Quarterly Newsletter January 4, 2016
As some of you may know I am an avid fan of Adam Smith. I have often quoted from his book Wealth of Nations which was written in 1776, 239 years ago. As I was starting to put this newsletter together I saw the following quote from Adam Smith’s other major book The Theory of Moral Sentiments which was written in 1759. I have read both and I would recommend Wealth of Nations; Moral Sentiments was a really tough slog.
This should provide the perfect segue to the topic for this newsletter, the oil industry. I want you to understand neither I nor any of the financial folks on television have any idea where the price of oil is headed. The charts below show the price of oil since June, 2014, and over the last 10 years. At the beginning of each period, absolutely no one, guru or otherwise, could have predicted what transpired.
Crude Oil price, $/barrel
After a swift crash in the second half of 2014, oil has dropped further this year, from $54 a barrel to start the year to $35 a barrel, or a little over 40%. From the 10-year chart we see oil peaked in mid 2008 at $140 a barrel and then collapsed to $32 a barrel later that year as a result of the financial crisis.
So far I have exhibited perfect hindsight and used no energy buzzwords to impress you with my knowledge of the industry but now it gets dicey as we enter the future and what might impact the price of oil. While there are many roads one can go down, the bottom line for us is good old supply and demand.
Historically the price of oil would rise to a point where everything that remotely looked like an oil rig was hauled out to look for oil. The OPEC countries were swimming in money. The economy rolls into recession, demand disappears, supply is too high, the price of oil drops and all of those things that looked like oil rigs are sent to Steel Dynamics for scrap. Sometime after all of the rigs are reduced to scrap, the economy improves, demand increases, there’s not enough rigs to drill, etc.
This time around the supply picture has changed. American ingenuity developed fracking, and all of a sudden OPEC has a competitor for US demand. Saudi Arabia, instead of reducing supply as prices dropped, decided to try to run the frackers out of business by actually increasing production. Frackers have plugged up high-cost wells but are pumping profitably from their lower-cost wells. Productivity and cost cutting have dramatically lowered the price at which producers break even on profit. The bottom line from the supply side is the world is awash in oil, and there is potentially more coming from Iraq and Iran. Storage tanks are full, and they cannot make tankers fast enough to hold all the oil.
Demand is increasing a little as we all start driving SUVs and exchanging coal fired electric power generation for natural gas. If the world economy continues to grow (especially China and India) and conversion because of low prices continues, demand should continue to rise.
If nothing changes, supply will continue to outstrip demand and put pressure on oil prices. Something that might influence supply is the tender geopolitical situation in the Middle East. With oil in excess of $100 a barrel, oil-rich countries attempted to use their newfound wealth to influence their own population and also their neighbors. The table below shows the oil producing countries’ annual production and their cost of production per barrel and the annual budget and deficit per barrel. It takes oil at $215 a barrel for Libya to break even pumping 470,000 barrels annually.
Needless to say with oil at $35 most of the countries are getting killed. What could suddenly go right for oil? Listed below are 5 situations which could reduce supply of Middle Eastern oil, and in turn enhance US frackers’ position in the world. These points come from an article by Gary Bourgeault, a contributor on the investment site Seeking Alpha.
- The civil war in Syria (now in its fourth year) involving Russia, Iran and terrorist organizations from Iraq and Lebanon has the ability to spread, igniting a full scale conflict in the region and possibly severely affecting oil production.
- After years of war, Iraq continues to be plagued by violence and terrorism, most recently with the rise of ISIS and its attempt to control the country and its oil production.
- The conflict in Yemen (now approaching its first full year) has the direct involvement of Saudi Arabia and Iran and borders another petrostate, Oman. Continuation or escalation of this conflict not only endangers the oil production of Yemen and Oman, but also further weakens the already weakened financial conditions of both Saudi Arabia and Iran.
- Since the removal of Qaddafi, Libya’s financial and political stability has greatly decreased. Continued skirmishes between ISIS—Al-Qaeda related forces and Libyan national forces continue to disrupt Libya’s economy and its ability to produce oil.
- US frackers have fundamentally changed the global oil supply dynamic. Despite Saudi Arabia’s efforts to keep oil prices low in an attempt to drive US frackers out of business or seriously impair their ability to produce profitability, US frackers have found ways to significantly reduce costs and continue to produce oil. As a result, while oil production from US frackers may vary within a range, it seems likely they will act as “shock absorbers,” cutting production if oil prices go to [sic] low and increasing production as oil prices rise.
Commodities—oil, steel, copper, soybeans etc. are in the tank. This could be the bottom or prices may continue to grind lower for a considerable time. Our investment philosophy states we like companies which have “control over cost and good pricing flexibility.” Commodity-oriented stocks do not meet this criteria so most of our accounts are underweight this asset class. Two energy stocks we are most comfortable buying are Exxon Mobil and Schlumberger. As you can see from the graphs below, Exxon has dropped from 105 to as low as 70 over the last year and Schlumberger from 115 to under 70. These are two of the biggest and best. As you move down the size scale and up the leverage scale, results deteriorate substantially. Speculators have pretty much been washed out.
It was my goal to show you what was going on in an out-of-favor industry. If you have an interest in this industry please let us know, and we can schedule a meeting to take a look at some of those out of favor stocks for your portfolio. One last bit of good news—recessions usually occur during periods of high oil prices, not low oil prices.
I hope you had a great Christmas and 2016 will bring us higher stock prices and more dividends.
Written by David M. Meyer