Energy investing - for me, at least - is mostly on hold. I do have some mid-stream gas pipeline companies that pay great dividends but little else besides cash. When will it be time to get back into energy stocks in a core portfolio sense? Let's work back from the new fundamental realities of oil prices to their implications for energy stock prices.
Before 2003 (except during the politically related oil crises of the 1970’s) there was only one condition in the oil market: plenty of oil. So oil tended to sell at a price related to the marginal cost of production. But something has changed since 2003 that adds a second possible oil market condition, scarcity.
What changed is the near-onset of peak oil and the related fact that when oil demand from developing economies ratcheted up, production could not be expanded as rapidly. So for a while in 2007 and 2008 oil demand ran ahead of available supply, a market condition that required a super-high price of oil in order to “destroy” some of the demand. During that time we saw the oil price behave not as a function of the marginal cost of production but as a function of the marginal requirement for reducing demand.
So there are now two possible conditions in the oil market: too much oil and too little. At the present time there is too much, but once the global economy recovers scarcity will motivate oil pricing again. Thus oil pricing is now like a light switch; it is either on or off. What determines the condition of the switch? The rate at which oil demand is either growing - or declining - which is almost entirely a function of economic growth. Therefore the price of oil is a leveraged derivative of the growth of the economy.
How far is down?
Some analysts - myself included - thought OPEC could maintain the oil price at a fairly high level, say $80, despite a global slowdown. And if the global economy had merely downshifted rather than the present condition of going into reverse, that might have been true. But in the current dramatic global GDP decline it seems that OPEC is powerless. Last week it was reported that Nigeria refused to go along with another OPEC production cut because Nigeria cannot afford lower volume. No doubt there are other oil exporting countries now suffering so much from the low price of oil that their fear that a cut in their output would not drive up the price enough to compensate for the lower volume prevents them from taking a chance on an output cut.
Even if OPEC could hold together to reduce production, the lower production might not prop up oil prices very much because analysts now understand that as OPEC reduces current oil production it simultaneously increases spare production capacity, which tends to damp oil prices almost as much. Why? Because analysts know that when oil demand begins to recover spare capacity will allow production to increase just as rapidly. Thus, it could take many months of economic growth before the price of oil would go higher than the marginal cost of production since analysts know that the cheap OPEC oil that has been kept off the market via collusion will come back on stream rapidly.
If OPEC can’t stop the slide in oil prices what will? A number of factors will soon start to kick in to stop oil prices from going much lower than the recent high-$40 level, including:
1. Enhanced Oil Recovery (EOR) operators will begin to shut down production since the enhanced recovery methods entail higher costs. They know they can only produce EOR oil for a limited time and in a fixed quantity. At a low enough price of oil they will deem their profit margins to be insufficient. Some operators will shut down because they can’t afford to operate but most will ask: why sell it for $50 when we are confident oil will eventually sell for a much higher price and we will only have a fixed amount from any given field to sell?
2. At some price some Canadian and Venezuelan oil sands operators will find their marginal costs for production, shipping, and marketing is greater than the price of oil and so will have to shut down operations. That floor price may not be too much lower than the present $48.
3. The rapid decline of old cheap-oil fields will reduce supply even more than OPEC will. Recently the IEA reported that old fields are starting to decline at rates of 6.5%, much more rapidly than the 4% that has been standard wisdom previously. Even a 4% decline rate means you have to bring on about 3.5 mb/d of new oil fields each year to make up for it. So the accelerating decline of old fields will have more impact on supply now when there is less supply and when there are fewer new fields coming on stream.
At some point, the market forces unleashed by lower prices - in other words the tendency of suppliers to produce less oil when prices are lower - combined with the natural decline of old oil fields will offset the forces pushing oil prices down, namely decreasing global GDP and the expectations for still lower prices on the part of speculators. As usual, “the cure for low prices is low prices.” My guess is that $40 could become a floor price - or maybe that has already been reached.
The road back to oil scarcity
Standard wisdom these days, it seems to me, is that eventually the economy will recover and with it oil demand will begin to increase again. What will that process look like?
There are essentially three kinds of oil that can be produced in quantity. They are:
1. cheap land based oil,
2. new production from oil fields obtained with more expensive Enhanced Oil Recovery techniques, and
3. expensive oil from new oil fields that lie deep offshore or in very inhospitable places like the Caspian Sea and Siberia, or oil that comes from converting near-oil such as oil sands or - much worse - “oil shale” into syncrude.
The production of cheap oil only requires a price in the $30 neighborhood. There is still a lot of cheap oil potentially available from Iraq and Nigeria in particular but it is unlikely to be developed quickly due to political issues. EOR operators probably want to see oil above $75 in order to be excited about their ROI. EOR oil production has probably been maximized during the past three years, although there is always opportunity for more production through new EOR techniques.
But despite the potential for some new cheap oil and new EOR, most of the potential future new flows of oil are the expensive type. They come from new oil sands efforts and new deep offshore drilling and recovery. That sort of production will probably require a price in excess of $100 to be economically feasible. So it looks like somewhere around $100 is the new marginal cost-of-production basis for oil pricing - and inflation will increase that price over time.
When global GDP growth causes demand to grow again beyond the ability of new production to satisfy it as it did in early 2008, the price of oil must rise to the point that cuts off demand to balance it with the available additional supply. That’s why we saw oil above $125 a barrel when the world was growing smartly. How long will it take to reach that point again? Given the current lack of investment in new oil production combined with the more rapid current decline in old fields, it might take only a year or two to progress from the point of all easily available new oil being produced to the need for higher prices in order to destroy demand. When that point comes, the old high price level - roughly $150 per barrel - could easily be surpassed.
Thus we see how the price of oil is leveraged to whether global GDP is growing or declining and at what rate. What about oil and oil service stocks? They are leveraged to the price of oil. Therefore oil-related stocks are super-leveraged to the economy.
Goldilocks
Is there a happy middle ground between too much and too little oil? Sort of. There are two conditions that could result in moderately high but stable oil prices. First, it can take some period of time to make the switch from the “off” setting to the “on” setting at GDP begins to grow again. During that time there will be a period when more expensive oil will come onto the market to satisfy the moderately rising growth of demand. There would be no need yet for a high enough price to destroy demand. That might be seen as a time of a “happy medium” in oil prices.
Secondly, we could get one or more “Black Swan” oil events of a “good” nature - say
- the rapid expansion of Iraqi oil by another million bpd each year for a few years, or
- a rapid transition to high fuel efficient cars under some Obama plan for saving Detroit and achieving “oil independence,” or
- an extended period of mild global GDP growth - say 2%, or
- more alternative fuel production, say cellulosic ethanol produced from algae.
If one or more of these developments occur fairly rapidly, rising oil demand might be able to be satisfied without requiring high prices to destroy some of it. We can imagine such a “Black Swan” scenario or a set of them. But by definition Black Swans rarely occur. I suspect such a Goldilocks future has a low probability of lasting for long.
The next phase, one scenario
Here’s what seems to be the current standard view of how oil prices might behave as oil demand begins to grow again:
1. First, all the cheap oil OPEC had removed from the market will be returned to the market, which will not require a much greater price for oil. This could take 6 - 12 months from the time GDP starts growing.
2. Some higher cost oil that was taken off the market or capped - say some oil sands operators who might have shelved some production or some off-shore operators who capped exploratory wells - will come back on stream along with higher prices after 12 to 24 months of growing GDP. Also speculators will come into the market and start to drive oil up, perhaps making price increases start even sooner. The higher cost oil will need prices in the $100 area.
3. Due to higher decline rates in old fields and the cancellation or deferral of many new field development projects during the economic downturn, it will not take long for higher demand to begin outpacing greater supply, thus driving the oil price beyond, and perhaps well beyond, its brief $147 high point in 2008. This point could be reached within two years of global GDP starting to rise again.
Current oil prices are anticipating such a scenario of oil prices starting to rise fairly soon as evidenced by the fact that oil futures are in an abnormally steep (but now somewhat declining) contango. So, for example, the price of oil a year out is about $10 higher than the current price and the price two years out is nearly $20 higher. This suggests that many traders are optimistic that the oil pricing switch is likely to start turning “on” within a fairly short time frame, meaning they think the recession will be fairly short. A bottom in 2009 seems to be standard thinking now.
Another scenario
An alternative future starts with a different premise. Instead of “as oil demand begins to grow again”, as above, suppose the next few years brings only continuing declines in economic activity and the start of deflation despite huge federal pump priming. If during the next several years (generally known as “the foreseeable future” although nobody can see it) there is only continued GDP decline, then the price of oil will stay at the marginal cost of production. I provided a partial road map justifying this sort of scenario recently. We can more easily visualize it by imagining that there may not be enough Federal money available to
1. offset the deflationary impact of state and city budget deficits that must be balanced,
2. keep the banking and insurance industries afloat as their commercial, credit card, and real estate loans crater,
3. build enough bridges and other public projects to grow jobs by 2.5 million in two years, and
4. give out a middle class tax cut.
If this scenario turns out to be the case, look for oil prices to stay in the “off” position for the foreseeable future - and look for the current contango to melt away. Here is a set of predictions by someone with a pretty good track record that paint one picture in which long term low oil prices seem more likely. And here is a straw in the wind, one example of the enormity of the global economic collapse that is now happening, the fact that Italian power use has declined by one third in only two months.
Stock Prices
Now, what about stocks? We see that oil prices are now leveraged to GDP. This is a new phenomenon. Prior to peak oil, it was not the case so much. There was a correlation of oil and the economy but it was not supercharged (except during the time of radical OPEC-induced shortages).
Meanwhile oil equities are leveraged to oil prices. Therefore oil equities are more than supercharged to the direction of GDP. So if GDP is now only in the early stages of falling then this is not the time to own oil stocks. That’s not to say we might not get a bounce in oil stocks from an oversold condition from time to time, as happened last week. It’s also not to say that global GDP has to be actually recovering before energy stocks will rise; we know stocks will anticipate global growth once there is some sniff of recovery or even bottoming in the air. But I think we should at the least want to see some slowdown in the rate of economic decline before we buy energy stocks.
That’s not to say that a slowdown in the rate of GDP decline must actually be published in the newspaper before we buy oil stocks. It might be too late to buy the oil stocks at that point. No, the first evidence that the rate of economic decline has slowed and therefore the turn-around has begun to begin will probably come from a sustained rally in stocks, which will include oil stocks. I don’t mean just a rally; I mean a sustained rally, one with pullbacks, higher highs and higher lows.
Of course if we wait for such a rally we will certainly not have been buying at the bottom. Buying or owning oil stocks at the bottom of this bear market is an enticing objective. It holds the promise of our recovering a lot of our lost asset values rather quickly. Many investors are acutely aware that there is so much cash on the sidelines and so much desire to participate in a rally in order to make up some of the losses everyone has suffered that when “the market” sees daylight ahead it will stage an enormous rally. A lot of people want to be at that party.
But the cost of buying now or owning now will be steep if the bottom of the business cycle is two or three or four years off. A great deal of additional asset value destruction could take place over two, three or four more years of declining GDP. So if one’s objective is to buy at the bottom, or at least to own at the bottom, one best hope that the bottom is not too far off. And that in fact is what many people are doing now - owning energy stocks in the hope of a quick upturn in GDP.
So the choice for the oil stock investor is whether to own them now, thus risking further portfolio value declines, or stand aside for now thus avoiding the risk of more portfolio declines but taking an opportunity risk that you will miss out on the early part of what could be a huge rally in stock prices. It is an individual choice. Whatever your choice, make it with the knowledge that in owning oil-related stocks you are super-leveraging yourself to economic conditions. If we are near a bottom in terms of GDP reduction, you could do very, very well. But if we are years away from it, the additional decline in your portfolio from here could be serious. That’s because the price of oil and the value of oil related equities are so closely tied to GDP growth or decline.
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This article has 25 comments:
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dondon
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13 Comments
Dec 04 12:30 PMIn your opinion, what would happen to the oil supply and price if Israel were to strike Iran?
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macsmart
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24 Comments
Dec 04 01:23 PM" ....make it with the knowledge that in owning oil-related stocks you are super-leveraging yourself to economic conditions. If we are near a bottom in terms of GDP reduction, you could do very, very well. "
I personally think we're near the bottom...and that energy investors who can hang on are going to do...very, very well.
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anarchist
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142 Comments
Dec 04 01:37 PM-
Chris B
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567 Comments
Dec 04 03:32 PMOn Dec 04 01:37 PM anarchist wrote:
> So what happens if we have a Japanese style stagflation and the economy
> doesn't do squat for fifteen years? Thats not my prediction but it's
> possible especially since Obama has loaded his cabinet and advisers
> with the likes of Sumner and Geither.
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joe1
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31 Comments
Dec 04 05:47 PM-
maslinsmith
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1 Comment
Dec 04 06:03 PM-
mangolfer
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162 Comments
Dec 04 06:08 PM-
joe1
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31 Comments
Dec 04 06:43 PM-
You're Kidding
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39 Comments
Dec 04 09:20 PM-
Tesa
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29 Comments
Dec 04 09:42 PM-
Greg Pinelli
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584 Comments
Dec 04 10:00 PMThe touchstones for ANY resource are..
1. How well can economies do without what this resource provides?
2. If the resource is underpriced and sources are shut down or not developed what is the pricing structure for product likely to look like when marginal demand increases? How long will it logically take for supply to catch up to demand?
3. What are the least risky ways to play reality hitting home?
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JanuaryBelief
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11 Comments
Dec 05 12:19 AM-
NOWHEREMAN
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1499 Comments
Dec 05 05:03 AM"You've asked questions..not provided analysis or direction!" Calling the Article a Long Winded Flummox.(Flummox=perpl... bewilder, puzzle, mystify)
Personally, I am flummoxed by the use of the word Flummox, since the posts here seem to understand the article. IMHO
Geo the non realist goes on to posit questions without providing analysis or direction. Doesn't even make an attempt at it.
Jim K: The printing presses will go into a higher gear and the Fed/Treas/Gov. will backstop everything potentially damaging including the Auto industry. The pre-announced Obama Stimulus package will be funded similarly. The Tax cut is debatable.
For the foreseeable future, The USA will mortgage our earnings, our children's earnings and their children's earning's if need be. This will not be looked on in askance by the other Developed world nations simply because they will be applying similar measures.
The construction/infrastru... stimulus package and similar ones around the world will all be commodity intensive. One nation will not sit on the sidelines waiting for another nation to finish before undertaking their own projects. In other words, the strain on all commodities including the softs will be virtually simultaneous.
I personally believe these projects will not commence in the dead of winter but having said that I would start following inventories at the LME.
I posit that oil will rise more quickly than you imagine when this process starts in earnest, say spring in the US. By that time, oil inventories will be very low costing too much to buy and store. Refinery shutdowns will be more prevalent and marginal oil production projects will have ceased.
So in the very near term, the Oil sector may resemble a direct hit by a cluster bomb. But by the end of 2009, I expect oil to be north of $75 even if Obama taps the SPR.
As far as stock picks, I have a list of stocks I wish I could have bought but didn't. I will be nibbling at them over the next 3 months, maybe with a couple of the Triple ETFs tossed in.
Good Article. IMHO
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CLH
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717 Comments
Dec 05 07:35 AM-
ferguson
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51 Comments
Dec 05 10:52 AM-
ferguson
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51 Comments
Dec 05 10:58 AMPerhaps the best indication of what the future holds is that President Elect Obama's rating from the public on conduct of the transition to the presidency is at 80%.
My bet is that a very thoughtful, disciplined and highly competent Obama administration will steer the way through the obvious difficulties to a more secure and more sustainable future.
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tuj
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87 Comments
Dec 05 01:12 PMBut overall I have to agree with JK in terms of ultimate long-term bullishness simply on resource theory. Certainly any stimulus packages we see shall be bullish many commodities, including crude. As for the demand destruction in the US, it remains a question as to how this magnitude of demand was destroyed in such a short time, and if/when consumers will maintain this level or revert to higher consumption in light of drastically lower price signals.
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Ferdinand E. Banks
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251 Comments
Dec 05 01:28 PM-
Jack Walker
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25 Comments
My Website
Dec 05 02:45 PMPerhaps one answer to the oil stock investor’s dilemma is to use a strategy that provides a defined and limited risk while staying in the game. This can be done by starting with a high quality integrated company that is not over leveraged and then buy a long term options bull call spread.
For example: ConocoPhillips (COP) 45.59. Here is an integrated with a debt to equity ratio of .24 that is not likely to run out of cash. Consider:
Buying the Jan 50 call YROAJ at 9.775 and then selling the Jan 55 call YROAK at 8.15.
The difference is the cost of the spread and is indicated above using the mid-prices between the bid and offer of 1.625. In order to get this spread, be prepared to pay a bit more, perhaps 1.75. For a one-lot position of 100 shares the cost is therefore $175.
The upside is limited to the difference between the strike price or 5, less the cost of 1.75 for a maximum gain or 3.25, which is almost twice your investment. In the meanwhile, if the recover is still years away, and oil price do not recover in the next year, the total loss is limited to the original debit cost of $175. In addition, since the position is long one option and short another it is insulated from changes in options implied volatility and time decay.
The large integrated oil companies trade with good options volume so the important options liquidity is available. XOM and CVX are two others to consider.
With this strategy an oil stock investor can stay in the game, limit risk and have a goo potential gain if oil prices recover in the next year.
Jack
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SeekingTruth
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64 Comments
Dec 05 02:56 PMBased on all the uncertainties of geopolitical factors, varying and rising costs of production, the possibility of "bad" Black Swan events, etc. , adding some selected oil stocks over the next year would not be a bad thing to do just to provide a little peace of mind, and if it pays a reasonable dividend, that would add a little comfort also. One could then accept the virtually certain volatility if not too severe , or simply buy enough to trade at perceived appropriate times. Options also should not be overlooked.
As one who has lived thru many, many of these cycles, doing nothing is perhaps the worst choice in this case, and assuming some risk here is appropriate over time, provided you have adequate emergency funds set aside for yourself and family.
With the excellent help of fine articles like this (and many, many more like it), we investors are beginning at last to get our arms around this nagging energy enigma . It is up to the individual, however, to fill in the gaps with constant study and attention to this vast, complicated and intriquing field.
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Mark Goldes
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31 Comments
My Website
Dec 05 04:36 PMAdvanced designs will soon be capable of producing torque and/or electricity on a self-sustaining basis. Devices without moving parts are comparable to an inexhaustible electric battery. One Proof-of-Concept prototype was evaluated by Lee Felsenstein, EE. He concluded it to be analogous to the early work on the transistor, which eventually led to a Nobel Prize and the creation of Silicon Valley.
2,000 watts is the maximum amount of power that can be drawn from a 110 volt wall outlet to recharge the battery of a plug-in hybrid car. Generators we are developing are expected to generate this much power and demonstrate replacement of the plug needed by a plug-in hybrid car, within a year. This will be a harbinger of automobiles that need no conventional fuel. With normal progress, prototype new energy conversion systems are anticipated to replace an automobile engine within three years. That goal might be achieved in less time if development involves four teams of engineers and technicians working on a 24/7 basis. These prototypes will open a path to mass production of entirely new varieties of automotive power plants. Vehicles powered by these technologies will never require conventional fuel of any kind.
Cars can become a source of income
Vehicle to grid (V2G) power was demonstrated by Google and PG&E during 2007. It was recently estimated that selling power to the grid from future production hybrid electric cars might earn the vehicles’ owner $4,000 each year. This assumes that power will be drawn by utilities from the car’s batteries, using a two-way, plug.
In the future, cars powered by new energy conversion systems are expected to earn much more, as these generators are anticipated to replace both batteries and car engines. Therefore, they are expected to produce far greater amounts of electricity. No plug will be required.
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Tesa
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29 Comments
Dec 05 09:35 PM-
SeekingTruth
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64 Comments
Dec 06 11:28 AM-
Grampa Jim
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5 Comments
Dec 06 12:55 PM-
NOWHEREMAN
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1499 Comments
Dec 07 03:19 AMThe same situation exists here.
Mark Goldes started with: " Unconventional Energy conversion systems are under development in several countries" and ended with " In the future, cars powered by new...etc." He presented a very good summation of mine own expectations in between.
Many countries are following many different paths down the same road. None of them has narrowed down to a viable system. While, in the future something will replace the engines, batteries which power current vehicles, nothing universally applicable is available now.
There was a movie released some time ago called "Total Recall" with Arnold S., the system used computerised cars using electified rails to drive to destinations, like the electric trolleys we used to have. A car like the Volt would be able to drive within proximity of a desired location, disengage and finish the trip via the battery installed, this battery is rated for 40 miles in the present configuration. I would hazard a guess that replacing the engine with another battery or two would enable travel everywhere. Recharge? Re-enter the grid or recharge at home.
Farfetched, sure. But over the next few years a major infrastructure stimulus program will commence, the inclusion of the rails in our highways would be ancillary.
The electrical grids themselves would have to be enhanced but they could be assisted by the use of Solar/Wind to generate additional supply.
How to price the cost of usage? Wireless tech applied to your mileage indicator and batteries (recharging thereof) billed monthly could work.
This will destroy the Auto industry in its present form. No sparkplugs, oil gaskets, mufflers, engines, etc. to include or maintain. The parts suppliers will become extinct slowly at first, ditto mechanics. Emmission Centers what emmissions? etc.
Wonder why all electrics are viable in small countries like Israel and Sweden, its not just the size of the country involved. It is also the Demand Destruction of all of the jobs associated with the present system.
I therefore submit that a lot of research is being done in the developed world to enhance mileage but to maintain the present vehicle construction configuration while smaller countries are doing their best to be truly Oil independent.
The supply/demand situation currently in place has brought oil prices down. But unless, production is curtailed more dramatically, that is to the estimated annual decline in currently producing oil fields then we will all face another crisis sooner than later.
Jim K., you've seen the estimate. Apply it to the pre-demand destruction production estimate. Now, lets assume that forecast increases in supply are also going down the tube, Demand Destruction is a two edged sword, then we have the possibility of $200 oil by 2011.
My scenario assumes aggressive growth stimulus packages from countries around the world. My scenario also includes the reality that Oil spiked to almost $150 with the US already in a recession. Think of the demand which will strain supply as we and others attempt to claw our way out.
To my way of thinking, "In the Future" is not a realistic approach. The future is what we can do Now, not 5-10 years from now.
IMHO
PS Sorry for the length, too much to say with too small of a window to view what was said.