A Case for Retreating From Oil Investments 9 comments
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I understand that oil’s 20+% retracement from its high is not unprecedented; such a pullback often occurs in a bull market. I also know that currently available values in oil and gas stocks seem excellent and that pullbacks in bull markets are the right time to accumulate bargains.
Nonetheless, instead of buying I’ve been increasingly liquidating oil and oil service stocks. I’ve sold my options on oil futures. I’ve increased the EIS portfolio’s cash position for one reason. This pullback may be over quickly but if it isn’t we could be entering a very unusual period of global contraction that would imply significant additional downside risk, particularly for oil related stocks. That could occur due to the emergence of a combination of some of the following possible new trends:
- a major contraction in China’s growth rate
- a period of maximum new oil and gas production over the next two or three years
- oil exporting countries experiencing a vicious cycle of lower oil prices causing less funding available to finance their growth; slower growth resulting in more oil available for export; contributing to lower oil prices, etc.
China
Analysts are conflicted about what the likely direction will be for post-Olympic Chinese oil use. Here is a good discussion of the arguments for greater and lesser oil use.
One important factor, however, is that lesser oil use is likely the favored direction of the Chinese government for several reasons. First, the Chinese economy can grow more easily in a low-price oil world, which would be fostered by lower Chinese demand. Second, lower oil prices reduce the troublesome risk of inflation in the Chinese economy. Thirdly, lower oil prices take pressure off the government to restrict energy prices and to subsidize oil which distorts the Chinese economy.
Thus, to the extent the government can control Chinese oil demand, it would clearly be happy if it were lower, not higher. There is evidence that Chinese consumers are buying fuel inefficient cars to show off. A wise Chinese government might well put high taxes on such purchase or take other steps to discourage such profligate oil use at a time of tight oil markets.
More important is the possibility that the Chinese economy will simply hit a growth wall. It has been expanding at an unsustainably high 10+% rate for over 10 years. That means enormous infrastructure projects have gone into the pipeline. If end product demand is lower due to the OECD slowdown, China may face a severe capital spending slowdown. As we know, a reduction in capital spending has a multiplier effect in slowing the general economy, just as the great capital spending boom of the past 10 years has had a multiplier effect on growth.
A much more erudite version of this argument was recently published by Vitaliy Katsenelson who describes the bloated and inefficient Chinese economy with this example: “the biggest mall in the world - the South China mall, with space for fifteen hundred stores, only has a dozen stores open for business - it is empty. Shoppers never materialized. Billions of dollars have been wasted.” I highly recommend his entire essay which explains why China may well be due for a significant slowdown.
The Coming Period of Maximum Oil Production
According to the Wikipedia and other Megaprojects analysis the years 2008 - 2010 will see the most new oil produced from new large fields that has occurred in history and it will be far larger than it will during the five years following 2010. Visibility of production out to 2015 is possible because of the roughly 7-year lead times that new oil projects require from announcement to production of oil.
Here is a graph that summarizes the Wikipedia Megaprojects model:
A detailed discussion of projected oil coming on stream is beyond this essay, but much discussion can be found at the above links. Moreover, one important part of the numbers is the simple fact that Saudi Arabia is bringing on stream two major fields in 2008 and 2009 that together are projected to add 2mb/d to global production.
Therefore, if any period of time is likely to see an abundance of oil production in the world, it is the next 2 - 3 years. After 2010, as several respected analysts have pointed out, global new production is looking weaker and it looks especially weak after 2012, four years from now. But the period we are entering now looks to be especially strong for new oil production.
Oil Exporting Countries Growth May Slow
Enormous infrastructure projects are underway in the Middle East and Russia based on cash flow from high oil prices. If oil prices decline, pressure will be felt to slow such projects down. There would be a lag period; a slowdown will not happen quickly. But orders for projects under consideration would be delayed and very new projects may be scuttled. Such actions would depress global capital goods markets.
Particularly impacted would be UAE projects in Dubai that are focused on high end business and leisure travel. The OECD slowdown will put pressure on the these highly leveraged projects from a demand viewpoint and a lower price of oil would pressure them from the ability to continue to finance them.
Moreover, less than projected cash flow to oil exporters caused by lower oil prices would also restrict the ability of oil exports to bolster OECD economies by making investments and providing liquidity. There will be less ability to prop up weak OECD financial institutions or manufacturers.
All in the Context of an OECD Slowdown
All of the above is predicated on a continuing slowdown in OECD economies. If the West were not slowing down, there would be far less pressure on China’s economy. While greater near-term oil production would tend to slow the rise in oil prices or cause a temporary pullback, it would not contribute to a significant and lasting fall in oil prices without the weak demand caused initially by the OECD slowdown. And without lower oil prices, there certainly would be no economic stress to the oil exporting economies.
But if the OECD slowdown continues and becomes more exaggerated, three factors discussed above could exacerbate a global economic slowdown and prolong and aggravate a normal pullback in the price of oil and possibly of N. American gas. In fact, these factors would combine with a severe OECD slowdown to create a vicious cycle - a negative feedback loop - that I have tried to flesh out in very brief summary above.
If that were to become the case, oil could slip back to $80 - or even go lower. Natural gas in North America would probably stay above $7.50. But the possibility also exists that very weak global economic performance and a negative feedback loop could cause the financial markets - already weakened by the credit crunch and housing slump - to perform very badly.
Let’s also bear in mind that the U.S. financial position has been severely compromised by two terms of deficit spending and increased national debt of record proportions. The U.S. is still the bell-cow of the global economy. Its weakened financial condition (especially in the context of ever-growing entitlement spending and interest costs) would tend to add to the negative feedback loop described above.
OPEC to the Rescue?
As the price of oil falls, OPEC will eventually try to support oil prices by cutting production. But such a cutback might be more difficult to engineer given the fact that Saudi Arabia is committed to increasing its oil capacity by about 2 mb/d in 2008 and 2009. The Saudis might drag out their construction process and might cap a lot of it. But it is simply harder to reduce production when you are already committed to bringing on important new fields.
Moreover, the Saudis have good political reasons to want to see much lower oil prices in the near term. Specifically, they are locked in a desperate competition with Iran for political influence in the region, both in terms of Lebanon and Iraq. They do not want Iran to proceed to become nuclear, nor do they want Iran to continue financing radical Shiite fighters.
Much lower oil prices would put huge pressure on the Iranian economy and could become a significant bargaining chip for the Saudi’s to obtain the political concessions they want from Iran. So it is not altogether clear that the Saudis will initially cooperate in an OPEC effort to reduce production and it is unlikely OPEC could succeed without Saudi leadership.
The Alternative
All of the above will probably not come to pass if the OECD and particularly the U.S. economies suddenly turn around and begin to strengthen. The chances for such a turnaround will be enhanced by lower oil prices. If the U.S. economy turns around due to lower oil prices, I will have been wrong to withdraw my investment capital from the market. On the other hand, I will have lost only opportunity, not money. It is a chance I have decided to take.
I am embarrassed that only 45 days ago I wrote that oil is an investment Tsunami and that the challenge to investors is to stay invested in it. But conditions changed over the past 45 days.
If I were not convinced that an economic downturn not seen since the 1930’s is a real possibility and that it comes just as China is due for a downturn and oil supplies are due to increase at the highest rate in history over the next 2 - 3 years, I would not have sold my oil-related investments.
Most of the factors that are inherent in the negative scenario could have been perceived 45 days ago. I make no excuses for not seeing them. But I do listen to markets. I see oil moving down when increased political tensions in oil-intensive areas should cause it to move up. I do not like what I observe.
If I’m proved wrong by moving to the sidelines now, so be it. I will plead guilty to panic. But if panic is justified, it is far better to panic earlier than later. Some will not call this an early time but we will not know that for another year or so.
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This article has 9 comments:
which is required to bring exploration finds to market. Another big factor
weighing on o & g futures is hurricanes in the Gulf ( predictions show
at least 10 more by season end ) plus the severity of winter weather
coming up. All of the above plus geopolitical uncertainity ( i.e. potential Israili attack of Iran ) keeps me invested in Energy Sector despite possible global economic slowdown.
WJM
In an article I published here in early 2008, I said I expected oil to cross $100, cross $110 and test $120, but then spend most of this year between $100 and $120. That remains my prediction. In my predictions, I did miss the irrational rise to almost $150, and perhaps I will be wrong again and oil will go below $100 and stay there for a while.
But I doubt it.
As the author has correctly stated, all the bearish factors he has discussed could have been perceived 45 days ago. Indeed, they could have been perceived 145 days ago. So that is not the reason for the author's change of heart. Instead, his change of heart is due to "listening to the market."
But, AT MOST, the market is telling us that oil was overpriced at $147. It is not telling us that oil is overpriced at $115. Yes, I know that some of the technicians in the crowd believe that oil's recent swoon indicates it's going to $60. But those technicians didn't tell us it was going to go to $147 less than two months ago, so we can all admit that technical analysis of where oil is going to be next week or next month is next to useless.
What I think ALL of us can agree on is that markets OVERSHOOT, both to the upside and to the downside, so market movements don't help me much.
What DOES help is a supply-demand analysis, which the author has done, but I think he has missed some very key factors, which I will discuss in the next post.
The King and the Saudi oil minister have said on several occasions that Saudi oil should be saved for future generations. $80 oil would provide a powerful incentive to do EXACTLY that--especially since SA knows that if they wait just 2-3 years, the world oil situation will be much tighter and they will be able to get much more for their oil.
The other factor not taken into account by the author is that a significant portion of marginal oil production today is simply not economical at $70 to $80. Will the Brazilian Tupi and Carioca fields be produced if PBR believes all it can get for that oil is $80? I highly doubt it.
Will the Arctic be drilled (assuming it's allowed) for $80 oil? Again, I doubt it. I realize these are longer-term projects that won't produce in the next 2-3 years, but even today, there are a lot of marginal fields being pumped for $120 oil that will be shut down if only $80 can be gotten for that oil.
Finally, it has often been said that "the cure for high prices is high prices," but the same works in reverse--"the cure for low prices is low prices." If oil goes back to $80, and gas back to $2.50, demand reduction will be muted, if not entirely reversed. This will act as a self-correction mechanism.
Final thoughts in the next comment.
Jack
In the past year, I have played oil very simply--by buying and holding shares of three Canadian royalty trusts--HTE last year and PWE/PVX this year. Despite the gyrations in the oil market--and even in the value of these stocks, I am about breakeven on these stocks. But in the past year--which has not been kind to the markets--I have collected about 15% in dividends, which is not a bad return given what has happened in the markets in the last 12 months.
And these generous dividends will continue to be paid unless oil goes under $80 and gas under about $7.50.
To me, these stocks offer a wonderful dividend, which also protects against any major drops in the stock price, while offering substantial upside over the next few years.
Jack
Russia hurt the IOCs bad, BP perhaps worst of all, which reminds me of something Ayn Rand said, that Russia has an unbroken history of failure. By cheating and browbeating Shell, Exxon, and now BP, Putin sealed their fate. In two or three years Russia probably won't have any surplus oil and gas to export.
That puts Europe in a very, very difficult spot by 2010.
The Saudis may bring new projects online, or they may delay production as their King has indicated. But their additions to world production must be matched against subtractions elsewhere. Indonesia dropped out of OPEC because they are net importers now. Mexico and Venezuela are demonstrating declining production. U.S. production peaked 30 years ago and is declining 4-5% per year.
OECD demand destruction has been matched by ROW demand growth. The high demand quarter is just ahead too. The past 4 weeks of lower prices saw U.S. gasoline demand creep higher week over week. Demand was not destroyed as the media keeps spouting, it was merely subdued. Commercial inventories of crude are lower than normal. If oil drops below 110, look for those inventories to be replenished. Demand increases as price falls.
A bullish EIA report sent the spec shorts scrambling to cover today. How much of the recent drop was caused by shorting?
This has been a speculator driven fire sale caused first by long liquidation and then by shorting. Fundamentals are still strong and this dip was a great buying opportunity. While you were selling into and after a 20% or worse loss, I bought APA, CHK, RIG, BEXP, HK, PBR, NOV and DVN. The market never valued these stocks for $147 oil. Once the reality sinks in that crude is not going below 100 and maybe not below 110, the market will revalue the entire sector more appropriately, say 30-40% higher from here.
Second, I agree that I would not want to be long oil futures or options at this point. In fact, I would never want to be long commodity futures. I prefer the low cost and/or fast growing producers of the stuff. And those have been priced all the time for oil 80-100 at a maximum. With the recent sell-off in enrgy stocks, they are priced for oil at $70-80 already. Stocks like cop and apc and others will make a ton of money even if oil drops another 20-25$. If you calculate the cost of inefficient but important (from a volume point of view) marginal producers they need about $40/bl to be profitable. add in another 40-45$ that you need these days per barrel for replacing reserves. that gives about 85$ /vbl which I regard as sort of a longer term floor for oil prices (short term spikes below could happen, of course).
imho many oil-related stocks (and even more Natgas) are still severely underpriced. with their current free cash flow many could buy back their entire stock float over the coming 10-15 years if they just continued at their current buyback rates!
final word: oil is priced in dollars. the recent dollar rally notwithstanding, a new administration together with the fed will inflate like mad if a global economic depression were to arrive. And all other countries would follow suit. In that sort of environment, oil would be a harder currency than gold and the reserves held by oil companies would become more valuablöe by the day.
all in all, there are short term downside risks for oil stocks, true. but longer term, they will continue to be a heck of a great investment.