What is the extent of the 'opportunity' in the oil market?

bmichaud · November 22, 2015

I read an interesting quote by a former Baupost partner today. It said something to the effect that one needs to have the guts to double down on a thesis when conviction is at its lowest.

The price of oil makes almost no sense at this level on a long-term basis; but OPEC can afford to wait it out. So even if an E&P company can survive, it (and the sector) could be dead money for an uncomfortable amount of time.

Curious what the Board's general thoughts are.

Uccmal · November 23, 2015

Well, I am not the Board.... and I also cant predict the direction of oil...

Alot of unexpected things have happened. The biggest one I am noticing is that the price of production, due to technological advance, in the US is coming down fast. Presumaby this overflows to Western Canada. This is an unintended consequence of OPECs actions, not that they had any choice in the matter - this is a battle to the death.

The more expected side is the increasingly rapid development of renewables. At some point in the next few years the growth in the use of oil will stall, and start to reverse, regardless of price. That doesn't mean that oil cant be profitable in the long term for those who can produce it cheaply: such as Russia, NA, Saudi, Kuwait, Iran, and Iraq.

On an individual basis I think the only way to do this is to pick those that will be survivors. To that end I have invested 4% in each of Whitecap (WCP), Arc Resources (arx), and PWT(pwe) respectively. I also have much larger positions in Mullen Group, and Russell Metals, both of which are partly leveraged to oil and gas. All of the above, including Pwt's present management, have been through down cycles before. Arc, mtl, and rus came out of the 90s glut. I also have a sizable position in Brookfield Renewable Energy... call it hedging with benefits.

I dont follow US e&p companies at all.

TheAiGuy · November 23, 2015

I think could be good opportunities on the debt side. I don't like the trade (yet?) but there are some shale companies and coal companies that will probably survive for another few years that have debt with a 20% yield to worst. The beauty of investing the debt, is you can find a cash-flow company that can service its debt and reduce the investment choice to: will they / won't they be able to roll over their debt in X-years? If the price of oil goes up, probably yes; if it goes down a lot probably not; some where in between, who knows. Dilutive equity raises are positive in the case and you don't even really care how well the company does -- it only needs to squeak by.

Long term I'm with Uccmal.

rohitc99 · November 23, 2015

is it not also the case that countries like Russia, Saudi, Iran etc will have to produce no matter what the price. A canadian or US producer reduces production if the price start falling and remains low, but what option do some of these countries have

Just as a thought experiment, lets say by post 2020, alternative forms of energy reduce the demand for oil and the price gets stuck at say 50, production out of US and canada could reduce and only the efficient producers keep producing. but dont the other countries keep producing to the max just to maintain their revenue and support their economies ..they really dont have any other source of revenue. and anytime the price spikes, the marginal barrel of oil in NA comes online capping further upside.

i dont know the answer..but wanted to check what others think of this

KinAlberta · November 23, 2015

Heavily indebted governments around the world will see various global warming pacts and low prices as an opportunity to pile on carbon taxes and use the proceeds for all kinds of other spending. So don't count on great margins for oil in the future. Natural gas as a lessor of two evils, might be another thing.

bmichaud · November 23, 2015

(Al - I'm not refuting your post with the following; I am just using your thoughts as a baseline.)

Regarding the threat of renewables - XOM has global oil demand growing .8% pa from 2010-2040, including the effect of renewables. .8% on say 94 million BBLs is 752 thousand BBLs of growth per year for 30 years. Obviously that is higher now than it will be in the out-years...but regardless, oil demand continues to grow for decades...

With decline rates, and the ever-rising cost of marginal extraction, is it possible for the global oil industry to sustain the required investment to meet this demand growth at $50 oil? Some gross math...

As stated previously, let's say current demand is running at 94 million BPD. At a .8% CAGR for the next 25 years, projected 2040 oil demand is 114.72 million BPD.

SLB and CLB have said that global spare capacity is somewhere around 2% - let's bump that up to 5%, and say current marketable supply is 102.11 (97/.95)...

Say the global decline rate is 3% pa; 2040 baseline production is then 47.68 million BPD, which means the industry needs to bring 67.04 million BPD of *new* production online by 2040.

XOM's production/proved reserves is approximately 6%. Using 6% and the current global marketable supply of 102.11, the global PR base is 621 billion BBLs. Let's be conservative and say by 2040 production/PR only needs to be 10%. The required 2040 PR base would then be 419 billion.

Using the average of today's marketable supply of 102.11 and projected 2040 demand of 114.72, the Globe will consume 989 billion BBLs in the next 25 years, which means the global O&G industry needs to add 786.85 billion to its existing PR base.

If global F&D is $20/bbl, that's $15.74 trillion of capex required to meet global demand growth and base declines; or $629 billion per annum.

Global E&P spending reached over $700 billion in 2014...assuming over $80 oil. (See: http://www.worldoil.com/magazine/2014/february-2014/special-focus/ep-spending-to-top-700-billion-globally-in-2014).

...

1. Is the cost of adding 787 billion reserves going to remain at $20 in real terms?

2a. Are we shifting to a world where the low-cost producers can fund the bulk of this 787 billion requirement?

2b. Could OPEC fund this investment at $30 oil thru 2040?

2c. Can NAM fund this investment at even $70 oil?

...

Assuming the demand outlook outlined above is somewhat reasonable, the industry simply does not function at these levels...and arguably barely does at $70 over the long-term.

http://www.wsj.com/articles/low-crude-prices-catch-up-with-the-u-s-oil-patch-1448066561?alg=y

...

I happen to believe the short-term outlook is quite attractive due to the sentiment/positioning rubber band being overly stretched to the negative side of the boat...but the long-term outlook for the actual price of oil, IMO, is a no brainer.

Of course one must be extremely careful on the individual company side - both with debt and equity - but I agree with Al...if you can deal with the volatility, buying survivors and thrivers is a lay-up here.

orthopa · November 23, 2015

I bought two of the majors BP and CVX when they got wacked real hard in august. Currently getting at 8% yield on BP and almost 5% on CVX. I know most don't covet div paying stocks but Ill take it when buying at lower prices when the rubber band is stretched too far this way. If oil goes up Ill get 5-8% and some upside though not as much if I went all in on a single stock. I have taken a very small flyer on PWE which has done well but I dont have enough conviction/knowledge to make it a huge portion of my portfolio.

In regards to current prices they could easily shoot up back to 90-100 dollars a barrel with the Saudis cutting production. Eventually it will come down to them either wanting higher prices to fund their societies or to keep market share. The problem is NA production is sitting waiting to get going again.

FWIW we may be closer to a bottom in oil with the muted reaction to the saudis comments today. In the past comments about cooperating would have sent oil through the roof but it barely budged today. Have speculators thrown in the towel?

Aberhound · November 24, 2015

I don't see how anyone can predict oil prices. Oil prices face downwards pressure as the paradigm changes and the owners of the oil compete to convert their wasting assets into cash.

The trouble the powers that be face is that too many people realize the mainstream science is intentionally false and misleading. For example, a poet in this video demolishes the solar fusion theory in favour of the plasma sun theory. The main argument is that only a plasma sun emits a spectrum in all colors (ie white) and explains the mercury, a heavy element, being present in the solar wind. The biggest obstacle to the advancement of science over the last hundred years has been the wrong belief by individuals that they already know the answer. They don't as what they were taught in school was only an approximation sufficient for the technology of the time. Their own minds thereby create their own prison. Few can admit "I was wrong".

In a world multi-lateral world competition renders more difficult the continued suppression of science. The Anglo-American-Israeli alliance and the powers behind them no doubt wishes to succeed with their long term plans yet to do so requires technological advance to ensure continued dominance. Consequently advances are being allowed in many sectors due to competition from China, Russia and others.

There is no shortage of oil. The shortage has been cheap oil but that is changing. Cheap heat means cheap oil. Cheap electricity means cheap oil. Both cheap heat and cheap energy also mean greater substitution as does better batteries. Oil is also a wasting asset once you realize energy is available from the wheelwork of nature. Prices will spike again only if it becomes necessary to temporarily advance other plans.

How fast will the change occur? Probably rapidly as science is allowed to advance most rapidly when governments are preparing for war. The war drums are beating. I suspect there are already numerous firms and governments secretly using advanced technology. We will see this as deflation. This will only increase as the cost of advanced warfare has plummeted making private armies increasingly possible. It will be tempting for private companies to respond to perceived traitorous conduct by governments and competitors with force. Science fiction long predicted private armies. All attempts to use tyranny to control populations have failed so the increasing use of tyranny will cause more private armies to form. Already it is not clear who runs governments particularly where there is a lack of rule of law. Lack of rule law forces companies to either submit to aggression or to respond to breaches of their natural law rights with force as is their natural law right to do. In the past the trend leading to the formation of private companies was retarded by a wonderful illusion of progress and liberty. Now effective narrative is used to control people based on fear. This won't work long because people get angry when they realize they have been fooled. Imagine millions of women who get angry when they realize they have been poisoning their own children. When women feel guilty they will act, most likely by insisting that their men fight back. Millions of scorned women does not create stability. If the powers that be wish to continue their rule they will have to come up with another wonderful illusion. I suspect that new wonderful illusion is the reason for new age half truths together with new technologies. The NWO is likely a straw man put forward solely so that it can be defeated to create this new wonderful illusion. Otherwise you will have another so called thousand year Reich which lasts only a brief time. When the Babylonian money changers who backed Rome realized they could not control the barbarians they switched the paradigm by introducing

Christianity and the Vatican to rule from behind the scenes with another wonderful illusion created by the religion. I expect a new belief system will be introduced when chaos abounds. The new wonderful illusion is necessary to create a new stable paradigm. I don't think oil will be part of that new wonderful illusion.

Palantir · November 24, 2015

Not if that US or canadian producer has a ton of debt obligations he/she needs to meet!

Crip1 · November 24, 2015

The hypothetical US or Canadian producer with a ton of debt has a finite amount of time in which they can produce at a loss, as does Russia, SA, etc. But, the US/CDN producer has a much greater finite amount of time.

-Crip

JayGatsby · November 24, 2015

I don't think Russia and SA are producing at a loss (nor are parts of the US). They're not producing at a level that makes the budget balance, but the wells themselves are profitable I believe. I thought the all-in cost in SA is ~$10 or less because they basically just stick a straw in the ground.

My problem has been many of these companies are very levered at current prices, similar to what theAIGuy said. It's difficult to find an equity situation that doesn't entail balance sheet risk and I can't buy most of the debt as a non-institution. This is interesting: http://www.businessinsider.com/avenue-capital-ceo-marc-lasry-is-bullish-on-energy-debt-2015-11?r=UK&IR=T

Palantir · November 24, 2015

Not necessarily, the US/CDN producer has creditors who can declare it in violation of debt covenants anytime. Russia has gunz.

philly value · November 24, 2015

I think it depends on what you are looking for. If you are looking to make a macro bet on oil or gas prices, that is easy to do and there is clearly an "opportunity" where prices are currently very volatile. In terms of betting on producers, I'm not sure there is an opportunity and fairly sure that there isn't an attractive opportunity for the small individual investor.

For the small individual investor who is mostly stuck investing in equities, you face the issue that you are not betting on the long-term success of the producer, you are betting on the very near-term success of the commodity price environment essentially. You are really buying a short-term highly levered option, not an equity interest in a business. When you see debt tranches trading on a recovery basis and no longer on a yield basis then you know the equity is not trading on a long-term business valuation basis anymore.

Even if you can buy the debt and normally be in a position to own the company, many of the smaller producers at least (let's say up to several billion in TEV before the crash for sure, but even larger ones) are in a position where, in Chapter 11 bankruptcy, they are finding it difficult or impossible to reorganize because there is not a real business to organize around at current prices. At $40 oil and $2 gas, few of these guys can produce positive unlevered free cash flow with a sensible drilling program. If you can't even produce FCF on an unlevered basis, there is no room for debt capacity, at which point you have everyone in the capital structure forced to take equity in a reorganized, zero earnings company. It's not an attractive proposition. What has happened in a few cases and seems likely to happen is that the Chapter 11 process turns into a liquidation and the assets are sold to someone who can sit on the assets or absorb them into a bigger organization. And if that happens, even if you held the debt you are going to be closing your position via an asset sale in the current depressed pricing environment - you don't get a piece of the business in order to make money if pricing and the business recover.

So effectively my view is that if you are taking a macro view on prices, express that view directly and bet on prices. I think trying to bet on producers is little more than a levered short-term play on prices at this point, in most cases.

Packer16 · November 24, 2015

How many of the skeptics actually looked at the details of some of these producers and seen what types of profit they make at current prices? Attached is spreadsheet to give some color on what it looks like for some Canadian E&P companies with current netback, efficiencies and decline rates. I agree there are many that have negative IRRs at todays prices but there are a few that have positive IRRs and nice leverage if the price returns to $55. In addition to the names here, if you put in the parameters for ARC Resources (ARX), they have positive IRRs.

Packer

Incremental_Return.xlsx

Uccmal · November 24, 2015

The Russians and Saudis have no incentive to cut costs. Their economies and social programs and bureaucracies are incentivized for the opposite. If they cut costs people lose jobs, and there are no alternatives. Can/Us have much more elastic economies.

Lenders are never in a hurry to take on the expensive dog's breakfast of CCAA or Chapter 11, if there is any chance they will get repaid at some point. We have seen lending agreements modified over and over in the Canadian west over the past year.

The survivors in NA will come out of the low price environment in very good shape. If the price remains steady they will continue to cut costs as needed. Eventually the other countries will be forced to capitulate. This didn't work out according to plan.

TheAiGuy · November 24, 2015

So I really see two sets of opportunities:

1) I going to guess that a lot of Oil, Gas and Coal are going to go bankrupt. You could pick winners, those who will survive and do okay in this environment and will do phenomenally if prices rise. You can pick bad firms that aren't going to go bankrupt and buy the debt. You could also buy the debt of bad firms that will go bankrupt but have good non-cash assets.

I don't have enough money to do this. I also don't have the background. Implicit in this strategy is that people won't start drilling again if/when prices go up. Alternatively,

2) A lot of industrials have gotten killed over their exposure to this market. Many of these are otherwise good business that had abnormally returns linked to high oil prices. Some of them, in their other lines of business, also have completely unrelated problems related to currency and transitions in their otherwise healthy businesses (*cough* rolls royce *cough*). Many of these industrials will see their earnings go up if prices rise and people start drilling again (which would be bad for opportunity set 1) but they aren't as leveraged, both to oil prices and financially.

rohitc99 · November 24, 2015

+1

this is close what i have been thinking. The saudis/ Russians are not rational economic actors in this ..for them it is about revenue and keeping their spending afloat. if we apply game theory it makes a lot of sense

lets say, OPEC reduces production to prop up price, price goes up, NA and Canadian producers with marginal cost increase production and the price goes down. So the OPEC and other countries lose market share without gaining anything

OPEC increases production, price drops ..everyone suffers equally.

this almost looks like the prisoners dillemma - atleast in the short run. In the long run, it all comes down to whether oil demand keeps growing, or solar/ alternates caps that. on that count, it is even more confusing (for me)

argonaut · November 24, 2015

Thank for sharing your xls, Packer. I have this rough calculation for BXE...does this seem roughly on track with your thinking?

11/5/2015

Low netback/boe/d 12.58

High netback/boe/d 15

# days/year 364

Company's Boe/d 40277

Net debt 723,000,000.00

Fully diluted share count 205,800,000.00

Low valuation multiple 8

High valuation multiple 10

Canadian/usd exchange rate 0.75

Valuation: low netback/low multiple usd 2.75

Valuation: high netback/high multiple usd 5.39

rkbabang · November 24, 2015

I'm on the same page as well, the US becoming a major oil producer has really thrown a wrench into the works from the point of view of Russia and the Middle East. My only worry is the instability of some of these countries that depend on oil money. What will Putin do? I'm afraid ... no ... terrified, that we might be about to find out. He certainly has been handed the excuses he needs to start becoming even more militarily aggressive. And with a NATO country directly involved it is a dangerous situation.

Cardboard · November 26, 2015

"lets say, OPEC reduces production to prop up price, price goes up, NA and Canadian producers with marginal cost increase production and the price goes down. So the OPEC and other countries lose market share without gaining anything"

I think that this whole line of thinking is wrong because people think $40 OR $100 oil.

If Saudis were to cut 500,000 barrels a day tomorrow or OPEC together, oil would not pop to $100 because Iran is still likely on the horizon and other supply/demand factors. However, it would likely go between $50 and $60. Under that scenario, you would still see a mid to long term reduction in NA oil production since there are not enough well locations profitable at these prices (all inclusive cost) to offset declines. Moreover, new oil sand projects would not be funded as well as offshore activity. The appetite by bankers and investors to invest in oil projects barely profitable at $50 or $60 would be very muted. The same would likely apply in the North Sea, Mexico and everywhere else except in the Middle East and Russia (that is also a question mark based on their infill drilling and lack of investment).

So depending on how they manage this, OPEC should end up with more market share and more dollars in their pockets. Also, if the oil price does not skyrocket, renewables growth will continue slowing and global demand should keep increasing with a larger population and higher wages.

Cardboard

Cardboard · November 26, 2015

http://www.bloomberg.com/news/articles/2015-11-26/surging-fuel-consumption-shows-india-s-economy-picking-up-speed

sculpin · November 26, 2015

Gutsy move by this fund manager.....

"I refuse to let other people do our thinking for us. Also, the decline curve never sleeps."

Investor Letter on Oil

The Contrarian’s Burden

Posted on November 26, 2015 by Cale Smith

https://www.islainvest.com/2015/11/26/the-contrarians-burden/

It’s exclusively on the oil market and the Tarpon Folio.

The Short Version of The Entire Letter

The popular consensus is that the oil market is grossly oversupplied, due to Saudi Arabia’s determination to retain market share at the expense of U.S. “tight oil” producers – a relatively new breed of oil companies drilling in shale, sandstone, and carbonate rock. In this consensus view, the market will remain oversupplied until significant amounts of current production are reduced – a potentially long, painful process.

My view is different. I believe there are fundamental industry trends being ignored that, unless oil prices rise fairly soon, mean the oil market is at risk of sleepwalking into a supply shortage in 2016. In the meantime, the price of oil is unsustainably low and should self-correct fairly soon.

This collapse in oil prices has created egregious mispricings in securities across the capital structures of numerous energy companies. The common stock prices of U.S. exploration and production companies in particular appear the most untethered from conservative appraisals of true value. A number of these firms represent exploitable, once-in-a-decade opportunities for patient investors to compound capital at high rates of return with significantly less risk than extreme levels of volatility might otherwise imply.

I believe a significant and sustained rise in oil prices is inevitable much sooner than consensus. Massive cutbacks to drilling programs plus natural decline rates across the world’s oilfields may render the industry temporarily unable to increase production enough to control the pace of an increase in oil prices as demand begins to exceed supply.

Oh, and also:

Is it just me, or does the Middle East right now look like a Tom Clancy novel that ends in massive sectarian war?

Because, um, nobody has told the oil market.

The shares of the companies we now own in Tarpon have been extremely volatile. But that same volatility appears to have driven out the vast majority of institutional investors, who because of clients far less patient than you all, are doing their best to avoid the sector entirely. This has temporarily left us with a large, exploitable advantage over some of the biggest investors in the world.

I believe the odds we have on our side right now are the most favorable we have seen in any area of the stock market since late 2008. As a result, Tarpon is now entirely focused on this opportunity. I have deliberately chosen to concentrate our efforts and capital here. We are, effectively, all-in on U.S. energy companies, and this is somewhat of an unexpected and dramatic shift in our holdings.

I’m hoping the rest of this letter will help explain why.

bmichaud · November 27, 2015

If I use the 5.8% decline rate Cale Smith discusses in the letter posted, the above results may look a touch different :)

thefatbaboon · November 27, 2015

Which companies does cale smith own?

ScottHall · November 27, 2015

Well, good luck on his call but doing this with 100% of a portfolio is probably insane even if he turns out to be right. It's one thing if it's your own money, but managing on behalf of others is a different story. At least he's upfront about it so people who are uncomfortable can get out if they want.

What is the extent of the 'opportunity' in the oil market?

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