Tuesday, December 16, 2014

The 2014 Oil Story

One must be careful when listening to the media and hyperbole about oil.  Based on recent headlines and commentary you would think that we have so much excess oil that prices will continue to plummet until a large percentage of the producers go bankrupt. 

Like with most panics that are set off by the unexpected, the accompanying headlines tend to exaggerate. Here are some simple facts. You can review much of the data at http://www.eia.gov/.

Global oil consumption and production typically remain in equilibrium—supply equals demand and demand equals supply.   Both consumption and production have been increasing steadily except for one year in 2009. In 2009, global oil consumption was 84,971,000 barrels per day, with production being 84,951,000. This was a decline of 1,128,000 per day from 2008.  In 2013, consumption had risen by 6.4% to 90,375,000 barrels per day, with production being 90,130,000. So in essence, growth of both consumption and production grew from 2009 to 2013 by about 1.5% per year.

The buffer between supply and demand is inventory or stocks that have remained around 4,128,000,000 barrels or about a 45 day supply.  Whenever supply drops, this inventory normally supplies the market temporarily and rising prices tend to increase supply, bringing everything back to equilibrium.  Without having empty storage locations, if consumption drops or supply suddenly increases, there is no place to put the oil.  Production has to be reduced quickly or prices can fall rapidly.

Studying the numbers confirms that production has increased in North America significantly, rising as much as 1,500,000 per day year over year. The rest of the world’s production had remained stable, with one exception: Libya.  So in essence, the growth in North America made up for the loss in Libya and North America recently supplied enough to support stability and equilibrium.  That was until this Summer, when the production from Libya came back online.  Now, unless production was cut somewhere, production was about to exceed consumption by about 0.6% or 600,000 barrels per day.  With no place to put the oil, producers had one of two choices: A) Keep pumping and take a lower price, or; B) Stop pumping.

For the most part, producers have chosen option A and have kept pumping. After all, once you’ve invested in drilling the well, the incremental cost of pumping it is very low, so even at a substantially lower price, pumping oil is still a very profitable business for most producers. 

In fact, when the producer is a government (like with Saudi Arabia, Iran, Russia, and Venezuela) who needs the revenue to pay the bureaucrats and government programs, there is an incentive to actually pump more oil to “make up” for the lower price. So, even with too much production causing low prices, many producers may actually increase production causing the price to fall even faster and ultimately lower.  

So how does this finally stabilize?
First, consumption over time will increase. The trend is an annual increase of about 1,350,000 barrels per day. We may be below this trend in early 2015, but will likely return to this trendline in late 2105 or early 2016. And, lower prices tend to encourage consumption.

Next, production will stop growing as fast or even perhaps decline.  This is the “wildcard” and is extremely unpredictable.  Saudi Arabia could unilaterally decide that they are better off with higher prices and could cut their production by 10%.  There could be some other global event.  At present prices, one can be sure that new drilling will be seriously reduced.  Without new drilling, oil production tends to fall off quickly—particularly in shale oil locations.

Keep in mind, assuming a constant global consumption throughout the day at the rate of 90,000,000 barrels per day, the “excess” supply in the market is equivalent to only 14 minutes of global consumption!

History has taught us recently that the price supporting stable equilibrium for consumption and production is somewhere above $100 per barrel—almost double the price that it has currently reached.

It would seem rational to assume that we will be back to $100+/barrel within 18 months. Under certain circumstances we could be back within 90-120 days.

If you are a gambler, your “market bets” will require prediction of an exact date for “recovery” of oil prices. I wish you luck.

If you are a long term investor, consider that the current situation is an opportunity to increase your ownership of well managed, and well capitalized energy producers at bargain basement prices. These types of opportunities do not present themselves so often.  Each investor should examine their own tolerance for risk and act accordingly.

Of course, everyone likes to get the best price, so even the long term investor will want to predict the time when we will hit “bottom”.  Unfortunately the exact time of the “bottom” is unknowable.  So, when the “best” time is unknowable, but the opportunity looks attractive, the principle of “dollar cost averaging” is often the strategy used by the most successful investors---along with intelligent diversification.  Start buying and continue buying periodically as long as the price and opportunity seems attractive. 

Finally, always consider that there is always that remote possibility that the hyperbole turns out to be predictive—that panic begets panic and consumption begins falling because of economic contraction.  History teaches that this possible, but not probable. In such a case, the result is probably just that it will take longer than expected to see the benefits of your investments.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.