A Miracle Pill? The Case For Lower For Longer Oil

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Includes: USO, XLE
by: Chris Wallendal CFA

Summary

January brought enormous market volatility that was more tightly correlated to oil price swings than normal - and not inversely, despite the many benefits of cheap energy.

US dollar strength can add to dropping oil prices and headwinds for multinationals, but the volatility also appeared in domestic sales companies, importers, and energy users such as the airlines.

I use a make-believe analogy of an extreme disruption to another large sector of our economy - healthcare - to emphasize the shift that lower oil prices are causing.

Oil prices have experienced a "parallel shift" lower, driven by technology, which will ultimately benefit our economy, but not until some necessary, but painful adjustments are made.

Market Volatility Surged In January

The following chart highlights some of the notable market movements that started off 2016. Volatility, as measured by the CBOE S&P 500 Volatility Index (^VIX) ended up almost 11% after being as high as 50% from the beginning of the year. One of the often cited reasons for this and January's 5.1% decline in the S&P 500 stocks is the decline in United States Oil (NYSEARCA:USO) prices. West Texas Intermediate, the benchmark for U.S. prices, declined 15.6% in the month.

The lower portion of the chart also shows that the trend was for increasing correlation between the overall market as measured by the S&P 500 and the oil patch stocks as measured by the Energy Select Sector SPDR ETF (NYSEARCA:XLE):

VIX Chart

This correlation is counter-intuitive to many observers and represents a change from previous market behavior. It is counter-intuitive because lower energy costs should be a boon to our consumer led economy. Economists and market participants often talk about how lower gasoline and energy prices are a "tax cut for the American consumer". Taking a longer term view of the correlation shows that indeed, the correlation is often negative; i.e., the overall market goes up when oil stocks are lower and vice-versa:

Fundamental Chart Chart

Another way to emphasize this unusual behavior is by comparing the drop in oil and energy stock prices to the AMEX Airline index. Rather than trading inversely as they usually do, the airline stocks dropped by a greater amount than the XLE despite a sharp 16.5% decline in crude:

USO Chart

There are of course fundamental reasons why the airlines have underperformed recently despite the tailwind of lower energy prices, but it just illustrates the point that the stocks and sectors do not always move in predictable ways.

The Miracle Pill

Inigo Montoya: That's a miracle pill?

Valerie: The chocolate coating makes it go down easier. But you have to wait fifteen minutes for full potency. And you shouldn't go in swimming after, for at least, what?

- from The Princess Bride (Act III Communications)

Imagine a top-secret research effort by a previously unheard of biotech company develops and fast tracks a new miracle drug. In clinical trials, it rapidly and completely literally cures "whatever ails ya" with absolutely no side effects. Satisfied that they will have all the revenues they could ever dream of, the company prices it competitively with over-the-counter aspirin.

Obviously, this is a fantasy. But if this great boon to mankind were to occur, would it be great economic news? "Of course!", the economists would cry - the total cost of healthcare is more than 17% of the U.S. economy. And that doesn't even consider the effects of increased productivity. News such as the spread of the Zika virus would barely cause a ripple.

But on the other hand, healthcare is more than 17% of the economy. Think of all the suddenly out-of-work drug company, insurance company, hospital company, PBM, pharmacy, doctors, nurses, etc. and the knock on effects to banks which had exposure to this heretofore defensive sector, to the restaurants, hotels, and other services in biotech cluster areas.

So there you have it - a long run benefit of making the world healthier and more productive, if it happened too quickly, would create unimaginable economic disruption as the economy tried to redeploy over 17% of its base, retrain millions of highly skilled workers, and find alternate uses for MRI machines. The likely near term result would be a severe recession or even a great depression.

The Miracle Shale

Now, imagine a not so secret effort by the oil exploration & production services industry to develop new techniques to lower the cost of tight oil production, increase proven oil reserves, and create a "Supply shock from North American oil rippling through global markets" according to the International Energy Agency's Medium-Term Oil Market Report of 14 May 2013.

This increased supply should not have been a "shock". Carl T. Montgomery and Michael B. Smith wrote an article published by JPT Online in December 2010 which details the history of hydraulic fracturing and how the technology which enables recovery from low permeability shale and sandstone has its roots in the 1860's when nitroglycerin shots were used to break up formations. This was followed in the 1930's by injecting acid to create fractures. Then in the 1940's Floyd Farris and J.B. Clark of Stanolind Oil and Gas Corporation developed and publicized the "Hydrafrac" process, obtaining a patent in 1949. "In the first year, 332 wells were treated, with an average production increase of 75%." The article goes on to describe the technological improvements that were made to the process over time. The authors conclude with:

"As the global balance of supply and demand forces the hydrocarbon industry toward more unconventional resources including US shales such as the Barnett, Haynesville, Bossier, and Marcellus gas plays, hydraulic fracturing will continue to play a substantive role in unlocking otherwise unobtainable reserves."

I would add to this the parallel development of horizontal drilling technology as another powerful change in the E&P space.

The Parallel Shift Lower

It's been almost three years since the above referenced IEA outlook. However, as the next chart shows, the "supply shock" did not significantly effect prices until nearly 18 months later when the commodity fell off a cliff:USO Chart

What changed is the Saudi Arabian response to keep pumping in the face of both increased tight oil production and the pending return to market of Iranian supplies. Other major producers also maintained output levels as they attempted to maximize revenues to fund fiscal budgets (in the case of sovereign countries) or to service debt and maintain dividends (in the case of companies).

When oil prices first began this decline, many experienced energy investors and analysts began predicting when the recovery would begin. Prices of commodities are often self-correcting at either end of the spectrum. Energy is no different as low prices stimulate demand (e.g., more SUVs and trucks) and slow adoption of non-fossil fuel alternatives. What we are now experiencing is the downside of the other end of the spectrum - higher prices in the past stimulated supply. Margins were high enough to expand the amount of proven, recoverable reserves and the above detailed technology improvements lowered the production costs, creating the boom in supply. The availability of cheap debt financing, a necessary ingredient in any bubble, further pulled supply growth forward.

Conclusion

Lower oil prices are going to be "sticky" here, even with some rebound as lower investment and drilling will eventually lead to lower output. Other commodities are less politically driven and normally have a long run price associated with their marginal cost of production. Oil is a different animal with prices that are further exacerbated on the upside and downside by geopolitics and financial institutions, both sovereign and "private". But given the fact of new technologies that shift the cost curve down for the marginal producer, don't expect a return to the same normalized prices - even with geopolitical flare ups - as we have seen in the past.

Disclosure: I am/we are long XOM, COP, PSX, ESV, NAT, KMI, CVX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.