In 2015 we saw a lot of stocks get annihilated as market leadership narrowed. Hedge fund darlings were flipped from running higher to getting pummeled. Biotech stocks got pilloried and Hillaried. Energy names were the big story though, as most fell in share price, many were crushed and some went to zero. As measured by the SPDR Select Energy ETF (XLE) the industry is down over 30% from its high. Interestingly, the 50 day moving average has started to turn up. A blip? A head fake? Or, is something else going on?
Let’s revisit what Saudi Arabia did in November of 2014. In response to losing market share due to high cost drillers bringing supply to the market, Saudi Arabia refused to lower the OPEC cap on oil production. In fact, within months, OPEC, led by a 600,000 per day increase in oil production by Saudi Arabia, went from a little over 30 million barrels per day of oil production – their self-imposed limit – to over 32 million barrels per day. The result was a crash in oil prices.
Through the first half of 2015, the supposed targets of OPEC, American frackers, continued to produce record output, despite the low prices. Many “analysts” speculated that the pain for frackers would just grow worse if they did not cut production. In the case of small heavily indebted frackers that is certainly the case as we see bankruptcies accelerating.
However, common sense would tell us that the actual targets of Saudi Arabia were more than just the American frackers. In any price war, the most expensive marginal production is the first target. Given that supply only outstrips demand only by about 2% even with Saudi Arabia and Russia pumping at near full bore, we need to ask what is the most expensive 2% of oil production?
Here is a chart from 2009 that shows the cost curve of oil:
<Source: IEA, World Energy Outlook 2008, p 218
Here is a more current chart from 2014 projecting out for 2020 costs:
And here is a much more recent chart from October 2015:
What should jump out is that there is a significant price difference between bringing non-Middle Eastern production online. Canadian oil sands and Arctic production are the most expensive to bring new production online. Remember that existing producing wells are much cheaper. Given the massive upfront costs of creating new Canadian oil sands production we can expect projects that have not begun yet to be delayed or canceled. Already Shell canceled a massive project and took the $2 billion charge. Over a dozen projects have already been canceled. The currently started projects are likely to be among the last for a long time. The current projects will however bring about a half million new barrels per day on net after depletion of other wells.
In addition to Canadian oil sands projects being shelved that were not already started, there has been a huge reduction in deep sea oil projects scheduled. Capex is down dramatically. BP has canceled contracts in the Gulf of Mexico. Shell canceled an Alaskan project. ConocoPhillips has dramatically reduced deepwater exploration and canceled a drill ship order. There is a long list. In total, majors have canceled over $200 billion in deepwater projects so far this year. The will to commit spending to projects that might not be viable in the future is small. Hence why I wrote: The End of Deep-sea Oil Drilling as We Know It in MarketWatch in September.
In looking at the cost curve charts, the massive cost savings realized by North American shale in the past six years, especially the past one, is significant. I think it is reasonable to presume that costs will continue to come down as technology and expertise improve. Shale is rapidly closing in on Russian onshore, deepwater and ultra deepwater oil for cost. It is also less risky environmentally than deepwater projects despite being closer to our backyards. Shale is also less risky financially as wells can be drilled, capped, uncapped, fracked and put into production in a fairly orderly way. The end result is that U.S. shale has become the swing oil producer as it is at the higher end of the viable cost curve, more easily stopped and started, has fairly short well lives with prolific early production and in a secure nation.
Saudi Arabia knows everything I have just documented. So the questions once again become what is their goal and end game?
According to Larry Jeddaloh from The Institutional Strategist who was interviewed in Barron’s this weekend:
“The risk profile for oil prices is changing pretty rapidly. We think the risk of a conflict is going to build very fast now in the Middle East. There is no premium in the oil price whatsoever. There’s a new sheriff in town, Vladimir Putin, and he has an interest in higher oil prices, not lower oil prices. The old sheriff, the United States, had an interest in stable to lower prices.
What’s going on in the Middle East is the realignment of the petrodollar system. You have the Saudis talking to the Russians about a defense agreement. Deputy Crown Prince Salman, the defense minister, was in Moscow, visiting Putin. They discussed several agreements, including an oil agreement. With the U.S. pullout from Iraq and Afghanistan, U.S. influence over Saudi policy is just about gone. The Russians, on the other hand, need a higher oil price, as do the Saudis, because the Saudis are running through currency reserves at a very rapid rate, and are running a deficit that is nearing 20% of GDP. That isn’t sustainable. The Russians, Iranians, and Syrians are now all on one side of the camp. The Saudis are very concerned that the Iranian-funded, Iranian-trained Houthi rebels in Yemen will hit the Saudi oilfields. The thing to look out for is a deal in which Iran will stop backing the Houthi and, in return, Saudi Arabia stops pumping 10.3 million barrels a day and reduces output. The Russians broker the deal because they can benefit dramatically from a Saudi shift in oil policy. You get a more formal relationship developing between Russia and Saudi Arabia, which together have 21 million barrels a day in production. And they regain control of the pricing mechanism in the next six months. I think the Saudi willingness to over-pump is going to change when the threat to their wells recedes. When the Saudis shift their policy, the oil price will head north.
You are going to see a number of very large defense contracts from Russia to that region. The Chinese are already negotiating contracts and letters of credit with both Saudi and Russian companies to pay for oil in yuan, not dollars, and will have more and more influence.
For the immediate future, it is very likely we have lower prices going into year end. For West Texas Intermediate, there is support at $40 a barrel and then next at the old lows of $32.40. If you see WTI below $40, I would back up the truck. Next year, assuming the dollar begins to fall, we think it can trade up to around $70 or $80. If you are a buyer below $40, it would be well worth it. Another way to play it is just to buy very high-cost oil producers, because at the margin, they’ll have the biggest impact.”
Saudi Arabia has made it very clear they do not want to see oil spike in price and kill demand. They are also clear on wanting to maintain market share. They are going to have to find a balance. This isn’t a seek and destroy mission of American shale out of some sort of hubris. This is about how do they make the most money in their bread and butter industry before oil starts the inevitable downward demand trajectory in the next decade or two.
So far, many large scale oil and gas projects have been canceled by the higher marginal cost producers and those projects are difficult to bring online quickly. Also, hot money is no longer available in shale oil. Private equity money is flowing into shale and will continue to, although they are more likely to emphasize profits than those who sought to pump as quickly as possible and make their initial fortune. Remember, private equity is already rich.
I don’t think it is unlikely that Saudi Arabia shocks the world and announces a structure to caps on OPEC production in conjunction with an agreement with Russia at their December meeting. I think it is likely that by the spring OPEC meeting that some sort of OPEC agreement is come to. I believe it has an OPEC production number of about 31 or 32 million barrels per day of production, up from the 30 million cap they are currently exceeding. That will allow for Iran and Iraq to bring production online and Saudi Arabia to scale back to about 10 million barrels from the current 10.6 million. Saudi Arabia needs to pull back on production in order to maintain the ability to threaten higher production if higher cost producers once again threaten market share. Other OPEC nations will do a bit of math and see that slight reductions in production sold at prices twice as high will benefit them.
Of interest to investors is where will the money be made for shareholders of U.S. oil and gas companies. I will have my updated oil and gas report next weekend with 12 U.S. companies and a 3 international companies to focus on. I will also provide a strategy for speculating on a rise in the price of oil. Circle December 4th on your calendar. That is when OPEC meets.