Santa’s List, 2014 Edition
While stocks have dropped “only” 5% in the most recent market swoon, it seems a lot worse. Volatility has sharply increased, and world markets are seeing a lot more collateral damage than they have in a long time. Russia’s stock market and currency are collapsing, junk bonds are losing big money, and of course, energy stocks are getting decapitated. Who’s the man behind the curtain, pulling all the levers? Santa Claus, of course! While pretty much everyone was on his nice list in 2013, he’s been quite a bit more discerning this year. Rumor has it that he’s mad at Vladimir Putin, so he’s taking down anyone remotely connected to him.
Never before have we witnessed anything remotely like what has happened to the price of oil. At $54 per barrel, WTI crude oil is now half its price of just 5 months ago. The only time we’re accustomed to seeing the price of anything cut in half is either in a recession, or at Kohl’s. And, just to clarify, we’re not in a recession.
So how could it be? Is it rational? Is it panic-driven? Where will prices be next year? All good questions, and all are driving traders and investment advisors alike to pull out their hair in bunches. Before we make any bold predictions, though, let’s step back and get a few things straight.
First, there is no doubt that a price drop of this magnitude, of such an important commodity, no matter how long it stays down this low, is an absolute disruption. There will be dislocations, whether it’s oil producer bankruptcies, boom towns turning into bust towns, currency crashes, or even geopolitical responses. This story is in its early chapters.
That said, it’s good to be an American right now. While oil production has become far more important to the U.S. than it was just 5 years ago, our country is still a vast net beneficiary of falling oil prices. Same goes for all countries who are net oil importers. Consumers and companies in countries like the U.S. get more cash in their pockets, immediately, to either spend or save. Both choices are good! Then when you consider other side effects, like truck sales suddenly shooting up, they more than offset the negatives of less oil drilling activity and less exports to other countries.
Speaking of, did you know there are very few oil exporting countries in the Emerging Markets index? In fact, most Emerging Markets, like China and India, are big importers of oil. Most oil exporters are actually termed Frontier Markets, meaning their economies aren’t even developed enough to be called Emerging yet. Russia would be the big exception.
We are mindful that corporate America is not the same as the American economy. Remember that close to 50% of sales of U.S. multinationals comes from overseas. With a slowing global economy and a strong dollar, foreign sales are hardly growing anymore for most companies. Companies with most or all of their business in the U.S. benefit more than multinationals. Retailers probably benefit the most from falling energy prices, as consumers will spend more money, and as products they import from overseas get cheaper, thanks to the rising U.S. dollar. Industrial companies who sell a lot of stuff to oil producers will see a dropoff in business. Every other economic sector is somewhere in between.
We still expect profits to grow, thanks to growing U.S. sales and tempered costs in energy and labor. If the U.S. strong/rest-of-world weak trend continues for more than a year, however, we might see a 1998-2000 type of economy. GDP grew at a strong 4% annual rate then, and employment rose strongly, so rising labor costs crimped margins. Even though sales were growing, profits did not. Investors didn’t mind, as they drove stock valuations to insanely high levels.
That era also coincided with the last time we saw really low gas prices for a sustained period, close to $1/gallon. Oil prices fell in 1997 and 1998 as demand stopped growing in emerging markets, most of which fell into recession. Prices started rising in 1999 when demand growth came back, and actually rose during the 2000-02 U.S. recession, and skyrocketed all the way into 2008.
So what will happen this time? For sure, there will be a supply response. Non-OPEC oil producers (that is, producers not in OPEC countries) decide where to drill for new oil and gas based on prices, and that’s pretty much all their criteria. That would include current prices, and their outlook for prices over the expected life of the well they’re drilling. This does introduce a gray area, in that an unrealistically optimistic oil CEO might be expecting an immediate rebound in the price of oil back to $100/bbl, and thus not stop drilling. This type of optimism permeated the U.S. oil industry in the 1970s and early 1980s, which proved out a lot of bad drilling decisions made by “wildcatters” of the day. Large companies are responsible for most of today’s U.S. drilling, and their management teams would like to continue to have a career at a viable company. One impediment to continue drilling with ever-lower oil prices: you don’t have the cash flow anymore to pay for all the drilling. As prices fall, cash flow falls. The bank stops lending too.
When will U.S. production growth slow down? Probably right now. It takes a few months for drilling rig orders to get canceled or not renewed, and that just started in the last couple weeks. The Baker Hughes land rig count has fallen by 44 in the last 3 weeks, but this compares to a drop of 300 from 2011 to 2012 when the price of oil fell a lot less. Expect that rig count to plummet in a few short weeks, especially as we get into 2015. Then, that slowdown in production growth will become more noticeable. Could U.S. production even drop? If oil prices stay this low, it is possible. There could still be rigs drilling for new oil, which obviously adds to production. But here’s the big offset: fracked wells see a very rapid decline in production from year 1 to year 2, an average of 60%! This decline rate is MUCH more severe than for conventional wells. So, if we had no new wells being drilled, our production would fall a lot. In other words, the U.S. needs to drill a lot of new wells just to prevent our production from falling.
Productivity gains have been experienced in fracking in the last few years, which has enabled oil companies to get a new well started faster, to drill more wells at the same time, and to get production rates higher more quickly. These all raise the output potential from a new well, and lower the cost of drilling. In the short-term, these work against oil producers because many will keep drilling even if oil goes down below $50, but in the long-term, they make the U.S. very competitive with oil producers around the world.
Will anyone else in the world cut production? That’s the market’s $3 trillion question. Traders these days hang on the every word that comes out of the mouths of Saudi, Russian, Iranian, Mexican, and Norwegian oil ministers. It is noteworthy that every time the Saudi oil minister says they won’t be cutting production, the price of oil tanks. Okay, the first time he said it, it’s understandable, but the 10th time? Is this new information? Obviously, there are participants in the markets that are actively betting against oil and oil producers, and betting lots of money. It’s been a horrible year for hedge funds and traders, and they’re anxious to make some money in the final days of the year.
Meanwhile, buyers are scared. Actually, we should call them “would-be buyers,” because it seems on those days when the price of oil falls $2 and every independent oil producer’s stock is down 10%, there aren’t any buyers. If you haven’t been introduced to the concept of the “falling knife,” allow us to make the introduction. Look at an oil stock drop and imagine it is a knife. Would you to try to grab the knife as it fell? If you catch it right, you get….well….a knife. If you don’t catch it right, you get a bloody hand. But these wounds will heal.
Back to the question….at some price, either OPEC must agree to throw in the towel, or every other country except the Saudis will subvert the Saudis and throw in the towel. One country alone would never be so dumb as to cut production without other countries cutting production, because it would have a very limited effect on the price. They coordinate production cuts so that the resulting price increase will be big enough to offset lost revenues from production. So what is that price? No one knows. It is obvious that the Saudis want to see blood in the streets of Oklahoma, North Dakota, and Alberta. They also wouldn’t mind seeing the Iranians suffer either. But, as we have said before, the Arabian Peninsula countries—Saudi, UAE, Qatar, Kuwait—are alone in being able to withstand this drop in oil producers; there are 8 other OPEC members (and that doesn’t count large producers such as Russia, Indonesia, Mexico, and Norway). ALL the other 8 OPEC countries (nor Russia) simply cannot keep paying their bills at $80 oil, let alone $55.
The market has completely discounted the possibility of a geopolitical disruption to oil production. In the last 4 years, most OPEC countries have seen at least one major disruption to their production, whether from Islamic militants, populist uprisings, or incursion from outside forces. Only Libya right now is producing well below their potential. With Russia on the verge of a complete collapse, having seen their currency value cut in half this year, and now having raised interest rates to 18%, wouldn’t you think it’s possible something could blow up in Russia??? Russian citizens are cashing in their rubles as fast as they can, and rampant inflation for common goods like food has already started.
The final point to ponder is whether there might be a demand response to the lower prices. For most products that we Americans consume, if the price is 50% off, we buy more of it. With oil, this would require people to either drive more, buy gas guzzlers, drive faster, fly more on airplanes (which would require airlines to order more planes), or use more petrochemicals and plastics. You would probably agree that none of those demand responses happen immediately.
Speaking of, it seems like when gas prices were shooting up to $4/gallon in 2008 and again in 2011, suddenly a lot of drivers decided to drive more slowly—accelerating like a turtle, reaching the speed limit like 5 minutes later, and not driving over the speed limit. There was a fairly immediate response. Why isn’t the opposite happening now? We’re still waiting for the jackrabbit starters to re-emerge. Come on people, we could all massively improve productivity in this country if we all join together to drive faster. Do it for your country! Be a patriot!
So where is the price of oil heading? The safe, consensus projection is that the slide will continue into 2015, then at some point rebound. The continuing slide assumption is a reasonable one, given the lag time between rig counts falling and oil production falling, and if you assume that OPEC plans to ride out the storm until they see blood in the streets. T. Boone Pickens, longtime oil man and prognosticator extraordinaire, agrees with such a scenario, but sees the price rebounding back to $100 sometime late next year on the back of production getting cut too much. In fact, the lower the price goes, probably the higher it will bounce back for that very reason. If it bounces back too quickly, there won’t be as much production cuts, so that oil price bounce might not last very long.
So what do you do with oil stocks? The large integrateds like Exxon, Chevron, Royal Dutch, and BP can weather any storm. They are not only large oil producers, but large oil refiners. The refining and chemical businesses see profits rise when oil prices fall, creating a natural hedge. Much like farmers who farm grain and raise livestock.
The independent producers, with no refining business, have seen their stocks decimated. The shakier producers are down more than 75-85% in just the last few months. They are now in a race to cut spending to conserve cash and be able to make their interest payments to the bank and bondholders. But good producers have been hit nearly as hard; these are companies with low debt, with cash flow that covers a whole lot of growth spending, and with humongous reserves that will still be around whenever oil prices return to higher levels. It’s these stocks that will see the MOAR (Mother of All Rallies) when the oil price finally starts moving back up. You could easily see stock prices shooting up 20% or more in 1 day.
Right now, there are no buyers for their stocks, because would-be buyers are scared. And investors holding onto these stocks are either nervous or ticked off at the stocks that they end up panic selling at the bottom, or they want to grab a tax loss this year. This should continue into the end of the month, but abate in the new year. While this is not the same as the housing bust and financial crisis, which dramatically affected the rest of our economy, there are similarities in how bank stocks traded at that time. On March 9, 2009, when the stock market’s bottom was found, banks which hadn’t gone under saw their stocks soar by 30-50% some days. Citigroup stock rose 300% in 1 month; granted, it had fallen 97% prior to that.
All this to say, if you’re still reading this, we wish you a happy and joyful holiday!