Wishful Thinking

April 15, 2020

Do you remember that time when you wished that you could buy an investment that was completely, ridiculously undervalued and just leave it and know that it would appreciate in value without too much worry?

For savvy investors there is currently just such an investment.   It’s a bit scary, because the market for this product is full of fear, but the economics are undeniable, and all of the major suppliers have just shown their hands…simultaneously.

That’s not to say there isn’t stress ahead, and pain for some investors.  Perhaps even a longer wait than one might anticipate now, for the value to increase.   But the opportunity is clear.

That investment is oil.  Let me explain why you should consider investing in oil, and then a few ways to make that investment.

Oil prices (WTIC, US$) this morning are below $20 per barrel.  The last time oil prices went below $20 was in February of 2002 following a drop in travel after the World Trade Center attacks.

WTIC daily continuous 20200415

Monthly Oil Prices – A long term opportunity

There is a good chance that over the next 30-60 days, oil prices could drop further, but it is a virtual certainty that over the next 12 months, that oil prices will be above $30 and probably $40.

Why is Oil So Low?

The current price drop is a culmination of years of technology, business and geopolitics coming together simultaneously.   There is almost certain to be a book written about it and so this is just a brief overview of the three key areas.

  • Technology – Over the past twenty years, exploration companies have devised, implemented and improved a process called fracking that drills laterally into shale rock formations to ‘free’ oil and gas from the rocks.   This process has been wildly successful and allowed companies to extract oil and gas from these ‘tight’ formations for a fraction of the cost of drilling traditional wells deep into the earth and increasingly under deeper and deeper water.
  • Business – As the technology for extracting from these ‘tight’ formations improved, the cost of doing the work dropped rapidly and hundreds of companies set out to find these wells.   This was done at a time when prices for oil and gas were very high, so they could borrow money easily, drill wells, show how successful they were and repeat.   Unfortunately they were frequently not profitable, even at higher prices and despite massive gains in efficiency over a decade.   The solution was to drill more, borrow more or sometimes both.   In the end, this process took US daily oil production from about 5 million barrels per day (mmbpd) to almost 11 mmbpd currently.

EIA Oil Production 20200415

To be clear, this is a massive success story.  Akin to improvements in computing or transportation.   But as supply rose, prices went down causing many problems.

  • Geopolitics – Oil is a key resource for consumption almost everywhere and in the case of countries like Saudi Arabia, Russia, the US, and dozens of other nations its a significant export.  That makes it a significant factor in budgets.   The rising supply and falling price has resulted in budget difficulties for countries that export oil.

The shale ‘revolution’ (tight oil) has meant that production has grown very quickly (see the chart above).  This is a key factor in shale wells, since they can be drilled and producing within months with relatively limited budgets ($4-5 million) compared to deep wells ($50-500 million).  This is also true for developments such as Canada’s tar sands; those may require many years of work and investment to bring into production.

In the last century, there was a group of producers who worked together to control production and therefore prices.  OPEC as they are called did a marvelous job of controlling prices until the shale revolution hit.   At that point they lost one of their key customers (the USA) and that customer became a competitor as well (the US became a net exporter of oil in 2019).   In a free market, customers compete for market share, and the low cost of shale oil meant that the US was forcing the price of oil down AND taking market share from Saudi Arabia. During this time, Russia along with dozens of other countries were increasing their oil production and trying to win customers as well.

At the end of 2019, worldwide oil production was around 100 mmbpd, having grown steadily with expanding economies, but production was beginning to outstrip demand.  Then COVID-19 happened.   With the current pandemic, estimates are that oil consumption has declined by 25-30 mmbpd to 70-80 mmbpd.   That means that there is a LOT of oil with nowhere to go.

On top of that OPEC and Russia entered into a price war at the beginning of March and Saudi Arabia lowered prices dramatically to win customers.  They opened the taps and flooded the market with oil, instantly dropping prices by over $10/bbl.   This all happened as countries around the world started issuing stay at home orders and limiting cross border travel.

The world was almost instantly overwhelmed with oil.

There is one more problem that needs to be understood before you make any investment into oil.   It is estimated that there will be no where in the world to store oil within the next 30 days.   That may seem like a bit of an overstatement, but for the first time ever, it could happen.   Most of the world’s large crude carrying ships are already full of oil.   Storage bunkers are full of oil.  Strategic petroleum reserves may be filled shortly, and pipelines will soon run out of places to send oil.   If that happens, the price of oil could drop again, a final capitulation move where everyone sells just to get out.

What Will Make Oil Go Up?

There is a saying in the commodity business.  “The cure for low prices is low prices.”

The best reason to buy oil right now is that it costs more than its current price to take it out of the ground.   Even the lowest cost producer (Saudi Arabia) requires $25 to lift their oil, and according to their financial filings, they need to sell it at around $40 for their marketing arm (Saudi Aramco) to make money.  Further, the government needs about $80 to cover their program spending.

Russia has a similar story.   They can lift oil for about $25, but need about $46 to cover their government spending requirements.  Meanwhile in North America, the cost for lifting the oil is also around $25, and for companies to be profitable the average price needs to be in the $40 range.

The response will be that production gets shut in (the wells are temporarily plugged) until companies can find buyers for their oil at a reasonable price.  Some companies will simply go bankrupt and others will stop spending money to drill new wells.  Within a year, the price of oil should rebound to the $40 range.   It is currently at $20.

What Should You Do?

Buying oil now can still be risky.   If storage fills up, then volatility will spike (to the downside in this case; prices may drop dramatically, perhaps not to zero, but it is possible.)   Given that risk, there is a good chance that within 12 months oil returns to a ‘normal’ level that allows companies to operate profitably, and that price is somewhere above $40/bbl.

For the typical investor, buying oil is nearly impossible.  It is a commodity that trades on commodity exchanges, and to buy it, you need to buy futures contracts (which has a much higher level of risk than equities, mutual funds and of course bonds).

There are other ways to buy oil.  You can use an oil ETF such as the unleveraged United States Oil Fund (USO) in the US which is tied to the changes in West Texas Intermediate Crude or for a riskier, and leveraged bet, the BetaPro Crude Oil 2X Daily Bull ETF (HOU) in Canada which is also tied to WTIC.   (Be wary of leveraged ETFs.  They are NOT investments, they are trading vehicles.)

Another way to take advantage is to buy shares in the strongest oil companies you can find.   As mentioned, this shakeout will result in many small, or poorly financed oil companies declaring bankruptcy.   The larger companies with stronger balance sheets will benefit in the long run by being able to purchase assets at attractive prices.  Any company surviving this downturn will then take advantage of the rising prices in coming years.

A similar argument can be made for natural gas.   The reasons and fundamental drivers are slightly different, however prices are expected to double over the next 12 to 18 months.

Consult with your advisor.  If you do want to take advantage of these unusual times in the oil market, be mindful that there may be a LOT of volatility for the next 60-90 days, and spread out your investment over many months to distribute your risk.

 

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