Oil Oil, everywhere

[One World Trader]

Hi All,

 

Happy New Year!

 

What is going on with oil prices? I haven't filled my car for this low since I can remember. This is by no means a complaint, however I am skeptical.

 

I hear the US has doubled its production since 2008. What is the official purpose here?

 

Thanks all, I can always count on an informed response!

[berkshire101]

How much does it cost to produce a barrel of oil?  I read that it cost the Saudis $30 per barrel. 

 

Oil kind of reminds me of gold a while back.  It cost around $1000 to mine an ounce, but it was trading for like $2000.  So they produced a lot of the stuff and supply met demand.  They even had a reality show about it.  Maybe that's what happening to oil.  Everything I read says that the US will be the #1 oil producer going forward.  Or maybe electric cars will take over the world soon.  Those Tesla fanboys maybe right after all.

[jobyts]

Hi All,

 

Happy New Year!

 

What is going on with oil prices? I haven't filled my car for this low since I can remember. This is by no means a complaint, however I am skeptical.

 

I hear the US has doubled its production since 2008. What is the official purpose here?

 

Thanks all, I can always count on an informed response!

 

 

As far as I know, the US government has no direct control on the US oil production unlike the OPEC countries. The government could control the production indirectly only by the permit and export laws. Is that a correct assumption? How is the government control in other countries like Canada and Australia?

[petec]

Hi All,

 

Happy New Year!

 

What is going on with oil prices? I haven't filled my car for this low since I can remember. This is by no means a complaint, however I am skeptical.

 

I hear the US has doubled its production since 2008. What is the official purpose here?

 

Thanks all, I can always count on an informed response!

 

 

As far as I know, the US government has no direct control on the US oil production unlike the OPEC countries. The government could control the production indirectly only by the permit and export laws. Is that a correct assumption? How is the government control in other countries like Canada and Australia?

 

Yes, that's correct.  US oil and gas production used to be directly regulated I believe but are no longer.  It's a free market, so long as producers operate within the law (getting the right permits etc).

 

There is therefore no 'official purpose' of rising US oil production, only the impact of finding a new technology (fracking) and lowering its cost.

 

Five years ago a lot of people believed US (and possibly world) oil production had peaked and that psychology helped oil prices to very high levels, almost certainly above the marginal cost of production.  Today there is a possibility that fracking technology will go global and the world will be awash in oil, so there has been a huge shift in thinking.  People have also realised that OPEC won't hold the price up to the benefit of their competitors.

 

This is, therefore, a normal market reaction except for its suddenness.  But then even that might be normal: as we all know, in economics things can last longer than you can imagine and then change faster than you can imagine.

 

 

[Liberty]

I liked this piece:

 

https://fundooprofessor.wordpress.com/2014/12/08/who-will-bail-shale/

[yadayada]

the problem , people are confusing break even prices. Cash break even and full cycle break even. Cash break even is the cost of getting it out of the ground now, when land is paid for, seismic photo's are made and the oil wells are drilled in the ground. But those wells tend to run dry within 1-2 years for shale oil. And to make more photo's order new wells and put them in the ground, those costs run much higher.

 

Really those levered oil producers like PWE are drilling because they need to pay their debts. If they were all unlevered, production would have shrank significantly. They are not getting their original investment back. That only happens when oil is trading much higher. So when those wells run dry after one year, you need prices around 100$ for them to drill new shale wells. So when that happens , and price of oil is still 60$, you will see a sharp drop off in oil production, and price will spike up again, as there will be a small gap in supply/demand if prices dont go up.

 

Or maybe they will anticipate this, and drill new wells anyway with low oil prices, depends on how much fear and pessisism there will be in the sector.

 

Also oil is not comparable to gold. Oil is used up, gold isn't. If oil production would dry up alltogether, oil prices would shoot up close to a thousand dollars at least. If gold production dries up, not that much would happen with the price of gold since there are huge reserves.

[petec]

 

Really those levered oil producers like PWE are drilling because they need to pay their debts. If they were all unlevered, production would have shrank significantly. They are not getting their original investment back. That only happens when oil is trading much higher. So when those wells run dry after one year, you need prices around 100$ for them to drill new shale wells. So when that happens , and price of oil is still 60$, you will see a sharp drop off in oil production, and price will spike up again, as there will be a small gap in supply/demand if prices dont go up.

 

That's what I thought would happen with shale gas.  In fact, it turned out to be economic at much lower prices than this analysis suggested.

[Palantir]

US has been dramatically raising production for about 5 years now, if it was simply a supply vs demand imbalance, why was the transition a quick drop in prices rather than something that played out over 5 years? I have a hard time understanding the "increase in supply" line of thinking.

[yadayada]

 

Really those levered oil producers like PWE are drilling because they need to pay their debts. If they were all unlevered, production would have shrank significantly. They are not getting their original investment back. That only happens when oil is trading much higher. So when those wells run dry after one year, you need prices around 100$ for them to drill new shale wells. So when that happens , and price of oil is still 60$, you will see a sharp drop off in oil production, and price will spike up again, as there will be a small gap in supply/demand if prices dont go up.

 

That's what I thought would happen with shale gas.  In fact, it turned out to be economic at much lower prices than this analysis suggested.

 

Isn't the lack of exports holding down shale? prices are like 4x as high outside the US... It seems once the government stops blockign those terminals, prices would shoot up. As demand could not meet supply at those lower prices?

[Uccmal]

US has been dramatically raising production for about 5 years now, if it was simply a supply vs demand imbalance, why was the transition a quick drop in prices rather than something that played out over 5 years? I have a hard time understanding the "increase in supply" line of thinking.

 

The reason these explanations are hard to accept is because they are all Bs speculations.  In reality, no one is in control, and no one knows exactly what is happening. 

[txlaw]

I liked this piece:

 

https://fundooprofessor.wordpress.com/2014/12/08/who-will-bail-shale/

 

This was a great piece.  Really crystallizes what I think is "intelligent investing" in the O&G space (which includes points to consider by both Professor Bakshi and Friend).

 

I pretty much agree with every point except for parts of the last three by Professor Bakshi and point two of Friend:

 

------

 

Friend, Point 2 -- The Friend assumes that the cost of production will remain flat as a result of using up "best inventory."  I personally don't think this is the case, and one ought to prepare for the cost of marginal barrel or MCF to go down for unconventional producers.  That appears to be a defining aspect of the unconventional revolution in the US.  These guys continue to be able to reduce the cost to produce these barrels/MCFs.

 

The consequence of the notion I've articulated above is that the "equilibrium" price point around which oil/gas will trade -- i.e., the price where the marginal barrel meets demand -- could continue to go down.  In such a market, the rich producers (those with lowest costs) will be alright but their margins will compress, and producers with full-cycle break evens closer to the marginal barrel price have to be in an "arms race" of sorts to get an acceptable full-cycle ROI.

 

-----------

 

Bakshi, Point 6 -- As yadayada has pointed out, people often confuse the difference between cash break even and full-cycle break even.  And it is primarily the discrepancy between cash break even and full-cycle break even that keeps people producing in a "noneconomic" matter.

 

For example, oil sand producers can make cash margins on oil production at very low oil prices because their capital investment has been front-loaded.  And it is entirely rational for them to produce oil from those assets and make those cash margins in order to pay down debt and potentially invest where there actually is a full-cycle economic return, even when the full-cycle ROI on previous investments appears to be very poor (or even negative).  Thus, in pure commodity businesses that are very capital intensive, we often see prices trading below the "equilibrium price" for a long time.

 

Note that just because the above phenomenon occurs does NOT mean that a secondary market investor cannot make a return in this type of situation.  Because ultimately the secondary market investor gets to choose what price he is paying for the assets and liabilities, which has nothing to do with the amount of productive capital that was put into building the assets.

 

Another way of saying this is that when one looks at the "replacement capital" cost for a collection of assets, one often comes to the conclusion that the capital that was utilized will never generate a present value of cash to justify the amount that was spent.  This is why I personally think "replacement cost" is a poor method for valuation.  But the flipside to this is that the secondary market investor doesn't have to pay the replacement cost for an asset.  He can pay cents on the dollar and get a very nice return based on the price paid.

 

In the context of an oil sands producer, for example, it may turn out that the amount of capital put into these projects was wasted from a financial perspective.  But if the assets can churn out cash margins at $30 a barrel for the foreseeable future, there is obviously a price the intelligent investor will pay for the assets to generate great returns going forward.

 

---------

 

Bakshi, Point 7 -- A pithy WEB saying is always fun to use.  But the counterpoint is that being a lowest cost commodity producer as a result of technological innovation and asset selection/purchase, plus proper financing (not being over-leveraged), is essentially the way to be smarter (though perhaps not a lot smarter) than your dumbest competitor.  And being smarter is the right way to generate financial returns in a commodity business.  Although luck obviously can play a huge part as well.

 

It’s worth noting, btw, that WEB is invested in several commodity businesses where the businesses are said to be a lowest-cost provider.  POSCO is probably the example that is most analogous to O&G.  While Munger does argue that POSCO is almost a tech biz, the fact of the matter is that their commodity-like businesses dominate, and being a low cost, high quality producer is where the tech savviness plays a part in the moat.

 

--------

 

Bakshi, Point 8 — It’s unclear what Bakshi means by having enormous staying power.  Is he referring to producers or is he referring to investment managers?  Given that he is talking about no debt at all, he appears to be talking about investment managers rather than producers, which means he is conflating the issue of whether O&G businesses themselves can make intelligent investments with whether investment managers should stay away from O&G.

 

Also, Bakshi’s bias towards “branded” as opposed to “commodity" businesses makes sense as a general rule re: when determining whether or not a business is a “great” business. However, one always has to keep in mind the price paid for a business.

 

It is folly to believe that there will necessarily be pain in "seeing other people who invest in businesses that buy commodities but sell branded products get rich in environments when commodity prices are high or low.”  Because many of these other people will be overestimating the moats of these “branded” businesses and paying rosy (and perhaps outrageous) prices for these businesses.  In other words, if you are buying commodities producers at outrageously low prices, it’s not a given that those buying “branded” producers at outrageously high prices will have the leg up. 

 

-----

 

Anyways, just some thoughts I wanted to put to paper after reading a very thought-provoking post.

[Liberty]

Good post, txlaw, thanks for sharing your thoughts.

[txlaw]

Good post, txlaw, thanks for sharing your thoughts.

 

Thanks, Liberty. :)

 

One of my New Year's resolutions is to go back to putting more of my investment thoughts to paper, as I think it helps to keep the mind sharp.  Finance Twitter is very fun and valuable, but it's obviously very difficult to lay out nuanced arguments there.  And the snarkiness is fun but not necessarily helpful when trying to get the truth of a situation in order to profit.

 

Also, re: my post, I mention POSCO as the closest analog to O&G.  But, duh, WEB is invested in XOM, so . . .

[yadayada]

US has been dramatically raising production for about 5 years now, if it was simply a supply vs demand imbalance, why was the transition a quick drop in prices rather than something that played out over 5 years? I have a hard time understanding the "increase in supply" line of thinking.

 

The reason these explanations are hard to accept is because they are all Bs speculations.  In reality, no one is in control, and no one knows exactly what is happening.

I think it is a combination of both? Speculators shaken out, and supply and demand gap getting wider? I like the theory that says that because of deflation fears, a lot of commodities are shaken out. So all the speculators that went into oil in 2010-11 that went into oil because of inflation fears, are now shaken out because deflation seems more likely now for the next few years at least.

[Cardboard]

I recall seeing a chart recently about net long non-commercial contracts for crude. It was trending right around 0 before the QE Era, then moved up continually to the long side until the recent crude price slide. It was then heading straight down and fast.

 

I suspect this was largely hedge funds and pension funds allocating a tiny percentage of their enormous assets into non-traditional investments.

 

Once this reaches 0 again we may see more equilibrium for the price of oil since the so called glut is not that obvious to see based on global inventory reports.

 

Cardboard

 

[CorpRaider]

Good post, txlaw, thanks for sharing your thoughts.

 

Thanks, Liberty. :)

 

One of my New Year's resolutions is to go back to putting more of my investment thoughts to paper, as I think it helps to keep the mind sharp.  Finance Twitter is very fun and valuable, but it's obviously very difficult to lay out nuanced arguments there.  And the snarkiness is fun but not necessarily helpful when trying to get the truth of a situation in order to profit.

 

Also, re: my post, I mention POSCO as the closest analog to O&G.  But, duh, WEB is invested in XOM, so . . .

 

Haha.  I was all geared up to mention XOM, but you beat me to the punch.  He also didn't get totally out of the sector with the like-kind exchange of the COP stock for the (or the railroad investments, really).  I caught an article somewhere yesterday about an LNG export facility getting scrapped to collapsing prices for LNG which are apparently set off the price of oil in asian markets.  Hopefully, more companies survive the oil and gas revolution than made it through the internet revolution.

[HJ]

 

Really those levered oil producers like PWE are drilling because they need to pay their debts. If they were all unlevered, production would have shrank significantly. They are not getting their original investment back. That only happens when oil is trading much higher. So when those wells run dry after one year, you need prices around 100$ for them to drill new shale wells. So when that happens , and price of oil is still 60$, you will see a sharp drop off in oil production, and price will spike up again, as there will be a small gap in supply/demand if prices dont go up.

 

That's what I thought would happen with shale gas.  In fact, it turned out to be economic at much lower prices than this analysis suggested.

 

Isn't the lack of exports holding down shale? prices are like 4x as high outside the US... It seems once the government stops blockign those terminals, prices would shoot up. As demand could not meet supply at those lower prices?

 

Gas transport by sea is through LNG, a significantly more expensive proposition as a percent of the product transported compared with oil transport through VLCC.  You need to build refrigeration infrastructure to liquify gas on the export terminal, and then build infrastructure to receive liquified gas on the importing side.  Those add to landed cost of gas significantly.  Gas will never be as internationalized a commodity as oil. 

 

 

[yadayada]

 

Really those levered oil producers like PWE are drilling because they need to pay their debts. If they were all unlevered, production would have shrank significantly. They are not getting their original investment back. That only happens when oil is trading much higher. So when those wells run dry after one year, you need prices around 100$ for them to drill new shale wells. So when that happens , and price of oil is still 60$, you will see a sharp drop off in oil production, and price will spike up again, as there will be a small gap in supply/demand if prices dont go up.

 

That's what I thought would happen with shale gas.  In fact, it turned out to be economic at much lower prices than this analysis suggested.

 

Isn't the lack of exports holding down shale? prices are like 4x as high outside the US... It seems once the government stops blockign those terminals, prices would shoot up. As demand could not meet supply at those lower prices?

 

Gas transport by sea is through LNG, a significantly more expensive proposition as a percent of the product transported compared with oil transport through VLCC.  You need to build refrigeration infrastructure to liquify gas on the export terminal, and then build infrastructure to receive liquified gas on the importing side.  Those add to landed cost of gas significantly.  Gas will never be as internationalized a commodity as oil.

despite those costs, it would still be incredibly lucrative to export gas. Yet those terminals are being blocked by politicians that are paid by industries that like the really cheap gas.

[CorpRaider]

http://www.reuters.com/article/2014/12/30/us-usa-lng-excelerate-idUSKBN0K81CP20141230

[yadayada]

http://www.doctorhousingbubble.com/wp-content/uploads/2014/12/Oil-sands.png

those are full cycle costs.

 

If this is even remotely right, then oil wells will dry up in 1-2 years, and unless oil is at 80$+ or there is some hidden lost cost capacity somewhere (and the owners really hate money), oil is very unlikely to stay at these levels.

[frommi]

I am pretty sure that with the latest currency movements these costs are not anymore where they are in the graph. Or is it based on latest exchange rates?

[Scorps]

Costs will most likely come down as crude prices drop.

[rohitc99]

 

If this is even remotely right, then oil wells will dry up in 1-2 years, and unless oil is at 80$+ or there is some hidden lost cost capacity somewhere (and the owners really hate money), oil is very unlikely to stay at these levels.

 

any reason why these costs - especially the non-opec ones will not change ? most of the junior O&G companies seem to be showing a 3-5% drop in costs for the last few years. will that not continue and keep pushing the cost curve down ?

 

if one combines this with low cost of NG and other sources of energy which are being developed (at the periphery for now), this could depress the demand at the margin too.

 

just thinking out loud

[yadayada]

costs have been going up in the last decade or two.

[ni-co]

Jeremy Grantham in GMO's latest quarterly letter:

 

Starting around the year 2000 a remarkable change in the relationship between oil and the economy began: the growing demand for oil started to outrun the supplies of cheap reserves and the economy had to adjust by bringing in the higher and higher cost reserve so that marginal costs compounded at over 10% a year. Why the price of oil inflected around the year 2000 so sharply, from stable to rising, is not clear but certainly owes a lot to a growing world population and perhaps a lot more to rapid Chinese growth. Marginal costs, which usually determine price, rose from $15/bbl or so in 1998 to around $70 to $90/bbl today. (And average costs rose from about $10 to $60/bbl.)

 

[…]

 

In the long run, when the costs of producing oil rise, the prices will rise. But in the short run it is not always the case, and in such occurrences it is easy to confuse the effects of changes in costs with changes in prices. When global oil costs rise, as they are currently doing, global growth must suffer as we are forced to use more of our capital per unit of oil discovered and thus limit our capital investments in other growth opportunities. This is true even if prices simultaneously fall due to a temporary supply/demand imbalance. The current fall in price does nothing to offset the squeeze on the total economy from rising costs. It merely transfers massive amounts of income from one subgroup (oil producers) to another (oil consumers), in a largely zero-sum game. Oil consumers tend to spend more and save less than oil companies so short-term impacts are favorable. But we should not be carried away with enthusiasm because the declining investment from the oil industry will lower future growth. When, as now, oil costs are still rising even as prices fall there is of course a particularly savage effect on the profits of oil companies, squeezed from both ends. They must and will rapidly adapt by reducing expenditures and therefore oil production with the fairly obvious result that prices will rise again.

 

http://www.gmo.com/websitecontent/GMO_QtlyLetter_3Q14_full.pdf

 

I have no opinion on the "fair" level of oil prices and (therefore!) on the right price levels for the stocks of the oil majors. However, I think that Jim Chanos is absolutely right: If you take a look at both, the price movement in oil vs. in stocks of oil majors, at least one of the two price levels has to be seriously wrong. His long/short trade (already posted here) seems to me to be a great risk/reward bet – much, much better than buying/selling one of the two asset (classes) outright.