Download Oil`s Well that Ends Well

 Oil’s Well that Ends Well December 2014
This Time It’s Different The last six weeks have brought a stunning decline in crude oil prices. Typically, declines of this magnitude have coincided with economic recessions that result in sharp reductions in demand. While much of Europe is economically challenged, its usage of oil remains stable. Some point fingers at China as being the culprit. True, growth has slowed, but consumption is still increasing. Figure 2 depicts the global oil consumption trend. It is clear that the drop in oil is not being driven by a sharp drop in demand. Rather, the reduction in oil prices is best described as a positive supply side shock. Most of the time the term “supply side shock” has negative implications and include events such as an earthquake taking out infrastructure, an increase in government regulation, or anything else that unexpectedly increases a company’s cost of doing business. However, the rapid drop in oil prices has unexpectedly reduced costs for both consumers and businesses and provided a positive shock to the economy. Much of this is due to technological advances in drilling made over the past ten years. Thin layers of oil trapped in between rock and sediment provided only momentary gushers of oil when oil explorers punched vertical wells into the Bakken shale formation in North Dakota. The advancement of horizontal drilling coupled with injections of high pressure fluids to release oil from “tight” formations opened up enormous potential oil reserves in the United States. With projected recoverable reserves at one trillion barrels just in the United States, the U.S. shale oil fields could theoretically cover 25 years of global oil usage by itself. Capital for drilling new wells was financed by a wave of new debt and helped along by the easy monetary policies of the Fed (consider it QE Crude). This has led to a persistent decline in oil prices throughout the second half of the year. On November 27th, OPEC announced that they will not use their influence to reduce supply to stem a developing supply glut, which in turn accelerated the decline in oil prices. Not surprisingly, the E&P sector has been a victim of their own success as lower oil prices directly impact their bottom line. The S&P Oil and Gas E&P Select Industry index of stocks is down 46% from its peak in June. On days when the broad market is selling off, some market commentators attribute the decline to lower oil prices. But let’s be painfully clear: lower oil prices are a boon for every developed economy and many emerging market countries. This point is best illustrated by a simple example. Suppose a tour boat operator that provides three‐hour tours for its guests is blown off course by a sudden storm and becomes shipwrecked on a deserted island. This motley group of ten castaways then organizes itself into a small economy. But they find that they need two people working full time to bring fresh water to their camp since the only fresh water source is far away. With only a coconut to carry water, the price of water is very high and consumes 20% of the little island’s GDP. Alas, a 5‐gallon bucket washes ashore. Now only one person is needed to carry water back to the village. The second person is free to explore other gainful employment. The cost of water declines by half and the island’s GDP increases with the additional worker deployed elsewhere. The island experienced a positive supply side shock based on the technological advancement of the five gallon bucket. A Global Stimulus Package Back in the real world, the drop in oil prices is a non‐trivial event. If the world consumes 93 million barrels of oil a day, a lasting $30 reduction in the price of crude oil creates an $815 billion global stimulus each year (after backing out pass through profits from oil companies). Assuming global GDP is $75 trillion currently, the price drop equates to a stimulus of 1% of global GDP. If that doesn’t sound like much, here is some perspective: the stimulus package launched by Congress in 2009 to combat the financial crisis was, by most accounts, epic in size. The current oil stimulus equates to nearly two‐thirds of the government’s 2009 stimulus package. It’s a gift that keeps on giving as long as oil prices remain subdued and, unlike conventional stimulus measures, doesn’t add to the national debt. Portfolio Implications Cheaper oil has broad based implications for an investor. For starters, lower energy costs boost discretionary spending by consumers. This will spur economic growth and provide much needed revenue growth for many companies. Profit margins for companies outside the energy sector will expand – allowing both earnings and dividends to grow. Bond investors have something to cheer about, too. Lower energy costs will keep inflation in check and provide cover for central banks to keep rates lower for longer. Lastly, we expect some pain to be felt in the high yield corporate bond sector where energy is 15% of the overall market. Indeed, current bond prices already reflect the liquidity challenges that lie ahead with the energy sector trading at 88% of par. Assuming half of the bonds par value will eventually be recovered, this puts cumulative default rates at 25%. Fortunately, the holders of these bonds tend to be diversified asset managers – not banks – thus we see very low potential for contagion to other markets. Oil Price Forecast Our bullish view on the global economy is predicated on sustained sub‐$100 Brent oil prices. Oil moves in multi‐year cycles with both demand and supply slowly adjusting to changes in the price of oil. Forecasts for U.S. oil production in 2015 fall into a fairly tight range as all existing wells are economic at today’s prices and most of the exploration projects currently underway will be funded through completion. That means that supply may continue to increase before we see a meaningful pullback in domestic production. Forecasts for 2016, however, are a much greater unknown. Based on announcements already made in the past few weeks, we know that R&D budgets are being cut back 15% to 50% for new projects. What we don’t know is at what price unconventional oil projects will be uneconomical. Conventional wisdom pegged that number at $85 to $90. But technological advances have been pushing that number lower – perhaps even beneath $70. Supply will eventually fall in response to lower oil prices and the long term price of oil will converge close to the cost of producing unconventional oil. In the short run, with oil trading in the $60s there may be still further room for future declines in the oil price. Existing projects for new production in North American shale oil will be completed and they will result in further supply additions over the next six months. This could easily send oil prices into the $50s. For that reason, we expect to see a continuation of relatively lower oil prices, persistently below $70, over at least the first half of 2015 without a response from OPEC. In the long run, three things can restore the price of oil back into the $70‐$80 range. First, producers will not have the free cash flow and easy money required to fund the same level of new projects. As oil production declines from existing wells, we will begin to see a reduction in U.S. supply. Second, cheaper global oil prices will naturally stimulate the demand for oil over time. Lastly, OPEC’s marginal members require oil prices above $70 to fund social programs that enable political stability. This could lead to enough internal pressure to eventually take action to stabilize prices with a production cut. Even so, it is apparent that U.S. shale oil has put a new lid on crude oil prices for some years to come. The Fleeting Middle East Turmoil Premium Something that we haven’t seen in decades is starting to emerge: excess production capacity in the United States. In modern history, OPEC has been the only area that had the ability to bring additional oil to the market if supplies were tight. Figure 3 charts the amount of reserve capacity OPEC has had over time. When excess capacity drops below one million barrels per day, we enter the “danger zone” and oil prices tend to spike higher. The EIA estimates that current spare capacity is around two million barrels per day, projected to hit three million barrels per day next year. More reserve capacity at OPEC helps limit future price spikes. But OPEC will cease to be the producer of last resort. As domestic energy producers curtail new development projects, the United States will soon develop excess production capacity. Perhaps the spigot can’t be opened as fast as in Saudi Arabia, but oil companies already know where the oil is, know how to extract it efficiently, and will likely have access to rigs to drill the wells. Importantly, the $15 “turmoil premium” that has been embedded in the price of oil over the past decade will disappear for the foreseeable future. While unconventional oil is more expensive to extract, it has the enviable feature of existing in politically stable countries like Canada and the United States – thus resistant to many of the potential supply disruptions found in geopolitical hotbed countries. Conclusion The near term trading range for oil is at the mercy of the dynamics of capital budgeting by U.S. shale oil producers and unpredictable price support by OPEC. What we do know is the global economy will continue to benefit from the supply side economics stemming from lower oil prices. This will, in turn, support risk asset prices without triggering a bond market selloff. Disclosure CTC | myCFO is a brand delivering family office services and investment advisory services through CTC myCFO, LLC, an investment adviser registered with the U.S. Securities and Exchange Commission, a Commodity Pool Operator and a Commodity Trading Adviser registered with the Commodity Futures Trading Commission ("CFTC"), and a member of the National Futures Association ("NFA"); trust, deposit and loan products and services through BMO Harris Bank N.A., a national bank with trust powers; and trust services through BMO Delaware Trust Company, a Delaware limited purpose trust company. 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