Energy Stocks Will Roar Back - But Not Soon

[nacer-eddine06]

Energy investing - for me, at least - is mostly on hold. I do have some mid-stream gas pipeline companies that pay great dividends but little else besides cash. When will it be time to get back into energy stocks in a core portfolio sense? Lets work back from the new fundamental realities of oil prices to their implications for energy stock prices.

Before 2003 (except during the politically related oil crises of the 1970’s) there was only one condition in the oil market: plenty of oil. So oil tended to sell at a price related to the marginal cost of production. But something has changed since 2003 that adds a second possible oil market condition, scarcity.

What changed is the near-onset of peak oil and the related fact that when oil demand from developing economies ratcheted up, production could not be expanded as rapidly. So for a while in 2007 and 2008 oil demand ran ahead of available supply, a market condition that required a super-high price of oil in order to “destroy” some of the demand. During that time we saw the oil price behave not as a function of the marginal cost of production but as a function of the marginal requirement for reducing demand.

So there are now two possible conditions in the oil market: too much oil and too little. At the present time there is too much, but once the global economy recovers scarcity will motivate oil pricing again. Thus oil pricing is now like a light switch; it is either on or off. What determines the condition of the switch? The rate at which oil demand is either growing - or declining - which is almost entirely a function of economic growth. Therefore the price of oil is a leveraged derivative of the growth of the economy.

How far is down?

Some analysts - myself included - thought OPEC could maintain the oil price at a fairly high level, say $80, despite a global slowdown. And if the global economy had merely downshifted rather than the present condition of going into reverse, that might have been true. But in the current dramatic global GDP decline it seems that OPEC is powerless. Last week it was reported that Nigeria refused to go along with another OPEC production cut because Nigeria cannot afford lower volume. No doubt there are other oil exporting countries now suffering so much from the low price of oil that their fear that a cut in their output would not drive up the price enough to compensate for the lower volume prevents them from taking a chance on an output cut.

Even if OPEC could hold together to reduce production, the lower production might not prop up oil prices very much because analysts now understand that as OPEC reduces current oil production it simultaneously increases spare production capacity, which tends to damp oil prices almost as much. Why? Because analysts know that when oil demand begins to recover spare capacity will allow production to increase just as rapidly. Thus it could take many months of economic growth before the price of oil would go higher than the marginal cost of production since analysts know that the cheap OPEC oil that has been kept off the market via collusion will come back on stream rapidly.

If OPEC can’t stop the slide in oil prices what will? A number of factors will soon start to kick in to stop oil prices from going much lower than the recent high-$40 level, including:

1. Enhanced Oil Recovery (EOR) operators will begin to shut down production since the enhanced recovery methods entail higher costs. They know they can only produce EOR oil for a limited time and in a fixed quantity. At a low enough price of oil they will deem their profit margins to be insufficient. Some operators will shut down because they can’t afford to operate but most will ask: why sell it for $50 when we are confident oil will eventually sell for a much higher price and we will only have a fixed amount from any given field to sell?

2. At some price some Canadian and Venezuelan oil sands operators will find their marginal costs for production, shipping, and marketing is greater than the price of oil and so will have to shut down operations. That floor price may not be too much lower than the present $48.

3. The rapid decline of old cheap-oil fields will reduce supply even more than OPEC will. Recently the IEA reported that old fields are starting to decline at rates of 6.5%, much more rapidly than the 4% that has been standard wisdom previously. Even a 4% decline rate means you have to bring on about 3.5 mb/d of new oil fields each year to make up for it. So the accelerating decline of old fields will have more impact on supply now when there is less supply and when there are fewer new fields coming on stream.

At some point, the market forces unleashed by lower prices - in other words the tendency of suppliers to produce less oil when prices are lower - combined with the natural decline of old oil fields will offset the forces pushing oil prices down, namely decreasing global GDP and the expectations for still lower prices on the part of speculators. As usual, “the cure for low prices is low prices.” My guess is that $40 could become a floor price - or maybe the has already been reached.

The road back to oil scarcity

Standard wisdom these days, it seems to me, is that eventually the economy will recover and with it oil demand will begin to increase again. What will that process look like?

There are essentially three kinds of oil that can be produced in quantity. They are:

1. cheap land based oil,

2. new production from oil fields obtained with more expensive Enhanced Oil Recovery (EOR) techniques, and

3. expensive oil from new oil fields that lie deep offshore or in very inhospitable places like the Caspian and Siberia, or oil that comes from converting near-oil such as oil sands or - much worse - “oil shale” into syncrude.

The production of cheap oil only requires a price in the $30 neighborhood. There is still a lot of cheap oil potentially available from Iraq and Nigeria in particular but it is unlikely to be developed quickly due to political issues. EOR operators probably want to see oil above $75 in order to be excited about their ROI. EOR oil production has probably been maximized during the past three years, although there is always opportunity for more production through new EOR techniques.

But despite the potential for some new cheap oil and new EOR, most of the potential future new flows of oil are the expensive type. They come from new oil sands efforts and new deep offshore drilling and recovery. That sort of production will probably require a price in excess of $100 to be economically feasible. So it looks like somewhere around $100 is the new marginal cost-of-production basis for oil pricing - and inflation will increase that price over time.

[nacer-eddine06]

When global GDP growth causes demand to grow again beyond the ability of new production to satisfy it as it did in early 2008, the price of oil must rise to the point that cuts off demand to balance it with the available additional supply. That’s why we saw oil above $125 a barrel when the world was growing smartly. How long will it take to reach that point again? Given the current lack of investment in new oil production combined with the more rapid current decline in old fields, it might take only a year or two to progress from the point of all easily available new oil being produced to the need for higher prices in order to destroy demand. When that point comes, the old high price level - roughly $150 per barrel - could easily be surpassed.

Thus we see how the price of oil is leveraged to whether global GDP is growing or declining and at what rate. What about oil and oil service stocks? They are leveraged to the price of oil. Therefore oil-related stocks are super-leveraged to the economy.

Goldilocks

Is there a happy middle ground between too much and too little oil? Sort of. There are two conditions that could result in moderately high but stable oil prices. First, it can take some period of time to make the switch from the “off” setting to the “on” setting at GDP begins to grow again. During that time there will be a period when more expensive oil will come onto the market to satisfy the moderately rising growth of demand. There would be no need yet for a high enough price to destroy demand. That might be seen as a time of a “happy medium” in oil prices.

Secondly, we could get one or more “Black Swan” oil events of a “good” nature - say

- the rapid expansion of Iraqi oil by another million bpd each year for a few years, or

- a rapid transition to high fuel efficient cars under some Obama plan for saving Detroit and achieving “oil independence,” or

- an extended period of mild global GDP growth - say 2%, or

- more alternative fuel production, say cellulosic ethanol produced from algae.

If one or more of these developments occur fairly rapidly, rising oil demand might be able to be satisfied without requiring high prices to destroy some of it. We can imagine such a “Black Swan” scenario or a set of them. But by definition Black Swans rarely occur. I suspect such a Goldilocks future has a low probability of lasting for long.

The next phase, one scenario

Here’s what seems to be the current standard view of how oil prices might behave as oil demand begins to grow again:

1. First, all the cheap oil OPEC had removed from the market will be returned to the market, which will not require a much greater price for oil. This could take 6 - 12 months from the time GDP starts growing.

2. Some higher cost oil that was taken off the market or capped - say some oil sands operators who might have shelved some production or some off-shore operators who capped exploratory wells - will come back on stream along with higher prices after 12 to 24 months of growing GDP. Also speculators will come into the market and start to drive oil up, perhaps making price increases start even sooner. The higher cost oil will need prices in the $100 area.

3. Due to higher decline rates in old fields and the cancellation or deferral of many new field development projects during the economic downturn, it will not take long for higher demand to begin outpacing greater supply, thus driving the oil price beyond, and perhaps well beyond, its brief $147 high point in 2008. This point could be reached within two years of global GDP starting to rise again.

Current oil prices are anticipating such a scenario of oil prices starting to rise fairly soon as evidenced by the fact that oil futures are in an abnormally steep (but now somewhat declining) contango. So, for example, the price of oil a year out is about $10 higher than the current price and the price two years out is nearly $20 higher. This suggests that many traders are optimistic that the oil pricing switch is likely to start turning “on” within a fairly short time frame, meaning they think the recession will be fairly short. A bottom in 2009 seems to be standard thinking now.

Another scenario

An alternative future starts with a different premise. Instead of “as oil demand begins to grow again”, as above, suppose the next few years brings only continuing declines in economic activity and the start of deflation despite huge federal pump priming. If during the next several years (generally known as “the foreseeable future” although nobody can see it) there is only continued GDP decline, then the price of oil will stay at the marginal cost of production. I provided a partial road map justifying this sort of scenario recently. We can more easily visualize it by imagining that there may not be enough Federal money available to

1. offset the deflationary impact of state and city budget deficits that must be balanced,

2. keep the banking and insurance industries afloat as their commercial, credit card, and real estate loans crater,

3. build enough bridges and other public projects to grow jobs by 2.5 million in two years, and

4. give out a middle class tax cut.

If this scenario turns out to be the case, look for oil prices to stay in the “off” position for the foreseeable future - and look for the current contango to melt away. Here is a set of predictions by someone with a pretty good track record that paint one picture in which long term low oil prices seem more likely. And here is a straw in the wind, one example of the enormity of the global economic collapse that is now happening, the fact that Italian power use has decline by one third in only two months.

Stock Prices

Now, what about stocks? We see that oil prices are now leveraged to GDP. This is a new phenomenon. Prior to peak oil, it was not the case so much. There was a correlation of oil and the economy but it was not supercharged (except during the time of radical OPEC-induced shortages).

Meanwhile oil equities are leveraged to oil prices. Therefore oil equities are more than supercharged to the direction of GDP. So if GDP is now only in the early stages of falling then this is not the time to own oil stocks. That’s not to say we might not get a bounce in oil stocks from an oversold condition from time to time, as happened last week. It’s also not to say that global GDP has to be actually recovering before energy stocks will rise; we know stocks will anticipate global growth once there is some sniff of recovery or even bottoming in the air. But I think we should at the least want to see some slowdown in the rate of economic decline before we buy energy stocks.

That’s not to say that a slowdown in the rate of GDP decline must actually be published in the newspaper before we buy oil stocks. It might be too late to buy the oil stocks at that point. No, the first evidence that the rate of economic decline has slowed and therefore the turn-around has begun to begin will probably come from a sustained rally in stocks, which will include oil stocks. I don’t mean just a rally; I mean a sustained rally, one with pullbacks, higher highs and higher lows.

Of course if we wait for such a rally we will certainly not have been buying at the bottom. Buying or owning oil stocks at the bottom of this bear market is an enticing objective. It holds the promise of our recovering a lot of our lost asset values rather quickly. Many investors are acutely aware that there is so much cash on the sidelines and so much desire to participate in a rally in order to make up some of the losses everyone has suffered that when “the market” sees daylight ahead it will stage an enormous rally. A lot of people want to be at that party.

But the cost of buying now or owning now will be steep if the bottom of the business cycle is two or three or four years off. A great deal of additional asset value destruction could take place over two, three or four more years of declining GDP. So if one’s objective is to buy at the bottom, or at least to own at the bottom, one best hope that the bottom is not too far off. And that in fact is what many people are doing now - owning energy stocks in the hope of a quick upturn in GDP.

So the choice for the oil stock investor is whether to own them now, thus risking further portfolio value declines, or stand aside for now thus avoiding the risk of more portfolio declines but taking an opportunity risk that you will miss out on the early part of what could be a huge rally in stock prices. It is an individual choice. Whatever your choice, make it with the knowledge that in owning oil-related stocks you are super-leveraging yourself to economic conditions. If we are near a bottom in terms of GDP reduction, you could do very, very well. But if we are years away from it, the additional decline in your portfolio from here could be serious. That’s because the price of oil and the value of oil related equities are so closely tied to GDP growth or decline.