While those of us in this country are enjoying our Thanksgiving
festivities today, OPEC will be meeting in Austria to discuss oil production.
Given the abysmal collapse in oil prices in the second half of this year, the
meeting has taken on greater importance with profound economic and industry
implications. The price of Brent crude oil is down more than 20% from its
summer highs of $105 per barrel and WTI hasn’t fared much better. Many experts
are expecting a modest reduction from OPEC as a result of today’s meeting but
nothing is certain. Saudi Arabia has been a supporter of lower oil prices and
may not be as accommodating some sources say. As a possible ploy to wound
Russia, ISIS and other OPEC members both politically and economically, Saudi
Arabia may entertain weakened oil prices for some period of time.
Additionally, there are many who speculate the true motive
behind this “squeeze play” is to put a dent in the U.S. shale revolution that
has taken hold, increasing U.S. oil output by more than 40% in the past eight
years. While the growth in output is impressive, one needs to recognize that
production costs in the U.S. can be three to four times that of Middle Eastern
production. Thus greater survival odds from a price war lie heavily in Saudi
Arabia’s favor.
| http://www.businessinsider.com/citi-saudi-arabia-wont-win-this-oil-standoff-2014-11 |
Market experts place a $70 per barrel price target on Brent
crude as a breakeven point for the U.S. shale producers but that number has a
fairly wide range, from $50 to $120 depending on the efficiency of the well.
| http://www.businessinsider.com/shale-basin-breakeven-prices-2014-10 |
According to the U.S. Energy Information Administration,
Saudi exports to the U.S. have dropped by almost 30% since the summer from 1.25
million barrels per day to below 900,000 barrels in August. They have been
producing 9.6 million barrels per day accounting for roughly 31% of OPEC’s
production as other OPEC members gripe about the pricing strategy the Saudis
have embraced. Many experts speculate that OPEC would need to announce a 1
million barrel per day reduction to stop the free-fall.
| http://www.businessinsider.com/opec-november-27-meeting-preview-2014-11 |
The supply issues are magnified by current global demand as
Europe and China struggle economically. In the case of Europe, they are working
towards avoiding a recession throughout the region while China is struggling to
maintain its growth profile of the past several years. China is the number one
consumer of oil and is facing a slowdown that threatens to bring GDP growth
below its targeted 7%. Experts point out the economic dynamics at play in
China, i.e. record leverage and weakening real estate, thus a slowdown in that
region will impact the global economy and the price of oil exponentially.
Taken from MarketWatch (via Zero
Hedge), “As to how low the oil prices
can go, that depends on how much China will slow down as the number-one
consumer of oil. China’s financial system is operating on record leverage at
the moment. Record leverage in the financial system and a sharply weakening real-estate
market suggest that their economic slowdown has the potential to carry far
below Beijing’s GDP growth target of 7%.
Yes, China has had
three real-estate downturns in the past seven years, but the latest one is
coming at a time of debt-driven boom, which means the consequences this time
can be quite different. I used to think that China was a classic
savings-and-investment economic-growth model, and it was, but that was 10 years
ago.
I no longer think
that, since GDP growth in the past five years has come from ever-increasing
leverage ratios in the banking system. No debt-driven boom is permanent by
definition, so the decline in the Chinese real-estate market has the potential
to create a domino effect there in 2015. If China does decelerate well below 7%
in 2015, an oil price target in the $30 to $40 range is completely realistic.”
Talk about a worst case scenario. Another item that should
be highlighted is the current state of the high yield market. The Alliance Bernstein
blog has done a fantastic job covering this area. They postulate (via Business
Insider), “Energy-sector high-yield
bonds have been at the epicenter of recent volatility in the global high-yield
market. Between late August and mid-November, the US high-yield energy sector
is down 6.2%, compared to a 1.7% decline for the broader US high-yield
corporate-bond market. Since 2000, energy companies have invested some $1.5
trillion into operations—mostly exploration and production—and they’ve taken on
a hefty share of debt to do it. Debt issued by energy firms today comprises
more than 15% of the Barclays US High Yield Index, compared to less than 5% a
decade ago (Display). But not every segment of the energy industry stands to
benefit. Oil prices are now below $80 a barrel—in part a result of the supply
glut caused by the North American production boom. Small companies that have
levered up to fund exploration and production will see their margins
squeezed—with bankruptcy a distinct possibility in some cases. As a result,
many firms no longer have access to capital markets. But we think investors
should think carefully before deciding to snap up their existing debt at a
discount.”
| http://www.businessinsider.com/the-problem-with-high-yield-energy-bonds-2014-11 |
As contrarian investors, we are of the opinion that the energy
sector is an intriguing place to look for investment purposes. More
specifically, companies that will benefit from rising oil prices are what we
would like to introduce to the portfolio. The price of oil will not fall into perpetuity.
The global supply/demand dynamics assure that. As demand for oil increases
annually, production for the black stuff needs to grow exponentially as wells
are in a constant state of decline (this is especially the case for North
American Shale). Therefore it will take significant capital investment just to
keep pace with global demand of 1% per annum. That along with the inherently
volatile region that produces so much oil gives us comfort in knowing that the
price of oil will reach $100 per barrel in the future. It may take some time,
but my instinct tells me not as long as many are expecting.
Next week we will be providing some opinions on investments
that we are contemplating. Until then, we wish all a Happy Thanksgiving.
Joseph S. Kalinowski, CFA
Additional Insight
Energy & Oil
Prices
On OPEC Meeting
On Oil Prices
On Oil Demand
On Supply Production
On the Economy
On Gas Prices
On High Yield
Securities
On Energy Stocks
On Energy Politics
