Seeking Alpha

Black Gold - Political Vs. Practical

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, USOI, UWT, WTID, WTIU
by: James Hanshaw
James Hanshaw
Long only, special situations, growth at reasonable price
Summary

No commodity has become as politicised as oil and none is as important in practice for the world economy generally.

Supply countries are mostly addicted to the money it earns.

Demand countries want to curtail its use for environmental reasons.

Will unquantifiable and unpredictable politics beat practical outcomes?

Oil became politicised when cars became commonly used and remains so now as political leaders in some countries endeavour to force the use of alternative, supposedly less polluting fuel sources and those in others depend on oil to keep them in power. This is causing severe tensions, including cultural clashes within and among countries, that make it difficult to find a way forward for oil prices and thus investments in the oil industry. In this article, I have added links to points that aided me to explore a likely way ahead for the medium term. Some of these I found in the Financial Times and it owns the copyright to those linked articles.

Supplier politics vs. practical outcomes

As I did with my first article in February 2016 Light at the end of the oil price tunnel, I shall start with Saudi Arabia - KSA. I said that it had "shot itself in the foot" by declaring war on US shale producers. That remains as valid today as then because having lost some initial battles those producers have emerged as winners of the war. There is a frequent dripping of news from KSA that point to severe withdrawal symptoms as the new Crown Prince tries to wean the country off its addiction to oil money and as the effects of low oil prices continue to drain the nation's financial reserves.

According to the IMF, those reserves have dwindled by nearly one third since the end of 2014 and are now below $500bn. Its estimated break-even oil price (the price needed to meet KSA's national budget costs) is $84 per barrel. That price is unlikely to be seen again for many years unless another Middle East war breaks out. The much lauded IPO of 5% of state oil company Aramco (ARMCO) - needed to arrest further depletion of the financial reserves - is rumoured to have been pushed out from 2018 to 2019. Other rumours suggest that China will instead buy that 5%. There is also a great deal of resistance to change generally, with security forces being used recently to suppress dissent. It is also rarely talked about that the main KSA producing areas are in Shia populated areas and those people have long been kept pacified by the Sunni royal family with money from oil. Take the money away and a religious revolution may oust that family.

One practical outcome seems to be a near certainty; the Saudis will not increase oil output again, thus reducing prices and worsening that family and religious feuding. Other countries in the region are in a mess too as this article on Abu Dhabi indicates. Iraq has been pumping at maximum output but this could be disrupted by the Kurdish push for independence from Iraq that is seen as a threat by Turkey, Iraq and Iran.

Elsewhere, Libya is still war-torn with its biggest oilfield, the Shahara, being shut down by an armed group this week. Next week it will be something else. Nigeria is fragile with Biafra separatists continuing their fight for independence plus a Bokum Haram insurgency and saboteurs in the oil-rich Niger Delta adding to the problems facing the government. Russia appears to be relatively stable at present and is unlikely to risk that by increasing oil production and thus worsening its own financial position. Russia and Saudi Arabia have also made moves to get closer to each other, moves that will probably not please politicians in the US. US oil producers have so far kept output reasonably well restrained, as indicated by the weekly Baker Hughes (BHGE) rig count, perhaps under pressure from shareholders who would like to see some profit after long years without.

One very positive outcome of this forced and voluntary restraint has been a massive draw-down in oil inventories to near long-term average levels.

So much for my linking conflicting parameters with words; can a dollar value be extracted from this? One of oil investments in North America is Pioneer Natural Resources (NYSE:PXD). PXD has hedged 89% of its output for 2017 and 70% for 2018 at $50 per WTI barrel while keeping upside to $55. It claims its production costs are around $30, so it should be able to operate profitably for the foreseeable future. Similar is probably the case for other US shale producers. Saudi still needs that $84!!

User politics vs. practical outcomes

I started my above supplier thoughts with Saudi Arabia and shall do so also with it as a user. The ban on females driving in that country is to be lifted. This new freedom for women will put many more cars on the roads there and thus Saudi home demand will increase substantially. One can only hope this signals wider reforms that will lift that country out of the Dark Ages and perhaps lead others like it into the 21st century too. Females - a wife and two daughters - have been important partners to me in my sometimes bumpy ride through life so I wish well for those suppressed elsewhere. This is a very genuine wish but I must make a connected interest disclosure; that emancipation will increase the desire of females everywhere to be partners in art with me!

Elsewhere we hear of political demands for the electrification of cars. France, India and Britain have made 2040 the target year for all new cars to be electrical-driven - EVs. China and Germany are making vague noises about doing something similar. Currently, China produces about 75% of its electricity from polluting coal and its population is choking to death - additional power demand to recharge EVs will hardly help that.

In the case of India, its target is most unlikely to occur because the politics of that country are in a permanent state of flux plus there are many homes still without electricity to provide even the basic services of life, such as lighting.

Britain has long neglected replacing very old nuclear and coal-fired power generation facilities that can hardly cope with the normal usage demands of today. Those replacements plus the large additional extra power needed to charge all those EVs is unlikely to be available by 2040 not least because there is no money available from the public sector. Britain's debt to GDP already stands at nearly 90%, way above levels considered prudent and - among many other problems - the country's National Health Service is massively underfunded, students have become buried under a mountain of debt and there is a huge shortage of housing. Other practical needs include provision of charging facilities for EVs at or near people's homes. The UK central government has downloaded responsibility for that onto cash-strapped local councils which have more important priorities such as providing care home facilities for the ageing and, shockingly, protection for a large number of females fleeing from violence in their homes. The Dark Ages still persist for some even in supposedly advanced Britain! I am therefore sure that EVs will not be given preferential treatment over the basic needs of humanity in the UK and India.

France has a fairly good track record in building state infrastructure, so it might get things done; however, it has budget limitations too and the new president of that country is struggling to make the deep reforms needed to change that.

Germany has a political target, made in 2012, to phase out nuclear power by 2022. It also remains partly reliant on filthy coal-burning power generating plants. Little has yet been done to build replacements even to meet current demand needs as partly evidenced by that fact that it will miss four of its 15 Energiewende 2020 targets that include security of electricity supply for those existing needs. It takes decades to get anything new built in Germany due to stifling politics and bureaucracy, so it is very unlikely any significant additional power supply will come on stream in the next 20 or so years.

Politicians are also noted for making grand headline statements without thinking of consequences and, in addition to the points I have mentioned here, there is another consequence; car manufacturing is an important part of the economy in Britain, France and Germany. EVs require a significantly lower number of components than conventional petrol, diesel and hybrid cars, thus requiring a lower level of employees to make them. Those employees are practical people with votes and are unlikely to vote for those that make them redundant.

There is another practical point I never hear politicians mention when they announce their grand visions to clean up the environment with EVs. Battery production itself is very energy intensive plus the lithium and other materials required to make the batteries bring serious, adverse environmental problems of their own. As far as I know, no consideration has yet been given to recycling of those materials by governments. And nor by the producers if Albemarle (NYSE:ALB) is typical of those. I asked ALB about its lithium recycling plans and got no answer so I assume it has none. Cobalt is another key ingredient in the batteries and sufficient supply of this to meet the massive demand for EV batteries is questionable given the unstable nature of many source countries.

In addition to - and in support of - the points I make, this recent Financial Times article puts car demand for oil products nicely as does this one with regard to the EV threat.

I personally think that hydrogen fuel cells will eventually do better than batteries. Those pushing batteries today remind me of those who pushed "clean" diesel a few years ago - especially the German carmakers - and then hybrids came along from Japan, leaving those diesel engine carmakers in the slow lane.

I have focused on cars here because of the political connection, but they only account for around one fifth of total oil demand. Another one fifth - around 17 million barrels per day - is used by the trucking sector according to the International Energy Agency, IEA. They are big users of polluting diesel but I see little political pressure to change that. The IEA also expects demand for uses such as jet fuel and petrochemical feedstocks to grow strongly. There are some early-stage developments in electric and solar-powered aircraft, but I doubt this will have any impact on oil demand for at least 20 years, given glacial pace of change at the main aircraft makers - Boeing (NYSE:BA) and Airbus (OTCPK:EADSY) - and their customers.

In summary, I do not see user country politics and its headline-grabbing announcements about EVs beating the practical and growing oil needs of its citizens significantly in the next 20 years. We have already seen the biggest effects on demand via huge improvements in fuel efficiencies, including those in hybrid cars and in conventional aircraft design. While this trend will not be reversed, it will not have the same effect on demand in future years as it did in the first years of those improvements. Latest IEA figures support this conclusion by showing that demand since 2014 has been growing faster than it did in the last decade.

Demand and concomitant investment opportunities

When I started investing in oil in 2007 I did so primarily in the US, as I did not want to take risks in most other oil-producing countries because of their political insecurity. That proved to be very naive as I lost money when some of my "safe" US shale oil companies became victims of the Saudi war against them. Naivety can spawn wisdom and apart from getting that judgement wrong earlier I believe it provides a fairly sound foundation to build on today.

Many factors now favour US shale producers as some countries are pushing their refiners to produce cleaner fuels, thus increasing demand for light, low-sulphur (sweet) crude from the US. US politicians could do something practical by incentivising US refiners to do the same. That would be a nice retaliation to the Saudi war on US producers because Saudi owned refineries in the US would have to convert as well! Those politicians could also amend the ancient Jones Act on US coastal shipping; that means US east coast refiners can ship in oil more cheaply from far way Nigeria instead of buying US crude and shipping it from nearby Texas and other US producing states. This is exacerbated by lack of pipelines from the US oilfields to the east coast. The Trump administration wants to build infrastructure and US jobs and these provide opportunities that could all be done with private sector money. They could cost the taxpayer nothing except for the short term "cost" of the tax incentives that would provide jobs and profits from such investments for many years into the future.

Other such investments include building much needed crude oil export terminals as few ports in the US can handle the very large crude carriers, VLCCs, needed to transport the oil worldwide. Enterprise Products Partners (NYSE:EPD) estimates that US crude exports may rise to around 4 million barrels per day by 2022 - 5% of a global demand that is also increasing. The significance of that figure can be seen by comparing it with pira.com estimates of 520,000 b/d exported in 2016.

Those ships are another source of new demand. Ships are major polluters because many run on the filthiest of oil fuels. The International Maritime Organisation has issued new rules reducing sulphur requirements for ship bunker fuels to a maximum of 0.5% from the current maximum of 3.5%. Many existing vessels are very old and will have to be scrapped. This will create jobs for shipbuilders which are not in the US but it will create jobs elsewhere and those workers buy cars, etc.

China is a major and growing destination for oil and is now the biggest foreign destination for US crude oil. China's imports from the US are still well below those from Saudi Arabia and Russia - less than 1% of total imports of over 8 million barrels per day - but China has a very refined talent for mixing the political and practical. Unlike most politicians in the west many of China's leaders have an engineering background, meaning they might know how in real life things work. President Trump has made many noisy tirades against US imports of Chinese goods. The Chinese appear to be non-noisily responding by increasing imports of US crude oil - very political and very practical.

A lot of investment opportunities are rising like a phoenix from the ashes. During the long downturn in prices, many US onshore E&P companies have drilled wells, in order not to lose their land leasing rights, but have not completed them. These DUCs - drilled but not completed wells - are believed to number around 7,000 in the main oil producing regions such as the Permian.

I, therefore, conclude that companies specialising in completions will be the first to benefit from this; so I recently bought into US companies C&J Energy Services (CJ), Solaris Oilfield Infrastructure (NYSE:SOI) and Canadian company Trican Well Service (OTCPK:TOLWF) or TCW on the Toronto Exchange where I own it. Trican does a lot of work in the US and it took over another Canadian company, Canyon, that I liked very much because it endeavoured to keep its skilled teams employed during the downturn when others were making theirs redundant. If it managed to continue with that, it will pay off today because there is currently a skilled worker shortage for well completion services. CJ recently emerged from Chapter 11, so has no debt mountains to cloud its excellent service offering. SOI has patented proppant management technologies that save customers money and have very large potential, in my view. I sold Helmerich & Payne (NYSE:HP) in order to buy CJ. HP is one of the best drill rig companies, but I had to balance priorities and completing DUCs will have more importance than drilling new wells in the months ahead.

My choices among onshore E&P companies are Pioneer Natural Resources and Noble Energy (NYSE:NBL). I made a comment earlier about PXD's production costs and its hedging actions; however, I have heard several different figures for those production costs from PXD and I remain wary. I want to see if cash flow shows signs of improvement in its next report. I have held onto NBL for a long time because I like its big European offshore natgas finds and its recent entry into the Permian, but the share price performance has not yet backed my decision to keep holding.

I was burned earlier by deep water drillers and related service companies but recently decided to dip my toes back into the water and bought Dril-Quip (NYSE:DRQ). I also like Oceaneering (NYSE:OII) and may buy back into that soon. Both companies are among the best technically and have come through the downturn in sound financial shape.

It is important to note that US shale is probably close to peaking and fracking is not allowed in many countries so offshore must come back. While some big oil companies such as Chevron (NYSE:CVX) and Exxon (NYSE:XOM) have stepped up investments in US shale, all have been depleting their reserves faster than they have replaced them due to their massive Capex cuts since 2014. If they want to remain "big oil" companies they have to go back offshore because US shale will be nowhere near sufficient to meet their future production needs.

As with onshore drilling, costs offshore have been drilled down drastically. Statoil (STO) of Norway reckons its next-generation projects have reduced their break-even price from around $70 to $30 per barrel. Part of this is by investing in new technology, including automation, and some offshore production platforms are now unmanned. That is not good for investments in helicopter and oil rig supply vessels! Similar cost reductions are claimed by other oil majors such as TOTAL (NYSE:TOT) of France and Eni (NYSE:E) of Italy.

I have one company servicing both onshore and offshore needs; Core Laboratories (NYSE:CLB). A cursory look at its share price suggests it is expensive but deeper drilling exposes a very wide ocean that few will attempt to bridge. It is one of the very few service companies that have remained profitable throughout the downturn and today that high share price has only one way to go - higher. Those unfamiliar with CLB might find this presentation interesting.

My main midstream choice is Targa Resources (NYSE:TRGP) and in infrastructure I have MasTec (NYSE:MTZ) a company that provides, among other things, pipe laying services. It recently announced a $1.5-billion pipe laying order but gave no details - maybe that will connect US east coast refiners to the oil fields. I expanded my views on MTZ in MasTec in the Connected Age.

Last thoughts

The Trump administration is said to be pursuing a vision of "energy dominance." It also wants massive investments in infrastructure. It could make a start by providing incentives to US refiners to reconfigure from running on imported heavy crude to using high quality sweet crude from US oil fields, getting pipelines built onshore and US sea ports developed to handle outward bound VLCCs loaded with US oil. All would provide environmental benefits as well.

Growth in China continues at a breakneck pace - 6.8% in the last quarter - and, as but one example for the future, over the next three years the building of an extra 30 million social housing apartments is planned. That is sufficient to house the entire UK population! Those apartments will require electricity, many of the occupants will buy cars and the Chinese like gas guzzling SUVs.

Demand is increasing generally and substantially elsewhere as I have mentioned above and the US is becoming a preferred supplier in several countries, some sick of OPEC dominance.

Chief dominator has been Saudi Arabia. Now it is stuck between a rock and a hard place - both of its own making. It wants to wean itself off its addiction to oil money but anyone who has had an addiction will know how difficult it is to get out of its clutches. The Saudis had grand plans to do that in the 1980s and the grand plans of today will go the same way - buried deep down an oil well. The country is family-owned and that family is feuding over those plans. It is very unlikely Saudi Arabia will again flood world markets with oil and drain that family's fortune even further nor risk being deposed by religious revolution in the Shia populated oil-producing areas.

I want our environment to be protected and I welcome the development of EVs providing proper provision for recycling and cleaner energy sources for recharging is made in parallel with that development, but that is not the case at present.

However, none of these developments is going to stop oil demand from increasing in the coming decade and maybe not even in two. Recently one of the world's biggest commodity traders, Trafigura, warned that the era of persistently low prices is ending as $1 trillion of spending cuts since 2014 finally hit future production. It projects demand exceeding supply by 2m-4m barrels per day by the end of 2019 and there are no signs of that trend reversing thereafter.

My guess for the 2017 year-end WTI price is $55 and $60 by the end of 2018 with higher prices in following years because it will take time and massive investment to rebuild supply sufficient to meet growing demand. That investment will have knock-on benefits to the US and world economy outside the oil sector - the multiplier effect - but they are too extensive to go into here.

To conclude, politics are being beaten by the practical and may - for one very rare occasion - be forced to head along the practical track. That should favour US crude and my investments in it. No doubt readers have their own views and favourites and I hope they share those with us in comments here.

Disclosure: I am/we are long CJ, CLB, DRQ, MTZ, NBL, PXD, TOLWF, SOI, PXD. 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.