|
What a difference a year makes.
While March lions and April showers were at work in 2008, so were
these factors in the U.S.
and global economies:
l The Dow Jones Industrial
Average remained steady above 12,000.
l The leading indicator of
existing home sales was down over 21% from the previous year, and the
official unemployment rate was just beginning its upward creep by crossing
the 5% mark.
l The first official
admissions of the “R” word. In early April 2008, the International
Monetary Fund (IMF) declared a 25% chance of a global recession, and Federal
Reserve Chairman Ben Bernanke told Congress that gross domestic product
“could even contract slightly.”
l The novelty of bailouts
began. Bernanke also assured Congress that the Fed's emergency authorization
of a loan against $29 billion of Bear Stearns assets wasn't putting taxpayer
money at risk: “I feel reasonably confident that we'll be able to
recover all the principal and indeed some interest, and there is some chance
of even upside beyond that.”
l The dollar's six-year
slide against the euro, hitting its lowest ever at $1.60 in late April. It
also fell below the 7-yuan mark in China for the first time.
l And oil, comfortably
above $100/barrel, was heading for its summer crest of $147.
A scant 12 months later, the Dow is trying to
stagger back from a plunge to 6,500. Home sales are hinting a possible
turnaround, unemployment (even the official, conservative figures) is
expected to reach double digits before long, “recession” and
“bailout” are household words (often accompanied by four-letter
ones), the dollar is recovering... and a barrel of oil is worth half that
hundred dollars. Hardly worth pulling out of the ground.
What happened? And even more important for us
as investors, what's going to happen?
The Casey Energy Opportunities team pulled together
the pieces of the oil sector picture that other sources tend to scatter or
ignore. We’ll give you a broader understanding of the drivers within
the oil industry, the markets in which they operate, and how you can use that
knowledge to push your profits upward.
The Oil Industry Now: A Rock, a Hard Place,
and a Supply Glut That Isn't
Everyone who drives a car or heats a home with petroleum has welcomed
the fall in oil prices from their high in the summer of 2008.
While it's hard to argue that filling your
tank at $2 per gallon is a lot easier on the wallet than $4 or $5 per gallon,
the broader economic effects of such low oil prices are troubling.
Leading the concerns is the drop in oil exploration and drilling that
accompany a drop in price. Below the $50/barrel mark – and for many
companies the bar is closer to $65 even for conventional fields – oil
producers typically spend more money getting oil out of the ground than they
can recoup by selling it. At the same time, turbulent financial markets have
tightened credit. These two factors have pressured producers to allocate
exploration budgets away from drilling projects and toward meeting debt
obligations and day-to-day operating costs instead.
The plunge in prices has consumed the cash buffers of even the major
oil companies. ConocoPhillips, for example, announced in January that along
with eliminating 1,300 jobs and writing down $34 billion in assets, it was
also planning to cut its 2009 investment budget by 18%. Exploration projects
are part of both writedowns and spending cuts. The results of curtailed
exploration are two-fold. First, some oil companies will be simply unable to
survive the economic crisis. Second, supply in the longer term is being
sacrificed to stay afloat now.
Storage facilities are bulging. The chart below shows the contents of
the Cushing, OK, storage facility — where NYMEX deliveries take place
— have recently doubled from their average 2008 volume. Along with a
host of other facilities around the world, it got this way because of an
unusually dramatic contango at the beginning of 2009. (A contango is a kind
of market inversion, when the current [spot] price dips lower than the future
price.)
In January, the spot price of oil plummeted as low as $37/barrel,
while futures for July delivery were trading for $52. That meant if an oil
company could buy and store product for seven months, it could lay out
$37/barrel and be guaranteed a profit of $15 – or 40%, minus costs
– in July. And indeed the buying frenzy took off, reinforcing the
decision to turn off the drills.
So for the moment, we are artificially flush with oil, and demand has
dropped as the global economy will likely shrink for the first time since
World War II. It’s no surprise that oil prices have been staying down.
Many analysts say we won't feel the effects of declining exploration
for a few years. But the numbers are emerging already. According to the U.S.
Energy Information Administration (EIA), non-OPEC countries demonstrated an
average annual growth in supply of 570,000 barrels/day from 2000 through 2007. In contrast, they
recorded a drop last year of some
300,000 barrels/day.
At the same time, OPEC appears to be conforming to its production cuts
of 4.2 million barrels/day, begun in September 2008. The oil cartel is known
to announce cuts that its members don't actually follow; it's in their
economic best interest, if only in the short term, to sell all they can. But
this time, oil has plunged far below levels to sustain their economies. Even Saudi Arabia
expects to run a budget deficit this year.
OPEC, which produces about 40% of the world's oil, would like to see
prices around $75/barrel, at least. But the fragile global economy would have
a difficult time absorbing such a price at the moment, and the cartel decided
against further production cuts when it met in March. In fact, some three
weeks later, Saudi Arabia
actually announced a price cut on all its grades of crude to European, North
American, and Mediterranean markets –
a dramatic attempt to spur demand amidst high inventories.
So, entwined as it is with the economy, the oil industry is currently
in a conundrum. The fix it requires – higher prices for its product
– will choke the framework in which it operates.
At the same time, we've got supply problems ahead.
How Did We Get Here Anyway?
Like many aspects of the markets, movements in price are driven partly
by real factors and partly by perception. Rags-to-riches-to-rags-to-riches Texas oilwoman Sue
Sanders summed it up when she noted wryly in her 1940 autobiography that
“nothing succeeds like reports of success.”
Last year's run-up of oil was no exception: part real, part report. Some of the real
factors:
l The weak U.S. dollar. The United
States is not the only country that buys
oil in U.S. dollars. The price per barrel is pegged to it, in fact. When the
dollar is weak, the cost of U.S.
exports drops; and indeed by December 2008, the U.S. trade deficit had fallen to
its lowest in nearly six years ($39.9 billion, according to U.S. Commerce
Department data). However, a weak dollar means it takes more dollars to buy a
barrel of oil. Global concerns over the strength of the U.S. economy, including America's
ever-rising level of debt, had undermined the dollar to the point that OPEC
members began to murmur about dumping it for the euro or a basket of
currencies.
l Geopolitical turbulence in oil-producing countries. The Iraq war, oil-related militancy in Nigeria, and
Iran-Israel-U.S. posturing over nuclear issues were hotspots in the first
half of 2008. The average nightly news covered casualties in Iraq, but
industry watchers tracked attacks on pipelines and oil facilities. Likewise,
in Nigeria,
sabotage and oil worker kidnappings by militant groups such as the Movement
for the Emancipation of the Niger Delta (MEND) regularly shut down facilities
to repair, negotiate, or improve security. And as spring warmed up, so did
the war of words between Iran
and Israel.
By early July, Iran had
gone so far to indicate it would move against shipping in the Persian Gulf if attacked. The United States would have moved next, of
course... thus driving up the price of oil in the jittery oil markets, which
depend on Persian Gulf shipping lanes.
l Unusually low crude and gasoline supplies entering the 2008 summer
driving season. In early April, the EIA reported significant drops in supply –
gasoline declined by 4.53 million barrels and crude oil by 3.2 million
barrels, a one-two blow that surprised and worried industry watchers. Behind
the gasoline slump were lower refinery margins, called crack spreads. In
mid-March, when refineries would normally be coming off their maintenance
schedules to churn out gasoline for summer driving, the margin for turning a
barrel of crude into gasoline was negative for the first time in three years.
Refineries sought profits in other oil products, and the markets responded to
the expected imbalance in supply and demand.
l High demand. China
is a stand-out here, and for more than its usual energy appetite. China has a
penchant for aiming to break records – from its goals in five-year
plans and building projects to its haul of Olympic medals – and in the
first half of 2008, it was visited by some dramatic examples: a great
earthquake and major snowstorms, events that disrupted the country’s
energy industry. Combine that with the fact that China was also preparing for the
Beijing Olympics in August, and it’s easy to understand why it was
buying oil very heavily until mid-summer.
On the perception side of price drivers, it's hard to overlook the fact
that the market push stayed strong in the face of increasingly gloomy
economic data. Casey Research was earlier than most in predicting the
economic crash (we published reports such as “The Coming Currency
Crisis” in June 2006), but by spring 2008, even officialdom was dancing
around the word recession.
Normally, news of burgeoning foreclosures, plummeting home sales,
spiking personal and business bankruptcies, rising unemployment, and other
economic indicators would tend to exert a bearish influence. After all,
consumers generate 70% of U.S.
economic activity, and if they stop or cut back on driving to work or the
shopping mall, telephone relatives or business partners instead of flying out
to see them, reduce purchases of items containing plastics, turn down the
thermostat, and other weather-the-storm measures, oil consumption should
decline.
It took months for all these drivers to realign – but as we all
know, they did, and then some. The chicken-and-egg debate, whether oil's sky
shot triggered or portended the economic debacle in the closing months of
2008, will require more distance and data to resolve. But it's true that the
dollar had started its comeback by mid-summer, supply had caught up,
geopolitics had settled a bit, China backed off on its buying,
no major hurricanes hit – but economic realities did.
Meanwhile, Congress jumped up and down and cried
“Speculators!” “OPEC!” “Oil producers!”
in tidy sound bites.
The Next Big Plays: Where You Need to Be
Oil companies are influenced by the range of market drivers and
economic conditions according to size. The junior oil producers, those with
market capitalizations of $250 million or less, have the small-business
advantage of flexibility when times are good. These times aren't good, of
course, and even well-managed juniors with good projects are in trouble.
Their vulnerability is in the credit market. You’ve likely heard of
credit lines being revoked and refinancings denied to people with impeccable
credit. Now imagine pitching a drill project without a wallet full of assets
ready to lay on the table.
Mid-tier producers, with market caps between $250 million to $2
billion, will look to mergers and acquisitions to survive. The majors ($2-20
billion market cap) and Big Oil (over $20 billion) will also be shopping.
With low oil prices shutting down exploration, development, and even
production, these companies will be looking to replace their reserves instead
by purchasing smaller, solid companies with proven production. It's simply
cheaper.
We see two ways to profit
from this trend.
First, we buy shares in
undervalued, producing companies that are profitable even below $40/barrel,
are best of peer, and own large reserves. These are the companies that Big
Oil will be looking to acquire. One such company, an oil sands producer,
is currently a part of the Casey Energy Opportunities portfolio.
Second, we believe that owning a potential
consolidator is the best position. As debt load and low commodity prices
overtake them, junior producers will be forced to consolidate their projects.
We currently own one such candidate, and are scouting for others with such muscle.
Consolidators will be purchasing projects from the bank at 25 to 30 cents on
the dollar.
Our tactics have already paid off handsomely
in the last six months: all our recent recommendations have been on fire. A
few tripled their value, and one generated a return of 540%.
As we’ve seen, supply problems are
looming, no matter what timetable of Peak Oil you may believe in. With
increased demand inevitably come higher prices. Our approach at Casey Energy
Opportunities positions us to take advantage of the trend in both the short
and longer term. And we guide our subscribers not only when to buy or sell,
but also when to take profits and a “Casey Free Ride” to
eliminate risk.
We’d like to offer you the
opportunity to kick the tires of Casey Energy Opportunities RISK-FREE for 90
days, with 100% money-back guarantee. Click here to give it a try.
Marin Katusa
Casey Energy Opportunities
All
articles by Marin Katusa
Also Marin Katusa
Marin Katusa is the
Senior Editor of Casey Energy Opportunities
| 
