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In the last year, I have been reading more and more articles about crude oil.  And as the world very slowly comes out of a severe downturn, and with the Asian economies continuing to expand and grow, oil stocks would seem to be the place where some good money could be made. I normally don't go to commodities due to their very cyclical nature. But given that crude oil stayed in the 70-85 U.S. dollar range thru these tough times of 2008-2010, I am beginning to think that it would be a good idea to overweight oil stocks in my portfolio for the next few years.

 

Have already bought small amounts of Canadian Natural Resources, Daylight Energy, Total, ATP Oil and Gas, Penn West and Petrobank.

 

Would like to know from more knowledgeable investors than me on this site, what are your thoughts?  Are you putting funds to work here? staying away?  What is the counter-argument to where I am leaning?

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A friend of mine, who knows next to nothing about investments (was paying loaded funds, for instance) texted me the other day about buying "crude oil."  Oil is way, way outside my circle of competence. However, since "everyone" knows this is temporary and that oil will be higher a year from now, I wonder how the future really will play out. Personally, I don't know.

 

What if OPEC keeps oil low for more than a year?

 

What if Prem is right and we go through deflation?

 

Bargain, I'd be careful with USO. Look at the price of it vs the actual commodity. I don't quite understand it, but something with contango can affect pricing - so even if you're right, you may not make much.

 

 

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A friend of mine, who knows next to nothing about investments (was paying loaded funds, for instance) texted me the other day about buying "crude oil."  Oil is way, way outside my circle of competence. However, since "everyone" knows this is temporary and that oil will be higher a year from now, I wonder what the future really will play out.

 

+1.  I had the same thing happen to me.

 

He went on and on about how USO was going to be a big money maker for him.  I threw some curveballs in the thesis at him and he says, "I don't care to hold this for the long-term, even if that means six months."

 

This was when USO was at $26.

 

Investors look at declines in commodities and think they behave like stocks and mean revert.  The best commodity traders I know would actually keep shorting into a falling market or buying into a rising market.  You can't really apply the typical value investing philosophy to these kinds of things.

 

It will be interesting to see how this plays out.

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Guest Schwab711

...with the Asian economies continuing to expand and grow...

 

I'm not so sure I agree with this outlook. I know China reports 7%+ growth but I don't believe it and generally think of their GDP as a very aggressive estimate (so real GDP growth around 3%?). Japan and Korea stink and lots of currency devaluation.

 

...I normally don't go to commodities due to their very cyclical nature.

 

Just because they are generally cyclical and prices have dropped doesn't mean the current prices are at a long-term low or that they need to go higher (or conversely, not go lower) in the short-run.

 

But given that crude oil stayed in the 70-85 U.S. dollar range thru these tough times of 2008-2010, I am beginning to think that it would be a good idea to overweight oil stocks in my portfolio for the next few years.

 

Past prices (especially short-run pricing or after such a large event like the credit crisis) for commodities mean nothing with regards to future prices. China was growing at a much faster rate at the time and there were a significant number of relatively large stimulus programs running concurrently throughout the world. I imagine these programs, which pulled-forward future demand manipulated prices significantly. Oil is not that far away from the price at the time of the U.S. stimulus which was the first to be enacted throughout the world [started the trend].

 

Oil is tough in my opinion because even if supply and demand are the dominate forces in the long-run, in the short-run it is an important enough resource globally that politics, and even war, may intervene at any time and has a higher probability of occurring when prices have recently been volatile. It's hard to determine whether countries want higher or lower prices in the short-run depending on if they need additional purchasing power immediately or not (whether a country wants to help itself or hurt others). Global politics becomes quite complicated to figure out and you will never have all the information you want [or even what you need]. This becomes speculating and not rational investing for myself. You may be more skilled or experienced in this arena and speculative returns certainly spend the same as any other earned interest, I'm not picky.

 

Disclaimer is I have no special knowledge on commodity investing or oil and I'm just trying to present a bear case in investing in oil stocks. I have no ability to do technical analysis or predict prices either. I know PV calculations of reserves can be manipulated (even though I wouldn't think it is very common or often-abused) so good management is a necessity. Capital allocation history would seem like it would be very important. More mature companies will likely withstand any negative prices better since there is a substantial bi-forcation between well exploration/initial well development/mature producing wells.

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If I could add one thing to Schwab711's excellent reply. 

 

It is the attached chart.  US crude oil production just topped Feb 1986 levels.  Things have radically changed in terms of US oil production since 2008-2010.  New technology has revolutionized the industry and until this trend breaks, get out of the way of the supply bus.  I discussed this chart on my blog over a year ago.  I would venture to say that we are in the top of the first inning of the shale oil revolution.  What will happen as this technology is exported all over the world?

 

The way this is playing out is nearly the same as the shale gas revolution that begun 5 years prior to the oil supply shift in the US.  It took more than a year for almost everyone, myself included, to eventually throw in the towel, walk away, and admit we were wrong.  Now look at NG, new 52 week low last week.  The current NG price is well below the marginal cost in Alberta, and it has been there for years.

US_oil_production_dec.jpg.55a7cbc194da8a96a44b86b7c8a3a629.jpg

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If I could add one thing to Schwab711's excellent reply. 

 

It is the attached chart.  US crude oil production just topped Feb 1986 levels.  Things have radically changed in terms of US oil production since 2008-2010.  New technology has revolutionized the industry and until this trend breaks, get out of the way of the supply bus.  I discussed this chart on my blog over a year ago.  I would venture to say that we are in the top of the first inning of the shale oil revolution.  What will happen as this technology is exported all over the world?

 

The way this is playing out is nearly the same as the shale gas revolution that begun 5 years prior to the oil supply shift in the US.  It took more than a year for almost everyone, myself included, to eventually throw in the towel, walk away, and admit we were wrong.  Now look at NG, new 52 week low last week.  The current NG price is well below the marginal cost in Alberta, and it has been there for years.

 

Those who are venturing into oil producers have far bigger cajones than I do, or they are simply not aware of some of the ex-US development of shale.  For instance, Argentina has one of the largest shale deposits in the World (vaca muerte); they are just beginning to develop this shale which should result in substantial amounts of new oil and gas production in South America.  Mexico is opening up their oil industry to foreign companies.  This should result in increased production from existing fields, as well as new oil and gas production.  China has the largest shale reserves in the world, and they are also beginning to develop those (although I think their severe water issues will slow this development initially). 

 

Those who are betting on a snap-back in crude pricing are not taking into account all of the new reserves that are now technically and economically feasible around the world.  While I don't think we are going to see a substantial drop from current crude oil pricing, I simply don't see the price of crude oil bouncing back.  I think we are entering a period of pricing that is similar to natural gas pricing.  As price recovers, marginal shale producers open up the spigot and flood the market, thus depressing prices.     

 

If you are determined to play the energy space, I would stick with companies that benefit on the demand side from low prices and/or increased use of hydrocarbons.  I have a sizable investment in pipelines because I think that lower prices will stimulate a higher demand for natural gas and crude oil, thus creating the need to move more product through these pipelines.   

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A friend of mine, who knows next to nothing about investments (was paying loaded funds, for instance) texted me the other day about buying "crude oil."  Oil is way, way outside my circle of competence. However, since "everyone" knows this is temporary and that oil will be higher a year from now, I wonder how the future really will play out. Personally, I don't know.

 

What if OPEC keeps oil low for more than a year?

 

What if Prem is right and we go through deflation?

 

Bargain, I'd be careful with USO. Look at the price of it vs the actual commodity. I don't quite understand it, but something with contango can affect pricing - so even if you're right, you may not make much.

 

 

Point well taken, stahleyp.

 

I've just had pretty good luck with temporary "snap back" trades with ITM options in the past and USO is certainly looking interesting here. I'd only commit 1% of my portfolio for the trade at most since (outside of a global recession) I can't imagine oil trending this way and this fast quarter after quarter.

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The way this is playing out is nearly the same as the shale gas revolution that begun 5 years prior to the oil supply shift in the US.  It took more than a year for almost everyone, myself included, to eventually throw in the towel, walk away, and admit we were wrong.  Now look at NG, new 52 week low last week.  The current NG price is well below the marginal cost in Alberta, and it has been there for years.

 

Kevin, I think your caution is reasonable but I'm sure you know oil pricing behaves different from natural gas:

- Oil is a global commodity (easy to export), NG is local. So increased US production will have a larger relative impact on NG pricing.

- NG is often a byproduct of oil or liquids production. So normal laws of supply and demand break down.

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Those who are venturing into oil producers have far bigger cajones than I do, or they are simply not aware of some of the ex-US development of shale.  For instance, Argentina has one of the largest shale deposits in the World (vaca muerte); they are just beginning to develop this shale which should result in substantial amounts of new oil and gas production in South America.  Mexico is opening up their oil industry to foreign companies.  This should result in increased production from existing fields, as well as new oil and gas production.  China has the largest shale reserves in the world, and they are also beginning to develop those (although I think their severe water issues will slow this development initially). 

 

Those who are betting on a snap-back in crude pricing are not taking into account all of the new reserves that are now technically and economically feasible around the world.  While I don't think we are going to see a substantial drop from current crude oil pricing, I simply don't see the price of crude oil bouncing back.  I think we are entering a period of pricing that is similar to natural gas pricing.  As price recovers, marginal shale producers open up the spigot and flood the market, thus depressing prices.     

 

To this point, aren't these new tight oil discoveries also subject to similar marginal costs as the ones in the US? Where oil is right now, it's pretty much trading near Ghawar's $40 estimated marginal cost....

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Gary Shilling thinks $10 could be the worldwide marginal cost of production:

http://www.bloombergview.com/articles/2015-02-16/oil-prices-likely-to-fall-as-supplies-rise-demand-falls

 

As I said in in other threads as well: I'd think  carefully about controlling my value investing reflexes here and control the risks. This could be a very long price slump – and then what? LEAPs are the only way I'd even consider to invest into the oil sector right now. But actually I bought puts back in December because I think they have the better risk/reward ratio. This could be a real value trap that catches many of the investors who've been so successful in buying the dip in recent years. Buffett was absolutely right to exit this awful risk/reward investment.

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I don't see how $10/bbl is anywhere close to reality. Shale, oil sands, and offshore costs are way over 10.  So for marginal barrel to be $10 you must assume that the world is oversupplied by at least 20 million barrels a day.

 

rb

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I don't see how $10/bbl is anywhere close to reality. Shale, oil sands, and offshore costs are way over 10.  So for marginal barrel to be $10 you must assume that the world is oversupplied by at least 20 million barrels a day.

 

rb

 

I think people are a bit too fixated at the supply side because that's what's immediately relevant to the U.S. right now. But look at the way demand for most hard commodities is developing – China has been stock piling them basically since 2009 and the market is telling you that they couldn't keep it up any longer. This is at least as much a demand as a supply story. In my opinion the demand side is even far more important. Oil is hit especially hard because all the increases in supply came at just the wrong time. But that's really more of a distraction.

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I think people are a bit too fixated at the supply side because that's what's immediately relevant to the U.S. right now. But look at the way demand for most hard commodities is developing – China has been stock piling them basically since 2009 and the market is telling you that they couldn't keep it up any longer. This is at least as much a demand as a supply story. In my opinion the demand side is even far more important. Oil is hit especially hard because all the increases in supply came at just the wrong time. But that's really more of a distraction.

 

I'm a bit confused by your post. Maybe I don't really understand it.

 

Are you saying that China has been hoarding oil? I don't think that they have the capacity to store meaningful amounts of it - say one year consumption. But let's assume they do. That means that the gap between supply and demand is even bigger because China had artificially high demand because of hoarding.

 

If you're saying that the outlook for oil demand is positive because the Chinese are gonna consume more and more of it - that's possible. But price is established by both supply and demand. So China is going to consume more. Ok, how much is it going to cost to meet that demand? There seems to be plenty of shale and at $80 it was drill baby drill! So obviously at $80 they're making money so equilibrium price is probably somewhere lower. Btw, I don't think it's $50, so somewhere in between. It could be a while until we figure it out.

 

rb

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What I tried to say is that China has been stock piling hard commodities (like copper or iron ore) for years and that this was not sustainable. They used it to fuel their synthetic domestic investment boom. It doesn't matter that they don't have storage capacity for oil because they have long term oil and gas agreements with Russia – so Russia is basically storing for them. Now, the Chinese investment spree is over because they aren't able to keep it up and, at the same time, the rest of the world's demand for China's products and/or for commodities hasn't picked up either but rather been slowly declining.

 

Can you imagine what it means when the country that consumes 45% of most important industrial commodities (like copper), which used them for years partly to fuel an unsustainable investment boom and partly to stockpile them, now begins to end this game? It took the world years to ramp up all this commodity production capacity and because of the economics of mining/drilling it will take the world years to reduce them back to where real demand is. Also think about that producing and transporting those hard commodities is very energy intensive. It is highly likely in my opinion that what we are witnessing is only the beginning of a massive, secular decline in commodity consumption (except for food) and therefore prices (because of the lag involved in reducing production capacities). I think this decline will go on for years and most people seem to completely underestimate it.

 

Add to this the energy production boom in the US and you can imagine why Prince Al-Waleed says we will "never" see $100 oil again (though this might be a bit too pessimistic).

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Here is an interesting discussion between Wilbur Ross and Gary Shilling about the further development of the oil price and how producers are going to react:

 

http://www.bloomberg.com/news/videos/2015-02-18/opec-playing-game-of-chicken-with-oil-shilling-says

 

Interesting what Ross is pointing out towards the end: at the big oil companies cashflow doesn't cover capex plus dividends.

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Russia does not store oil for China! They have oil in the ground or available as produced...

 

The only way that oil can go to $10 is once storage in the U.S. is completely full and that people accept anything for it since they have nowhere to put it. In reality, it will be a very short term phenomenon, if it occurs: Shutdowns will occur, pressure will build on U.S. to export (they already started by going around the law) and rail cars will head to the Canadian East and West coast to ship it out. There is also 36 million barrels of spare capacity in the Strategic Petroleum Reserve which they would be crazy not to fill up if prices head that low.

 

Demand for oil has been going up for years if not decades at a very steady pace. It tracks very closely population growth. And it makes sense since more people means more cars, more need to transport goods, more plastic, more rubber, more fertilizers, more heating demand.

 

EOG or the largest U.S. shale producer announced no volume growth this year. This goes completely against the mentality that all of a sudden shale production cost nothing and can expand add infinitum without new drilling. And this is one of the best managed operator in the shale. Many marginal players are forecasting declines in production. Once bank reviews occur in April/May, expect even more capex reductions from various players which will lead to production declines.

 

Cardboard

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Shilling didn't say that $10 will be the equilibrium price but that that's how far prices could go temporarily. I think this is possible but I don't know how probable it is.

 

I didn't mean to say that Russia literally stores it for them. But Russia and China have huge oil and gas deals with fixed volume and pricing. Does it really matter in the end, whether the oil and gas is first transported to China and then stored there or whether it stays in the ground in Russia and is only transported when China actually consumes it? Russia is the marginal producer of oil and China the largest marginal consumer. When those countries agree on a lower price – like they did twice last year – this will be the new world price for oil – everything else will be temporarily.

 

US supply has been completely dependent on demand from China meaning that China's genera demand for oil drove the price so far up that shale oil became viable in the first place. Now, China's demand softens and it's completely logical that the oil price drops. But if you think about that mechanism it's also logical that the price will remain low for quite some time if this is indeed the case.

 

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I agree with ni-co that China distorted the commodity markets for the past decade with huge real estate and infrastructure build. But oil is a bit of a different beast since it's more of a flow rather than a stock. You can increase demand for iron ore to make steel to build a building that will last for 50 years and don't need that ore again.

 

But oil is 2/3 used for transportation and 1/3 for chemicals. So to say demand for oil will go down you have to make the case for ok, someone will not drive that car tomorrow or someone will not go on a trip next year, or efficiency of the combustion engine will increase like crazy. The way I see things is that demand will continue to grow but at lower rates than in the past.

 

So to get an equilibrium price of oil you need to figure out the demand and then figure out how much it will cost to fill out the last barrel of that demand. There's very good figures at the US Department of Energy for demand. Supply figures are more muddled because oil producers aren't that eager to publish their true costs. Btw, Russia is quite expensive, as their existing fields are depleting and new field will be pretty expensive. I also don't think that Russia is in the business of doing China any favours. So who's the swing producer? I don't have any data, but I think it's US shale. So immediate minimum price for equilibrium is OpEx for US shale. Medium term is replacement cost for US shale.

 

Longer term if consumption goes up is Alberta oil sands and Orinoco Valley oil sands. These are very expensive.

 

Let me state that I am quite bearish on the long term (50 years) prospects for oil. Conventional field production is still going down (peak oil and all). Shale can bridge the gap for a while but then you need to go to oil sands. This oil is very expensive to get out of the ground and the cost will only go up. There's also a price cap on oil dictated by the spread of electric car vs combustion car and oil vs electricity.

 

However in the short to medium turn prospects may be quite bleak for oil. This being an investment board and I'm in the business of deploying capital to make more, I ask myself what to do? The stock prices of oil companies have stood up very well to the point where they're really expensive now. I don't see the blood. There's probably much better value in the suppliers to the oil industry, something like NOV and Vallourec - whose stock prices took much more of a beating.

 

rb

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Pickens made some comments on oil.

 

I think most of the article is important:

http://www.gurufocus.com/news/317644/t-boone-pickens-predicts-oil-rebound-buys-12-energy-stocks

 

The key take away:

“I said on Dec. 23 (2014), give me 12 to 18 months, and we’ll be back to $80 or $90 a barrel. I still believe I’m right on that.” - pickiens

 

I personally think call options are a good strategy right now.

 

 

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