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Oil Update–June 2016

I am still trying to wrap my head around Brexit and what implications it might have for oil. As a consequence, I have nothing meaningful to add for June. Let’s see what the next few weeks bring.

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Oil Update–May 2016

I am surprised by the strength of oil prices. As I type this post, West Texas Intermediate is flirting with $50, skirting a few pennies above or below.

Of course, the recent turmoil Africa, especially Nigeria, and the wildfires in northern Alberta have hampered oil supply. With forest fire no longer a serious threat to Fort McMurray or oilsands production facilities, companies are in the process of restarting their production, so this shortfall shouldn’t last much longer.

The next shoe to drop might be Venezuela. As we know, the country is experiencing severe difficulties, and that’s putting it mildly. Many are wondering if the country will completely collapse, and, if so, what that development might mean to its production.

OPEC has its next meeting this week on June 2. Given the rivalry between Iran and Saudi Arabia, I don’t expect any changes in OPEC’s position.

I am waiting and watching to see how some developments play themselves out. Does Nigeria continue to get worse? How long until Alberta production resumes normal levels? Will Venezuela be the next crisis? Does OPEC do anything unexpected? And how does the oil industry react to these higher price levels? Wrapping up, there’s just more continued uncertainty.

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Oil Update–April 2016

This is yet another installment on the latest oil price movements.

The Doha pow-wow turned into a non-event as Saudi Arabia at the last moment pulled the plug on any potential deal, stating that in order for there to be a deal, Iran must be included.

The Doha failure surprised me because I thought there was no downside and only upside. All represented countries were at or near maximum capacity, so landing on a deal would not have made any significant difference to their production levels. Yet, if a deal had been struck, that action might have added more confidence to an oil rebound.

Even more surprising to me was the oil price reaction after the Doha failure. Oil has been remarkably strong during the past two weeks. John Kemp at Reuters suggests in his article “Oil rally is not just about hedge funds” that oil prices are becoming dangerously overheated. We will discover soon whether recent prices are warranted.

At this point, I am skeptical of oil rising much further or falling back close to prior lows in the near term.

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Oil Update–March 2016

As a follow-up to my February post regarding oil prices, I am still not optimistic about a quick recovery.

As we have seen, there was no March meeting for OPEC and some non-OPEC countries to agree to a production freeze. Now, the latest plan is for those countries to meet in the Qatari capital of Doha on April 17. Assuming that the meeting does proceed and that they do agree to a production freeze, I am unsure of the benefits. That agreement would just freezes oil production at or near maximum levels. In other words, the world would remain awash in surplus oil.

Compounding the problem, according Janet Yellen’s speech yesterday (New York Times—a subscription might be required), global economic growth remains sluggish.

While I remain skeptical of a quick recovery, I am hopeful that oil prices won’t fall much further.

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Oil Update–February 2016

In December of 2015 I indicated that I was no longer confident that oil would not remain in the US$30s for more than two months. Well, now that we are at the end of February 2016, we see that oil has remained in the US$30s and even briefly sunk lower.

The question now is, where will oil prices go from here? Unfortunately, I am not optimistic about a quick recovery. I have been following as closely as possible various news articles related to oil. Some members of OPEC plan to convene a meeting by mid-March in hopes of achieving a production freeze. Because I doubt that Iran will agree to a freeze as it ramps up its production back to pre-sanction levels, I am doubtful that OPEC and others will agree to a production freeze. Even if they were to agree, with or without Iran, I am not sure that it would have much effect. The world is still awash in oil. And as we have seen in recent weeks, prognosticators seem to be lowering their price forecasts. Moreover, there is still considerable uncertainty about the strength of the global economy and its desire for more oil.

I want to wait for a few more months to see how world oil production reacts to these very low prices. Do these low prices finally cause oil production to fall more precipitously than was previously expected or does oil production remain resilient?

I honestly do not think anyone has a very good crystal ball at this point. So we wait for more information.

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Market Expectations for 2016

The Wall Street Journal featured a helpful article “Happy New Year…Now What?,” (subscription required) that stated:

Collectively, Wall Street forecasts are similarly inconsistent. Since 2000, the S&P 500 has returned a 4% average annual gain, excluding dividends. By comparison, Wall Street strategists have predicted 10% yearly returns, according to Birinyi. And, on average, the consensus always has predicted annual gains, missing all five down years in that stretch.

So what’s my take? My take is that Wall Street strategist forecasts are essentially useless.

Going into 2015, I wrote that SPX options had a skew to the downside, implying that there was more downside risk. Using a similar process, let’s look at SPX options for 2016.

On Thursday, December 31, 2015, the SPX closed at 2093.94. Looking at the SPX December 2016 Options (those that expire on December 16, 2016) and using thinkorswim’s platform for options, I note the following:

  • About an 80 percent probability that SPX closes above 1725;
  • About an 80 percent probability that SPX closes below 2275; and thus
  • About a 60 percent probability that SPX closes between 1725 and 2275 at expiration.

I arrive at these values by finding the SPX value at expiration where the put delta is roughly -0.2 and the call delta is roughly 0.2. I am using option deltas as a rough proxy for the probabilities.

The lower level is about 82 percent of the current SPX value and higher level is about 108.6 percent. Again, we see a skew to the downside because that implies about an 18 percent downside risk compared to about a nine percent upside risk. There is an approximately equal risk that SPX closes below 1725 as there is that it closes above 2275.

Even if the risks were perfectly balanced, there should be a skew to the downside because of dividends. Dividends make puts more expensive. So let’s adjust the put value to incorporate the dividends. SPY dividends have been about 2.4 percent. 2094 times 2.4 percent yields 50.25. Thus, to arrive at the amount of skew while incorporating dividends, we get a higher level of 84.8 percent (equals (1725 plus 50) divided by 2094). Thus, the downside risk of about 15 percent is nearly twice as great as the upside risk of about nine percent.

When learning of various forecasts, remember to keep an open mind. As the opening quotation shows, Wall Street forecasters are traditionally an optimistic bunch. While option pricing models are certainly not crystal balls, they do provide a quick snapshot as to how market participants view the current market. With the passage of time, of course, that view will change. In short, I am not wildly optimistic in my outlook for 2016.

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Happy New Year 2016!

This past year was a difficult year for Albertans. With oil and gas prices at extreme lows, many oil and gas companies are struggling. Even worse, many have had to layoff significant numbers of their staff.

Last month, I mentioned that I expected oil prices would not remain in the US$30 for more than two months. After the disastrous December OPEC meeting where they failed to even agree to disagree, oil prices remain under pressure. Every country appears to be producing near or at maximum capacity as there is no production ceiling. Consequently, I am no longer as confident that oil prices won’t remain in the US$30s for two months or longer.

With oil prices forecasted to be “lower for longer,” many companies will continue to struggle and some may even perish. Companies that are most at risk are those that exhibit some or all of the following conditions:

  • Relative to others, a high break-even cost of production;
  • High debt to equity ratio;
  • Share price has declined more than 65 percent during the past two years; and
  • Large percentage dividend cuts.

For those who own shares in such troubled companies, this is a challenging time. Do you sell shares now and absorb your loss? Or, do you hope that the situation changes so that you can recoup some of your losses? There is no easy answer. You will have to assess your personal financial situation and that of each company. And, then make your decision.

While 2015 has been a difficult year and the early start of 2016 appears to be challenging, too, some analysts are forecasting better commodity prices in the second half of the year. For Albertans, let’s hope our situation improves soon.

I wish everyone a happy, healthy, and successful 2016!

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2015 Year End Oil Price Outlook

In late January 2015, I postulated that oil prices were near or at their bottom. I wasn’t alone, however, as even Abdalla El-Badri, the OPEC chief, thought we were near bottom, too.

Here we are coming into the close of 2015. The question remains: As oil prices hover around the $40 mark, are they near the bottom?

This past year has surprised most experts as oil prices have stayed lower, and for longer, than most expected. Looking forward to the next few months is equally challenging. Inventories remain at record high levels, Iran and Iraq will be producing more, and the geopolitical environment is challenging. While the rig count is down substantially, US production is off only modestly.

During this past year, many capital projects have been cutback or eliminated. While those capital reductions might not have an immediate impact, over time their effect will be felt. In fact, Saudi Arabia is now voicing concerns, as evidenced in a recent Financial Times article “Saudi counters ‘lower for longer’ oil mantra” (subscription required), that the industry might not be investing a sufficient amount for future growth.

A year on, as Opec ministers prepare to meet next week with oil languishing near $45 a barrel, senior Saudi officials have a different message. In recent weeks, in public forums and private briefings, they have emphasised the dangers of future supply shortages as the oil industry has slashed investment in new projects.

Prices fell further than they ever anticipated, they say, remarks that for many in the oil market imply the Opec kingpin wants the year-long oil rout to come to a close.

Saudi officials say they are not about to reverse the policy that saw them open the taps and prioritise their long-term exports over short-term financial gain. But behind closed doors they say they want prices to stabilise between $60 and $80 a barrel.

That level, they believe, would foster oil demand but not encourage too much supply growth from alternative sources — a goldilocks scenario. Market watchers say that by focusing on the future outlook the kingdom can slowly coax the price higher without abandoning its strategy.

Back in late January, I thought oil prices might touch the high $30s, but doubted that prices would stay there for an extended period of two months or longer. While I am still of that view, I had expected that prices would have shown more strength by now.

I will be watching for any developments arising from the December 4 OPEC meeting and generally watching the oil environment over the coming weeks and months. Current prices are unstainable, so it is a question of when, not if, prices rebound higher.

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Wishing Trudeau Good Luck

Like most voting eligible Canadians, I voted in the recent federal election.

Unfortunately, I was not thrilled with my choices, neither in terms of federal parties nor in terms of local candidates. I agonized over my choices considering the parties’ different platforms, with each of their strengths and weaknesses. Ultimately, my decision was based upon my perception of the “lesser of the evils.”

Canadians provided Justin Trudeau and his fellow Liberals with a majority government. The general consensus is that Canadians wanted change. The conservatives ran a negative or divisive campaign, whereas the liberals ran an upbeat, positive, sunny campaign. Trudeau also performed well throughout, seemingly gathering momentum with each passing day. The long campaign certainly worked to his advantage.

I am pleased to see that Alberta elected a few Liberal seats, which should provide Alberta with at least one cabinet post. And, many of the constituencies ran a very close race. Perhaps this latest change signals an end to Alberta’s tendency to vote for just one party. Having some diversity is good, because that suggests Alberta will always have a voice in cabinet, regardless of which party wins.

Now that Trudeau has been elected as our Prime Minister, I wish him good luck in governing. I hope he is able to effect the positive changes that he imagined. And, where it makes sense to modify or amend his plans, I hope he is open to altering his course. Canadians have impossibly high expectations of our new government. After a few months, however, we will all have a better sense of the new direction. Although he faces many challenges, I am sure Trudeau is excited by his opportunities.

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Shale Boom, Shale Bust: The Myth of Saudi America

Having read his earlier book, Oil’s Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy, in 2011, I highly recommend Dan Dicker’s latest book, Shale Boom, Shale Bust: The Myth of Saudi America.

Up until the latter part of 2014, the American shale oil boom seemed to promise that North America would become energy self-sufficient. However, just as we began to prepare to welcome 2015, OPEC began to increase its production thus lowering the price of crude oil, in order to regain its historical market share. This change posed a significant threat to the US shale oil industry. Dicker’s book walks us through the shale oil story.

The first chapter, “Saudi America,” provides the foundation for the shale oil story. It begins with US Energy Information Administration graphs depicting expected shale gas and oil production. Then, a broader picture is developed showing a cost curve for various sources of oil found across the globe. Because shale oil is more expensive to produce than conventional OPEC oil, the United States can never live up to the hype of Saudi America.

The next chapter, “Shale Oil Is a Ponzi Scheme,” begins with a discussion of shale oil decline rates. Shale oil production declines rapidly, with more than half of an entire well’s production occurring within the first two years. The first six months of a well are the most prolific. Thus, shale oil is much like a Ponzi scheme in that more wells need to be drilled simply to stay ahead of the massive declines in production.

The third chapter, “Shale Scalability and Results,” discusses the economics of oil shale. With its lower upfront costs and fast quick production profiles, shale oil drilling will be quick to react to changes in oil prices. When prices are sufficient, activity is brisk with economic shale oil production. When prices are low, the converse is true. Coming into 2015, some of the shale oil players were hedged. That hedge allowed them to continue throughout 2015 without the full burden of lower oil prices. As shale oil producers work their way through 2015 and much of their hedges, they will collide head-on with declining production and lower prices.

The next chapter, “The U.S. Export Ban on Oil,” provides a historical background about why oil exports were initially banned and why, in Dicker’s view, they should continue to remain banned. A key underpinning argument is that shale oil is a limited resource.

The fifth chapter, “The Collapse of 2014 Oil,” discusses the reasons why oil prices tanked. Dicker identifies the following five reasons, listed in no particular order of importance:

  1. The rising strength of the US dollar;
  2. The defensive market share posture of Saudi Arabia within OPEC;
  3. The increasing production of US shale oil and resultant global “oil glut”;
  4. The continuing malaise of China and European economies; and
  5. The demise of US investment banks’ commitment to oil marketing—the hiatus of the endless bid.

Each is described in further depth.

The sixth chapter is a continuation of the earlier chapter. Each of the five factors is explored and analyzed for its effect. I found the fifth reason along with the effects especially interesting because I had neglected to consider it prior to reading this book.

“Three Phases to Shale Bust” is the next chapter. The chapter begins by discussing how oil prices can move to extremes, both on the upside and downside. Next, “Phase 1: Living Through the Oil Price Crash,” covered the period starting from early 2015. “Phase II: The Capital Chase: Cutting Jobs, Raising,” discussed the industry’s reaction to low oil prices. Last, “Phase III: Consolidation of Asset Ownership,” which is close to where the industry is now as I write this review, outlined expected developments as many companies face the inevitable cash crunch.

The old saw is that the cure to low prices is low prices and the cure to high prices is high prices. With the cure of low prices forcing consolidation, the seeds for the next oil boom have been sown. “The Next Boom” discusses the onset of the recovery. This eighth chapter discusses the expected global oil demand that exceeds the existing base production. That then leads to capital expenditures to increase production to meet future demand. Dicker outlines some key assumptions that support his position.

After the eighth chapter, Dicker presents “Conclusions,” where he states the “…United States is not one step closer to finding a unified energy policy that works, and the U.S.—despite its tremendous success with shale—is going to end up without the energy independence from foreign oil it craves. In my opinion, Washington and particularly the President are to blame for this.” He then goes on to provide more detail and some ideas for policy considerations.

His final chapter, “Addendum: Boom Bust Investing,” covers three key topics for investors who want to capitalize on the changes in the shale industry. “Investing in Exploration and Production ‘Survivors’” is as the title suggests: Invest in those companies that will survive. In his book, Dicker mentions specific companies for consideration. Next, “Investing in Pipeline Companies” is covered. And last, “Investing in the Cash-Rich and Opportunistic” discusses investing in those companies that are to take advantage of this downturn.

Again, I highly recommend Dicker’s book. Through his years of experience of being an oil trader and investor, he will provide you with thought-provoking material.

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