which is now trading at a fraction of the issue price).  Overleveraged oil companies that go bankrupt will have their debts extinguished and will be formidable competitors, but all this takes time.  Oil demand is still growing and will gradually soak up excess supply.

Last year, most people thought the floor was $40 and prices would settle around $60 this year – the past month or two has been a shock, and models and forecasts are being adjusted accordingly.

How does this affect overall market psychology?  Big downside, hard to handicap.  And well outside most investors’ knowledge base.  Further, the most salacious predictions get the most attention.  The forecaster who breaks ranks and predicts $10 oil is a headline story; the 99 others who think this is unrealistic get short shrift.

How will the next few months play out?  First, market participants will take some time to research and digest the new risk.  There’s a learning curve.  Second, the information flow will shift from hysterical knee jerk reactions to more informative, balanced assessments. Finally, there are always powerful vested interests – governments, policy makers, central banks – that will seek to counteract adverse effects, but this often isn’t apparent until things deteriorate.

This is not to underplay the risks.  The fiscal issues in countries like Venezuala and Brazil (and possibly Russia) should not be ignored, and defaults could have profound effects on the markets.  Write-downs of trillions of dollars of malinvestment across the commodity complex could destabilize many Asian financial institutions.  And a falloff in capital expenditures and commensurate job losses will reverberate through the global economy.  That said, investors always are faced with risks, and these risks are not new.  The key is for investors to be able to make rational judgments about the likelihood of different outcomes and position their portfolios accordingly – and not get swept up in confident declarations of misinformed pundits or hysterical news flow.

January 16, 2016

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