Black friday for oil stocks

Everything's on sale!  But they will get cheaper yet.

I'm really regretting not getting those PXD options on friday, which would are up about 500% + (hard to tell because they're thinly traded.  But I'm glad I have a position in American Airlines (up 8% right now).  I'm looking to unload EOG, because I think it has much lower to go.  Its too painful to try to sell WLL today.  Some of the companies, even large caps E&Ps, are down 20% right now.

Oil can go MUCH lower than this.  Why shouldn't it go to $50?  If OPEC is not balancing the market, the market will have to balance the market.  We should see some major capex cuts, but what can stabilize the market in the short term?


The fact that the S&P is up right now seems strange to me.  There could be huge consequences to what happened yesterday.  Countries like Venezuela or Iran or even Russia could be in serious trouble.  Default rates on sub-investment grade corporate debt could start to spike, because energy is a big chunk of this market.  US Petrochemical industry (DOW, LYB, WLK) could be hurt because they rely on an advantage of US natural gas liquids vs global oil prices.  Within the transport sector we're seeing rails get hammered today because they transport so much crude by rail today.  It's going to be an interesting couple of months.

thoughts on the OPEC meeting

The meeting is on the 27th.  I had incorrectly written the 22nd earlier.

I did put out a bid for some January out of the money puts on PXD as a bearish bet going into the OPEC meeting.  I have shares of EOG and WLL on the other side of the ledger.  My limit order did not hit though, so I'm still marginally long oil going into the OPEC meeting.

I'm not sure if it is unprecedented, but it was very interesting to read about the Russians and Saudis giving joint statements on oil production levels.   The Russians may be signalling that they will cut output if OPEC does.  Between them they are 45% or so of world production, vs 33% for OPEC alone.  If I were the Saudi's I'd only be willing to cut if I knew that everyone was cutting their fair share.  Russian cooperation would go a long way toward that.  The funny thing is that people are speculating that the sanctions against Russia may cause production declines next year either way.  Maybe they can pretend to cooperate without really having to do anything.

It is worth mentioning that much of Russian oil production is not in the hands of state owned companies like Rosneft and Gazprom.  But no one should doubt that Putin could order the private companies to cut output if he felt like it.

Next week will be interesting.

A second historic example: the gas crash of 2008

A second example which may also be instructive to the current situation in the oil markets is the 2008 crash of NYMEX natural gas.  The gas price crash of 2008 pertains only to a local market (USA) since US gas is isolated from the international market.  But it may be instructive to look at because the production curves are similar to  unconventional oil wells, and the companies doing the producing are those same companies adding all the excess supply currently.

The US gas market is different than the world oil market in a number of key ways.  Besides being a much smaller than oil, there is also very limited storage availability and strong seasonal use in winter.  This can lead to price spikes during the “draw season” (when storage facilities are drawn down).  Both of these things increase price volatility.  There is also another factor which reduces price volatility.  Because much of the gas produced is used for electrical generation, it is substitutable, to some extent, with coal.  Natural gas turbines are relatively cheap to install, so utilities don’t mind leaving them idle if the price is high, as long as they have other options for generating power.

During the first half of the last decade gas production was in decline in the USA and there was a worry about a shortage.  This spurred investments in expensive LNG import terminals (terrible investments as it turned out).  Then came the shale gas boom.

A Brief history of the US Shale gas boom

(This is not researched and mostly from memory so let me know if there are any inaccuracies)

The Barnet Shale in the Fort Worth area was the first shale region that was actively produced.  It turned out that gas could economically be produced from a huge area if hydraulic fracturing and horizontal drilling were combined.  Companies like Devon Energy, EOG, Chesapeake Energy, and Encana were all early producers.  Shortly after, three other plays were discovered.  There was the Fayetteville Shale, in northern Arkansaws, The Haynesville in East Texas, and the Huge Marcellus Shale in West Virginia, Pennsylvania, and South-Central NY state.  Companies rushed to stake their claim to these huge geographic regions.  The rig count went sky high.  Production started to outpace demand, and the price crashed (after a speculative bubble in 2007 and 2008, but that’s a different story).

 Something interesting happened when the price crashed and the rig count along with it.  The production continued to increase!   How did this happen?  It is instructive to look at the individual regions.

First there is the Barnett, where the whole shale gas boom was kicked off.  Production stayed largely flat after the price drop, despite a huge drop in the rig count.

One reason that the regions tend to level out rather than declined is that in many cases there are firm take-away agreements between the gas producers and the pipeline companies, so they get penalized for producing below a certain level.  We are seeing this currently with Chesapeake in the Haynesville region.  Other reasons are that the pipelines were built, well pads and roads built, seismic studies conducted.  The land was leased and much of the land was also held by production.  All of this decreases the incremental cost of drilling additional wells.

The production increases since the crash have been driven almost totally by the Marcellus (South Texas Eagleford can take a bit of credit too).  Marcellus production was slow to take off because there was much less infrastructure in this region compared to Texas and Louisiana.  But the geology is much better than the other shale regions.  In fact, production now is mostly constrained by the ability to move the gas and NGLs to market, rather than by price even though pricing is terrible in the region, with realized prices far below the NYMEX price.

How does this relate to the current situation in oil?

The current world oil production growth is driven almost totally by unconventional oil production in the USA.  This production growth is exceeding world demand growth causing an oversupply situation.  We will not see prices stabilize until production and demand are matched.    Will the lower prices spur higher demand?  Will OPEC try to balance the market with cuts?  Will high priced production turn off to balance the market?  It is impossible to say for sure.

One thing is sure though.  We have not seen the cuts in investment so far that would indicate that the current price decline is adequate to balance the market.  It may be that it will just take more time at these prices for an effect to be seen, just as it took several years for the gas rig count to decline fully.  But the lack of a producer response does suggest that further price declines will be necessary.

If prices stabilize or go down another $10 or so from here, I wouldn't be surprised if we see a substantial decline in the US rig count and capex, but continued production growth from the most efficient producers in the most efficient regions.

There is an OPEC meeting on the 27th and I we may get a substantial price move in either direction on next Monday.  Buying either calls or puts on E&P companies this week might be a good idea.

(All charts are from Baker Hughs rig-count or EIA.gov for production)

Historical comparison: The oil crash of the 1980s

For those hoping for a bail out from OPEC, it is interesting to consider the crash of the 1980s:

Setting the scene:
As background, oil exporting countries initially had a pretty poor deal from the western companies that came and extracted their oil.  The Anglo Persian Oil Company (later BP), Standard Oil of California (later Chevron), Standard Oil of NJ (Exxon), Standard Oil of NY (Mobil), Texaco (later bought by Chevron), Royal Dutch Shell, Gulf Oil (later bought by Chevron in 1984) would produce oil in the Middle East and bring that same oil back and refine it in their refineries, and then sell the gasoline in their own filling stations.  There was no standard exchange traded price for oil, so it was very difficult for the producing countries to know what was a fair price for their oil.  At one point there was a study that suggested that Saudi Arabia received less from their oil than the US government received from corporate income taxes on the profits that the oil companies derived from producing the Saudi oil.

The balance of power started to shift in the 1960s as new western companies like Armand Hammer's Occidental Petroleum, Mattei's Eni, Getty Oil tried to fight their way in by offering better contract terms to the producing countries.  Occidental Petroleum in Libya gave 55% of the profits in 1970.  The Tehran Agreement of 1971 established 55% profit share with a 35 cent price increase for Iran.  Libya, Algeria, Saudi Arabia, and Iraq subsequently push through a $.90 price increase per barrel.

Then it's off to the races...

In the early 1970s the prices were renegotiated again and again in favor of the producing countries.  Demand was increasing, and the Arab countries were voluntarily cutting output to gain negotiating leverage.  In the negotiations at the 1973 Vienna OPEC meeting the oil companies offered a 15% increase in price.  OPEC wanted a 100% increase to about $6 per barrel.  Remember that since there was no exchange traded oil at that time the price was wholly negotiable.  In the midst of this negotiation came the 1973 Yom Kippur war between the Arab states and Israel, in which the US sent supplies to the Israelis.  This was very unfortunate timing for Big Oil.

OPEC then unilaterally announced that they would be taking 66% of the retail price of gasoline at the pump as taxes.  They had been receiving the equivalent of about 9%.  They later also started refusing to ship oil to the countries that supported Israel, including the USA.  At this time all oil in Saudi Arabia was produced by US companies.  But in the next few years, many of the OPEC countries nationalized production, including Kuwait and Saudi Arabia.  Oil price went up and up.

OPEC official selling prices went from $1.80 per barrel in 1970 to $11.65 per barrel in late 1973.  The following decade was one of turbulence and high prices in oil, culminating in the second oil shock following the fall of the Shah of Iran.

But the time when OPEC could simply dictate the price was short lived.  In March of 1983 West Texas Intermediate, started to trade on the NY Mercentile Exchange, the first exchange traded crude (heating oil had been traded previously).  Producers initially switched to exchange linked pricing because the price was going up so fast.


The crash:
There is an old adage in the world of commodities: "High prices are the cure for high prices".  Demand was eroded by increases in fuel efficiency, and new supply was brought online, especially from non OPEC countries like Russia, the UK and Norway's North Sea.  The US land rig count topped out at 4,530 (Baker Hughes) in 1981.  This is compared to about 1,928 currently.  Most importantly, there were big investments and technical advancements that led to the opening of the north sea and deepwater production more generally.  There was also the North Slope of Alaska.  All these things were spurred by the high oil price.

Oil is a strange commodity because there is such a long gap between the time when an investment is made and when it pays out.  When you are producing copper or iron ore most of the costs are in operating expense rather than capex.  So a mine can be mothballed if prices drop, quickly balancing supply and demand.  With oil, the majority of the cost is in up-front capex.  Those wells drilled in the North Sea produced for years after prices dropped.  While it may be valid to point out that many of these wells presumably lost money, the fact was that this was a sunk cost, and they went on producing with the low price environment after 1985.  And the incremental cost of drilling additional wells after the production platforms were in place, seismic studies completed, pipelines built etc, was quite a bit lower per barrel produced than when the first wells were drilled.  So even further development was practical at the low prices.

As demand waned and world production increased the Saudi's tried to balance the market by cutting output.  Others were supposed to be cutting to, but in many cases they cheated on their opec quotas.  This chart is fascinating:

As the Saudis cut and cut most of the other countries both in OPEC and especially non- OPEC took advantage of them.  Keep in mind that the world oil production was only about 55 million barrels per day in 1985, so Saudi Arabia had capacity equal to nearly 20% of world supply.  When Saudi production dropped all the way to 3 mm per day, they decided to give in and turn the taps back on to hold onto market share.  This coincided with the plunge in prices in 1985.

Prices probably would have stayed even lower through the 1990s if the USSR production hadn't collapsed with their government.

The Aftermath:

The 1983-1985 price of oil (around $80 per barrel in today's money) was never again hit in nominal terms until after 2000.  In inflation adjusted terms it was not hit until late in the last decade.   Production in higher cost areas like the North Sea and Alaska, stayed strong even through the low price period.

Alaska North Slope production http://planetforlife.com/anwr/



How does this relate to today's situation?

You might make an analogy to 1985 for today's situation.  High prices spurred new technology and large-scale investment.  That investment has been in relatively expensive supply like deepwater, oil sands, tight oil ("shale").  It also spurred conservation in the form of higher CAFE standards, consumers preferring higher millage cars, switching from fuel-oil heating, more efficient jets etc.   In some cases it can be difficult to determine whether the motivation is cost or due to environmental factors.

On advantage compared to the prior situation is that much of the new source of supply has a relatively short production life, or at least the production of a new well declines quite rapidly from the first few months.  Therefore if the price plunged and companies pulled back on capex then the decline in production (or at the very least production growth) should be extremely rapid.

One thing is sure: it is hard to believe that the Saudi's would be willing to balance the market alone, as they more or less tried to do in the 1980s.  They would only agree to a cut if their was substantial cooperation from other OPEC producers.

There is another example that I want to look at as well, and hope to get a chance to post on shortly.

Breakeven Price

Just finished a work project and am going to get back into this a bit.  I haven’t really taken any actions since bailing out of Apache, Chevron, and FCX a while back, and buying a small amount of EOG.   The EOG purchase has only  gone down about 4% or so, quite remarkably.  I’m going to do a post on two historical comparisons that are interesting to think about and may be instructive to our current situation.  But first here’s an interesting chart from a Bloomberg article.  Its from Goldman, trying to identify the areas where drilling will slow and stop.  “Break-even” price is something that the sell-side E&P love to do, but it is sometimes quite hard to get a handle on for a number of reasons.  Here are a few I can think of off hand.

1)     A major part of the break-even price is services cost, which will decline as the price of oil goes lower, lowering the break even.

2)      Take away costs may decline as production stops growing, so the producers get a price closer to benchmark pricing.

3)      Learning is always increasing, and efficiency in terms of oil production per active rig or dollar spent has been on an uptrend in the shale plays for years.

4)      There is a wide range of economics within each play.  Companies that have pads set up and gathering networks in place have a much lower cost.  There are also differences in acreage quality and technical ability that will have an impact.  So if 50% of the rigs leave a play, it doesn’t mean it will produce 50% less oil over the long term.  The inefficient rigs will leave first.

5)      Exploratory drilling may be the first to shut down, and the development pad drilling may continue.  Thus the rig count may decline with little actual effect on production.

One broad take-away from this map is that the mid-continent regions are in bad shape.  Of the three major resource play areas, Bakken, Eagleford, and Permian, it is the Permian basin that is most at risk.  Ironically this is also the area that has seen a parabolic increase in production recently.  But within the Permian there are a wide variety of different sub-plays, with varying economics.