Observations on Oil

The plummeting price of oil has been much in the news of late. And no wonder. Over the last six months, the price of oil has fallen from over $60 into the middle $30’s.

And that level may not hold. In fact, $20 a barrel oil is now a very real possibility. In inflation-adjusted terms, that is the same price that oil traded for in 1947.

The idea of oil falling that far and even staying there for some period of time may trigger a bout of disbelief, even incredulity, among many dear readers. But that is only because we are humans. And humans tend to get fixed in certain beliefs and ideas.

I well recall when in my early twenties I tapped my grandfather for a loan to buy a car, mine having been stolen from the mean streets of LAX without the benefit of insurance, just the sort of lack of attention expected from one in their early twenties.

Always a most agreeable fellow -- in fact my favorite relative of all times -- my grandfather quickly piped up and with a pat on the back said, “Sure, I’ll give you $300. That should buy you a doozy!”.

In actual fact, what $300 bought me was a sputtering, gas guzzling, smoke spewing beater that somehow managed to make it home and even live a year before shedding its mortal coil.

But it was all a matter of perspective and in his perspective, formed when flappers were all the rage, a good car was to be had for $300.

In the modern experience, we are accustomed to oil prices remaining persistently high for years on end. In my mind, gasoline in the U.S. still costs about $4.00 a gallon.

(Thanks to the recently departed and deeply flawed outgoing government here in the Argentine outback where we live most of the year, it still runs about that).

In actual fact, the average cost of a gallon of gas back in the United States now hovers around $2.00.

While no one can ever be completely sure about these things, I strongly suspect it’s going lower.

WHY?

The answer is multi-dimensional, but the largest culprits are, in no particular order:

  • The shale drillers. A hearty bunch with a serious inclination to shake things up, they have met falling prices with ever more ingenuous methods of squeezing liquid energy out of rock previously thought to be unproductive. In the process, they accomplished the long anticipated energy self-sufficiency.

  • The Saudis and their un-indicted co-conspirators in OPEC. Concerned about the shale revolution, some sheik with his turban tied a bit too tight reckoned that by continuing to flood the market with cheap oil even as global oil production rose, they could chase the shale folks out of Dodge. They reckoned wrong.

  • Bogey men lurking in the wings. And by that I mean the lifting of sanctions on Iranian oil in early 2016 and, once the rest of the civilized world completes turning the ISIS strongholds in Iraq into the proverbial (and maybe, actual) parking lot – the return of Iraqi to full production as well. Toss into this mix Russia under Putin, which has also had the pedal to the metal on oil production, and voila, you have an oversupply of epic proportions.

The long and short of it can be seen in this chart from the always excellent Energy Matters blog.

Cutting right to the chase, not my strong suit, the world has never produced more oil. As in, well, never.

In fact, we are pretty much awash in the stuff.

The Conclusion?

Any contrarian worth the label will be tempted to hop into some of today’s massively oversold energy plays. In fact, these very same plays have fallen to the point where even the eyebrows of the most ardent deep value investors are beginning to twitch. Make no mistake, many of these are profitable companies with real assets selling for a fraction of book value.

However, speaking with some recent personal experience in the matter, should you feel the urge to bottom fish, you may wish to instead bang your head against the nearest wall.

It will be a lot less painful.

There is, of course, good news to be gleaned from oil’s mad descent.

  • For the short-sellers among you, shorting the big energy companies can make a lot of sense. Exxon (XOM) seems to me a likely candidate as (a) it is still selling for almost two times book and, (b) it is heavily owned by institutions and (c) it’s year over year quarterly revenue growth is off by 47%. Should XOM cut its handsome 3.80% dividend and/or the energy outlook expressed here become more widely accepted, a mass rush for the exits could soon ensue. That said, a friend who knows about these things tells me they are a bit oversold, so one might want to wait for a bit of a rally before piling on.

  • Lower energy prices are a net positive for the economy. For those of you expecting a crash in the U.S. stock market, don’t bet the farm on it. A 2014 study from UBS suggests that a sustained drop of $10 per barrel of oil will add 0.1% gain in GDP for the U.S. and 0.2% GDP growth globally.

    In addition, there is an increasing likelihood the Fed will raise rates shortly, albeit only a small amount and probably just once for the foreseeable future. That will dissolve some of the constant uncertainty market participants so detest, giving rise to the potential for a big rally.

  • The price of gasoline is cheap and will get cheaper… so hitting the trail in your cozy SUV will be a lot less expensive. At this rate, we may even see the return of the Humvee.

So, that’s a quick overview of the situation. Lots of chaos and change in the oil patch and, if you play it right, maybe even some profits.

Until next time...

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