Oil: A Slippery Slope Ahead?

by: Andrew Mickey

Dr. James Schlesinger says the U.S. attitude towards oil “has only two modes – complacency and panic.”

Schlesinger should know. In the 70’s he closely watched the Middle East as the U.S. Secretary of Defense. Then he would move on to become the first U.S. Secretary of Energy when oil prices were really starting to move up during the Carter Administration.

He was in the thick of the oil panic of the 70’s, and he was there, holding numerous seats on oil companies’ boards of directors, during two decades of complacency.

Oil is hovering around $50 a barrel and we’re at the middle of the road. No trader is willing to take a big bet either way for the short-term, OPEC has brought out the dogs and ponies, and oil stocks appear to have hit a temporary bottom.

Still a lot of questions hang over any near-term rebound in oil prices like, how long will the recession last? How high is U.S. unemployment going to rise? How deep an impact will a major production cut from the Detroit’s Big Three have? How big will the coming U.S. stimulus package be? How hard of a hit will China’s economy, which we discussed the other day is perfectly built for booms, take from the global recession?

All of the economic uncertainty has sparked a new era of complacency in the oil industry. If you look at history, the best time to buy oil stocks is during periods of complacency.

So, as I’m sure many of you are wondering, is now a time to buy oil stocks?

To find the answer, we have to figure out how bad the oil price drop has hit the oil industry, how OPEC could actually send oil prices even lower (yes, it could happen), the short-term impact of the oil bubble, and how long complacency will last.

Drastic Times and Drastic Measures

The drop in oil prices has taken many by surprise. Most now realize the bubble has burst. It’s been sudden and drastic and oil companies are responding with sudden and drastic measures.

The most widely noted impact is the elimination of new projects. Every oil bull will cite this as a huge problem facing the oil industry down the road.

Frankly, they’re right. However, it’s going to be a very, very long road.

If the oil downturn was just going to be a few months, oil companies would just slow down or temporarily halt production where they could. However, they are bracing for a much longer period of $50 or lower oil prices. Dozens of new projects have already been shelved, and with each passing week, more and more oil projects are added to the list.

That’s not what really has me concerned though. While some oil companies are taking their medicine now and shelving projects (which needs to be done), others are still pumping away in desperate hopes of a near-term rebound forcing them to take more drastic measures.

Last week, private oil trading firms and oil producers including Royal Dutch Shell (NYSE: RDS.A) announced it is renting oil supertankers to hold excess supply of oil. They are booking multiple supertankers to store millions of barrels of oil.

Mike Rothman, of New York consulting firm ISI, said:

The Gulf is crammed with supertankers chartered by oil-producing governments to hold the inventories of oil they are pumping but cannot sell.

Iran is also getting in on the action, and at last report, Iran had leased 10 oil tankers to hold 20 million barrels of oil no one wanted to buy.

Renting oil tankers is a desperate move. Regrettably, desperate moves rarely pay off. In this case, the stored up oil is going to help keep a temporary cap on oil prices when the global economy shows some signs of life again. If oil prices jump, the owners of the oil will certainly start to sell off the millions of barrels of oil they’ve just been sitting on.

When Bubbles Burst

Clearly, the glut of supply we’re facing is big. And thanks to the long period of high oil prices and bubble-like mentality of oil companies, the supply glut isn’t going away anytime soon. As bubbles form, investors and companies race to capitalize on the opportunity. When oil prices started to rise, the race to make money on oil was on.

More than 500 energy focused hedge and private equity funds bought oil. At the peak, there was between $150 billion and $250 billion of speculative capital running up oil prices. They didn’t want or need oil. They just wanted to buy it and sell it at a higher price. When oil started to turn down and all of this extra money was pulled out, oil prices came crashing down.

It wasn’t just the hedge funds though. All kinds of investors and oil companies who joined the oil race were aggressively funding new projects. New project spending was rising steadily for years. Total capital expenditure rose to $160 billion in 2005, $200 billion in 2006, and surpassed $250 billion in 2007.

Not all of this money was squandered. It was spent on new oil wells, developing new technologies, exploring for more oil reserves, and the purchase of equipment to produce more oil.

The capital equipment hasn’t vanished. In most cases, it’ll be simply standing at the ready for oil prices to recover. It’s like a giant spigot just waiting to be turned back on. If and when oil prices rise, many of these projects will be turned back on, supply will increase quickly, and oil prices will be held down.

When bubbles burst, a glut of capacity is usually left to show for it, and it usually takes a while to work through it. Just take a look at how long it will take to sell thousands of Miami condos or the decade it took for demand for fiber-optic cables to pick up again. The current oil supply glut could take just as long. If you think that OPEC is going to be able to keep oil prices propped up, then think again.

OPEC Could Send Oil Prices Spiraling Even Lower

OPEC slashed oil production by one million barrels a day a few weeks ago. Over the weekend, a strategic OPEC meeting failed to produce any material cut, and the market is already expecting a one and a half million barrel per day cut from OPEC in a couple of weeks. Through it all, oil prices continued to slide and we’ve seen how truly weak OPEC is.

Here’s the thing about OPEC, its members may actually send oil prices tumbling further. As we analyzed in "The Future of Oil" a few weeks ago, National Oil Companies [NOC] now dominate the world’s oil market. They control 80% of the world’s reserves and their profits are used to fund social programs. The revenue from NOCs is drastically reduced with oil at $50 a barrel, and most countries still haven’t adjusted their spending for lower oil prices. Venezuela’s budget for 2009 was made with an average oil price of $95. Russia’s government will be running a deficit if oil doesn’t average $70 a barrel next year.

Falling oil prices puts these countries into a bind. If they cut production sharply enough to keep oil prices up, per barrel of revenue will increase, but total revenue will be lower. Basically, if you sell 100 barrels of oil at $50, you make $5,000, and if you sell 50 barrels at $80, you only walk away with $4,000.

The numbers are a bit oversimplified, but you get the picture. Many countries will be facing big problems if oil falls further or if they cut production enough to keep oil prices propped up. When hard times hit, OPEC members look at what’s best for themselves instead of the group.

This wouldn’t be the first time this happened though. It happened in the late 90’s when oil fell to $10 a barrel. Now it looks like it’s happening all over again. OPEC recently agreed to an output quota 27.3 million barrels a day. Petrologistics, an oil industry research firm, notes OPEC countries are producing 27.8 million barrels a day.

It’s a lose/lose situation that could easily keep a few OPEC members pumping oil at or near full capacity even if oil prices fall further.

That’s why I wouldn’t pay much attention to OPEC at the moment. It’s a weak organization with no enforcement mechanism for the quotas. In the end, it looks just like OPEC is doing what it does best, making headlines instead of effectively propping up oil prices.

Two Ways to Go From Here

From here, oil prices are likely to continue to fall. Frankly, hopes for an oil recovery are still too high, and as a result, most oil stocks are still priced for a rebound, which (except for maybe a few short-lived spikes) isn’t likely to happen.

For a long time now, many of you know I’ve absolutely hated the oil sands. Any business that requires oil prices at multi-decade highs ($80 just to break even), has a 10-year or longer payback period, creates unbelievably large environmental issues, and requires multi-billion dollar outlays before the first dollar in revenue is received, makes about as much sense as ethanol. However, oil sands stocks are good for one thing, as they can tell us how much hope is still around for a rebound in oil prices.

Companies which own large oil sands projects like Suncor (NYSE:SU) and Canadian Oil Sands Trust (OTCQX:COSWF) have watched as their shares are clobbered. Still, I find the best indicator of how much hope for a turnaround is left in the markets is probably Oilsands Quest (AMEX:BQI).

Oilsands Quest is a pure-play on oil sands. So with oil at $50 a barrel (and not much possibility of oil prices rising above $80 – where it would be able to break even), it’s pretty much worthless. At the moment, Oilsands Quest has a market cap of $250 million. And if we were truly in a period of complacency, it wouldn’t be worth more than $50 million (and that’s being generous).

In the end, we can’t ignore what other commodity bubbles bursting have shown us. If every other commodity is going back to 2002 price levels and mining stocks are going with them, there’s no reason not to expect oil and oil stocks to do the same.

My money is still on the sidelines waiting for a further drop in oil prices, as I just can’t think of many good reasons to buy oil stocks right now. Massive stockpiles are building up, and the oil production projects made during the oil bubble are still in place. Oil demand continues to drop as, for the first time in decades, Japan, Europe, and North America will all be in a recession at the same time.

The only real reason to go “all in” on oil stocks now is if you expect a sudden rebound in the global economy or expect Wall Street to take the long-term view. I wouldn’t bet on either happening anytime soon. Be sure to stay current with the Prosperity Dispatch, our free e-letter, for more investment tips and analysis.

The window to invest in oil stocks should be open for at least a year. For me, there are just too many expectations for an oil recovery that are just too high, and when it comes to investing, great expectations usually lead to great disappointments.

There will be some amazing opportunities in oil over the next year, but for now, it’s best to keep plenty of cash on hand and wait for them to fall even further. As oil prices slide down a slippery slope, it’s a buyer’s market and we don’t have to chase anything.

Disclosure: None

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