Global Market Comments
April 13, 2018
Fiat Lux
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The first thing I do when I get up every morning is to curse the oil companies as blood sucking scourges of modern civilization.
I then fall down on my knees and thank God that we have the oil companies.
This is why petroleum engineers are getting $100,000 straight out of college, while English and political science major are going straight on to food stamps.
I recommend (XOM) and other oil majors as part of any long-term portfolio. In my lifetime, the price of oil has gone up from $3 a barrel up to $149.
The reasons for the ascent keep growing, from the entry of China into the global trading system, to the rapid growth of the middle class in emerging nations.? They?re just not making the stuff anymore, and we can?t wait around for more dinosaurs to get squashed.
Big oil companies aren?t in the oil speculation business. As soon as a new supply comes on stream, they hedge off their risk through the futures markets or through long-term supply contracts. You can find the prices they hedge at in the back of any annual report.
This is why the oil crash barely caused the shares of oil majors to move. Exxon Mobil (XOM) shares are now down only 15%, while its principal product is off by an astounding 80% from its 2011 top.
When oil made its big run to $149 a few years ago, I discovered to my amazement that (XOM) had already sold most of their supplies in the $20 range. However, oil companies do make huge killings on what is already in the pipeline.
Working in the oil patch 15 years ago pioneering the ?fracking? process for natural gas, I got to know many people in the industry. I found them to be insular, God fearing people not afraid of hard work.
Perhaps this is because the black gold they are pursuing can blow up and kill them at any time. They are also great with numbers, which is why the oil majors are the best-managed companies in the world.
They are also huge gamblers. I swallow hard when I see the way these guys throw around billions in capital, keeping in mind past disasters, like Dome Petroleum, the Alaskan Pipeline oil spill, Piper Alpha, and more recently, the ill-fated Macondo well in the Gulf of Mexico.
But one failure does not slow them down an iota. The ?wildcatting? origins made this a faith-based industry from day one, when praying and dousing wands were the principal determinants of where wells were sunk.
Unfortunately, the oil companies are too good at their job of supplying us with a steady and reliable source of energy. They have one of the oldest and most powerful lobbies in Washington, and as a result, the tax code is riddled with favorite treatment of the oil industry.
While Social Security and Medicare are on the chopping block, the industry basks in the glow of $53 billion a year in tax subsidies.
When I first got into the oil business and sat down with a Houston CPA, the tax breaks were so legion that I couldn?t understand why anyone was not in the oil racket.
Ever wonder why we have had three presidents from Texas over the last 50 years, and are possibly looking at a fourth (Jeb Bush, Rick Perry)?
Three words explain it all: the oil depletion allowance, whereby investors can write off the entire cost of a new well in the first year, while the income is spread over the life of the well.
This also explains why deep-water exploration in the Gulf is far less regulated than California hairdressers.
No surprise then that the industry has emerged in the cross hairs of several presidential candidates, under the ?loopholes? category. Not only do the country?s most profitable companies pay almost nothing in taxes, they are one of the largest users of private jets.
It is an old Washington nostrum that when things start heading south on the domestic front, you beat up the oil companies. It?s the industry that everyone loves to hate.
Cut off the gasoline supply to an environmentalist, and he will be the one who screams the loudest. This has generated recurring cycles of accusatory congressional investigations, windfall profits taxes, and punitive regulations, the most recent flavor we are now seeing.
But imagine what the world would look like if Exxon and its cohorts were German, Saudi, or heaven forbid, Chinese. I bet we wouldn?t have as much oil as we do today, and it wouldn?t be as cheap.
Hate them if you will, but at least these are our oil companies. Try jamming a lump of coal into the gas tank of your Prius and tell me how far you go.
Well, that?s enough ranting for today.
Love Them, Hate Them or Both?
There are very few people I will drop everything to listen to.
One of the handful is Daniel Yergin, the bookish founder and CEO of Cambridge Energy Research Associates, the must-go-to source for all things energy.
Daniel received a Pulitzer Prize for The Prize: The Epic Quest for Oil, Money, and Power, a rare feat for a non-fiction book (I?ve never been able to get one).
Suffice it to say that every professional in the oil industry, and not a few hedge fund traders, have devoured this riveting book and based their investment decisions upon it.
Yergin thinks that the fracking and horizontal drilling revolutions have made the United States the new swing producer of oil. There is so much money in the investment pipeline that American oil production will continue to increase for the next six months, by some 500,000 barrels a day.
Much of this oil is coming from heavily leveraged, thinly capitalized producers whose bankers won?t let them cut back a drop on production so they can maintain interest payments on their debt.
This new supply will run head on into the seasonal drop in demand for energy, when spring ritually reduces heating bills, but the need for air-conditioning has not yet kicked in.
The net net could be a further drop in the price for Texas tea from the present $31 a barrel, possibly a dramatic one into the teens.
Yergin isn?t predicting any specific oil price as a potential floor, as it is an impossible task. While OPEC was a monolithic cartel, the US fracking industry is made up of thousands of mom and pop operators, and no one knows what anyone else is doing.
However, he is willing to bet that the price of oil will be higher in a year.
Currently, the 96 million barrel global market for oil is oversupplied with 2 million barrels a day.
If the International Monetary Fund is right, and the world adds 3.0% in economic growth this year, we will soak up 1 million b/d of that with new demand.
In the end, the oil price collapse is a self-solving problem. The new economic growth engendered by ultra low fuel prices eventually drives prices higher.
Where we reach the tipping point, and the oil market comes back into balance, is anyone?s guess. But when it does, prices will go substantially higher. The cure for low prices is low prices.
This is why I listed energy as the top performing asset class this year (click here for my ?2016 Annual Asset Class Review? by clicking here.
The bottom line is that there will be a great time to buy oil companies, but it is not yet.
What we are witnessing now is the worst energy crash since the 1980?s, when new supplies from the North Sea, Mexico and Alaska all hit at the same time.
I remember the last time oil plunged to $8 a barrel, because Morgan Stanley then set up a private partnership that bought commercial real estate in Houston for ten cents on the dollar. The eventual return on this fund was over 1,000%.
This time it is more complicated. Prices lived over $100 for so long that it sucked in an unprecedented amount of capital into new drilling, some $100 billion worth.
As a result, sources were brought online from parts of the world as diverse as Russia, the Arctic, Central Asia, Africa, the Canadian tar sands and remote and very expensive offshore platforms.
Yergin believes that Saudi Arabia can survive for three years with prices at current levels. After that, it will burn through its $150 billion of foreign exchange reserves, and could face a crisis.
Clearly, the Kingdom is betting that prices will recover with its market share based strategy before then. They are playing for the long haul.
The transition of power to the new King Salman was engineered by a committee of senior family members, and has been very orderly.
However, King Salman, a Sunni, will have his hands full. The current takeover of Yemen by a hostile Shiite minority, the Houthis, is a major concern. Yemen shares a 1,100 mile border with Saudi Arabia.
Daniel says that a year ago, there was a lot of geopolitical risk priced into oil, with multiple crises in the Ukraine, Syria, Libya and Iraq frightening consumers, so trading levitated over $100 for years. Delta Airlines, Inc. (DAL) even went to the length of buying its own refiner to keep fuel prices from rising further.
US oil producers have a unique advantage over competitors in that they can cut costs faster than any other competitors in the world. On the other hand, they are eventually going head to head against the Saudis, whose average cost of production is a mere $5/barrel.
A native of my own hometown of Los Angeles, Yergin started his professional career as a lecturer at Harvard University. He founded Cambridge Energy in 1982 with a $7.00 investment in a file cabinet at the Good Will. He later sold Cambridge Energy to the consulting group IHS Inc. for a small fortune.
To buy The Prize at discount Amazon pricing, please click here.
I had a fascinating dinner last week at Morton?s, San Francisco?s best steak restaurant, with one of John Hamm?s original investors.
You remember John, the legendary Texas oilman who saw fracking coming a mile off and made billions?
Since some of what my friend had to say came true in a matter of days, I thought I?d pass on the essence of our conversation.
The oil storage facility at Cushing, Oklahoma is full, at 480 million barrels. The US Strategic Petroleum Reserve has been full for a long time, with 713 million barrels (36 days of US consumption).
Contangos are exploding. It might as well be the end of the world for the oil industry.
The oil Armageddon is here, and the final flush is upon us.
There is a 50% chance we will bottom at $32/barrel, and another 50% chance that we go all the way down to $20. If we go down to $20, the last three ticks of the move will be $22?.$20?.$22. Then a saw tooth bottom will unfold between $24 and $32 which will last for several months.
There will be many chances to buy this bottom. There isn?t going to be a ?V? shaped bottom in oil this time, like we saw in past energy crashes.
The margin clerks and risk control managers are in control now, so we may see the final low sooner than you think. But it could be some time before we break $40 again to the upside and hold it.
The industry was really drinking the Kool-Aid with both hands to get it this wrong. Ultra low interest rates drove in billions in capital from first time oil investors looking to beat zero interest rates. They also saw China continuing an endless economic boom forever, and the energy demand that went with it.
In the end, they got both the supply and demand sides of the equation completely wrong on a global scale, always a recipe for disaster.
Many of the fields drilled in places like North Dakota would never have been touched during normal times. Then Saudi Arabia came out of left field with a grab for global market share that has yet to play out.
The seeds of this recovery are already evident. Chinese auto sales are up 19% YOY. China is buying all the cheap oil it can to fill up its own strategic oil reserve. Miles driven in the US are already up 4.6% YOY, which is a huge gain.
All of this will contribute to a higher US GDP in 2016.
Once we put in a final bottom in oil, don?t expect $100 a barrel any time soon. The ma and pa investor in the oil patch will not be back in this generation.
Marginal sources, like high cost Canadian tar sands, deep offshore, and some in North Dakota aren?t coming back either. These supplies needed $100/barrel just to break even.
Personally, my friend does not see oil topping $80/barrel this decade. He see?s a $62-$80 trading range persisting for a long time.
As the US has become more energy independent, the geopolitical factors have mattered less and less. That is why oil moved only $1 on an ISIS victory, the Paris attacks, or some other disaster.
To call the bottom in oil, watch the shares of ExxonMobil (XOM), Conoco Phillips (COP), and Occidental Petroleum (OXY). When they revisit their August lows, down 5%-10% down from here, that will be a great time to jump back into the oil space.
None of these companies are going under, and the dividend payouts are now enormous, (XOM) at (3.7%), (COP) at (5.8%), and (OXY) at (4.2%).
Distressed debt is where the smart money is focusing now, where double-digit returns have become common. If the issuer goes bankrupt the equity owners get wiped out while the bondholders get the company for pennies on the dollar.
Energy companies and master limited partnerships (MLP?s) have far and away been the biggest borrowers in the high yield market in recent years.
There is a junk maturity cliff looming, with $145 billion in bonds due for refinancing from 2017-2021. Expect the default ratio to rocket from this year?s 2.8% to 25%. A 12% default rate is a normal peak in a recession.
Individual company research now has a bigger payoff than in any time in history, even the 2008-09 crash.
Small leveraged companies with exposure to the price of oil are toast.
The play is for the toll takers, master limited partnerships that profit from the volume of oil pumped, and not the price of oil. Over time, volumes will increase, and so will the profits at these MLP?s.
In the meantime, everything is getting thrown out with the bathwater, regardless of fundamentals. People just don?t want to be near the space, especially going into yearend book closing.
Nobody wants to be seen as the idiot who owned oil in 2015.
Linn Energy (LINE) is a perfect example of this. It suspended its dividend so it could buy more assets on the cheap. It has plenty of cash, and will be backstopped by Blackrock with additional credit lines, if necessary.
While this raises volatility for the short term, it increases returns over the long term. It?s definitely your ?E? ticket ride.
I pointed out that President Obama did the oil industry the biggest favor in history by dragging his feet on the Keystone Pipeline, and then ultimately killing it. It prevented US consumers from loading the boat with $100/barrel tar sands crude at the top of the market.
My friend conceded that it is unlikely the pipeline would ever be built. The market has moved away.
I have accumulated a variety of odd tastes in my half-century of traveling around the world.
So when I heard we were eating at Morton?s, I brought my own jar of Coleman?s hot English mustard. It makes a medium rare cooked filet mignon taste perfect, but my action always puzzles the waiters. They never have it.
John Hamm gained public notoriety last year when he wrote a $974 million divorce settlement check to is ex wife and she refused to cash the check. I asked if the check ever got cashed?
?She cashed the check,? he said.
Needless to say, my friend picked up the check for the dinner as well. I let him drive my Tesla Model S-1 back to his hotel.
While driving back from Lake Tahoe last weekend, I received a call from a dear friend who was in a very foul mood. He had bailed on all his equity holdings at the end of last year, fully expecting a market crash in the New Year.
Despite market volatility doubling, multinationals getting crushed by the weak euro and the Federal Reserve now signaling its first interest rate rise in a decade, here we are with the major stock indexes sitting at all time highs.
Why the hell are stocks still going up?
I paused for a moment as a kid driving a souped up Honda weaved into my lane of Interstate 80, cutting me off. Then I gave him my response, which I summarize below:
1) There is nothing else to buy. Complain all you want, but US equities are now one of the world?s highest yielding securities, with a lofty 2% dividend. That compares to one third of European debt offering negative rates and US Treasuries at 1.90%.
2) Oil prices have yet to bottom and the windfall cost savings are only just being felt around the world.
3) While the weak euro is definitely eating into large multinational earnings, we are probably approaching the end of the move. The cure for a weak euro is a weak euro. The worst may be behind for US exporters.
4) What follows a collapse in European economic growth? A European recovery, powered by a weak currency. This is why China has been on fire, which exports more to Europe than anywhere else.
5) What follows a Japanese economic collapse? A recovery there too, as hyper accelerating QE feeds into the main economy. Japanese stocks are now among the worlds cheapest. This is why the Nikkei Average hit a new 15-year high over the weekend, giving me yet another winning Trade Alert.
6) While the next move in interest rates will certainly be up, it is not going to move the needle on corporate P&L?s for a long time. We might see a ?% hike and then done, and that probably won?t happen until 2016. In a deflationary world, there is no room for more. At least, that?s what Janet tells me.
This will make absolutely no difference to the large number of corporates, like Apple (AAPL), that don?t borrow at all.
7) Technology everywhere is accelerating at an immeasurable pace, causing profits to do likewise. You see this in biotech, where blockbuster new drugs are being announced almost weekly.
See the new Alzheimer?s cure announced last week? It involves extracting the cells from the brains of alert 95 year olds, cloning them and then injecting them into early stage Alzheimer?s patients. The success rate has been 70%. That one alone could be worth $5 billion.
8) US companies are still massive buyers of their own stock, over $170 billion worth in 2014. This has created a free put option for investors for the most aggressive companies, like Apple (AAPL), IBM (IBM), Exxon (XOM), Wells Fargo (WFC), and Intel (INTC), the top five repurchasers. They have nothing else to buy either.
They are jacking up dividend payouts at a frenetic pace as well and are expected to return more than $430 billion in payouts this year (see chart below).
9) Oil will bottom in the coming quarter, if it hasn?t done so already. This will make the entire energy sector the ?BUY? of the century, dragging the indexes up as well. Have you noticed that Conoco Phillips (COP), Warren Buffets favorite oil company, now sports a stunning 4.70% dividend?
10) Ditto for the banks, which were dragged down by falling interest for most of 2015. Reverse that trade this year, and you have another major impetus to drive stock indexes higher.
My friend was somewhat set back, dazzled, and non-plussed by my long-term overt bullishness. He asked me if I could think on anything that might trigger a new bear market, or at least a major correction.
I told him to forget anything international. There is no foreign development that could damage the US economy in any meaningful way. No one cares.
On he other hand, I could think of a lot of possible scenarios that could be hugely beneficial for US stocks, like a peace deal with Iran, which would chop oil prices by another half.
The traditional causes of recessions, oil price and interest rate spikes, are nowhere on the horizon. In fact, the prices for these two commodities, energy and money, are headed lower and not higher, another deflationary symptom.
Then something occurred to me. Share prices have been going up for too long and need some kind of rest, weeks or possibly months. At a 17 multiple American stocks are not the bargain they were 6 years ago when they sold for 10X earnings. Those were the only thing I could think of.
But then those are the arguments for shifting money out of the US and into Europe, Japan, and China, which is what the entire world seems to be doing right now.
I have joined them as well, which is why my Trade Alert followers are long the Wisdom Tree Japan Hedged Equity ETF (DXJ) (click here for ?The Bull Case for Japanese Stocks?).
With that, I told my friend I had to hang up, as another kid driving a souped up Shelby Cobra GT 500, obviously stolen, was weaving back an forth in front of me requiring my attention.
Whatever happened to driver?s ed?
For the last few months, I have leapt off my biweekly global strategy webinars to check the weekly crude inventories announced minutes before. This week?s figures absolutely blew me away.
The American Petroleum Institute reported that crude stocks rose a staggering 14.3 million barrels over the past week. This is the biggest weekly build that I can remember after covering the industry for 45 years.
This comes on the heels of a breathtaking build of 6.1 million barrels the previous week.
Will someone please text me when the numbers come out during my next webinar? I hate being in the dark, even when it is just for 20 minutes.
Needless to say, crude prices (USO) fell like a stone, giving up 5.5% in hours. Prices are still plunging as I write this. It confirms my suspicion, voiced assiduously in the earlier webinar, that Texas tea has another run to the downside in store.
The 500,000 barrels a day of new production coming on line over the next four months make this a virtual certainty.
The implications for your investment portfolio are legion.
It means that a new leg down in the oil collapse is now unfolding. We may be in the process of taking another shot at the $43 low in January. Best case, this sets up the double bottom where you should buy the entire energy and commodity sectors. Worse case, we break to a new low in the $30?s.
Industry experts are keeping a laser like focus on the storage facilities at Cushing, Oklahoma. They are rapidly filling up, and will be full at 85 million barrels by June. Today?s numbers bring that day dramatically forward.
Once topped up, the industry could be facing a price Armageddon, and newly produced crude will have nowhere to go.
That will bring widespread capping of producing wells, which are never able to recover production when restored. This will be a terrible outcome for the producing companies and oil lease investors.
Consumers aren?t the only ones who are celebrating.
Oil traders are enjoying their best year since 2009, cashing in on the sky high volatility. Front month volatility is gyrating around the 55% levels. This compares to only 15.45% for the S&P 500.
Traders, eat your hearts out.
Big players like Glencore, Gunvor and Mercuria are cashing in with lower prices vastly offset by much greater turnover. Specialized energy hedge funds are also doing well.
The contango, whereby futures contracts for far month delivery are trading at huge premiums to front month ones, is also generating enormous trading opportunities.
The last time I checked, oil one-year out was trading at a 25% premium. This means you can buy a few hundred thousand barrels, charter a rusted out old tanker, and store it for future sale.
Ultra low interest rates to finance the position provide an additional kicker. Hedge funds with the right credit lines are pouring into the field.
OK, so you?re not set up to borrow billions, charter ships, and swing around huge amounts of crude. Nor am I, for that matter. However, the next best thing is also setting up.
When oil completes its next swan dive, there will be great opportunities in the options market.
One year dated calls on oil majors like Exxon (XOM), Conoco Phillips (COP) and Occidental Petroleum (OXY) and the oil ETF (USO) should rise tenfold in the next recovery if you are able to buy anywhere close to the bottom.
I?ll send out a Trade Alert when I see it.
I Think I See a Spot Over ThereThere are very few people I will drop everything to listen to. One of the handful is Daniel Yergin, the bookish founder and CEO of Cambridge Energy Research Associates, the must-go-to source for all things energy.
Daniel received a Pulitzer Prize for The Prize: The Epic Quest for Oil, Money, and Power, a rare feat for a non-fiction book (I?ve never been able to get one).
Suffice it to say that every professional in the oil industry, and not a few hedge fund traders, have devoured this riveting book and based their investment decisions upon it.
Yergin thinks that the fracking and horizontal drilling revolutions have made the United States the new swing producer of oil. There is so much money in the investment pipeline that American oil production will continue to increase for the next six months, by some 500,000 barrels a day.
This new supply will run head on into the seasonal drop in demand for energy, when spring ritually reduces heating bills, but the need for air-conditioning has not yet kicked in.
The net net could be a further drop in the price for Texas tea from the present $45 a barrel, possibly a dramatic one.
Yergin isn?t predicting any specific oil price as a potential floor, as it is an impossible task. While OPEC was a monolithic cartel, the US fracking industry is made up of thousands of mom and pop operators, and no one knows what anyone else is doing. However, he is willing to bet that the price of oil will be higher in a year.
Currently, the 91 million barrel global market for oil is oversupplied with 1 million barrels a day. That includes the 2 million b/d that has been lost from disruptions in Libya, Syria and Iraq.
If the International Monetary Fund is right, and the world adds 3.8% in economic growth this year, we will soak up 1.1 million b/d of that with new demand. In the end, the oil price collapse is a self-solving problem. The new economic growth engendered by ultra low fuel prices eventually drives prices higher.
Where we reach the tipping point, and the oil market comes back into balance, is anyone?s guess. But when it does, prices will go substantially higher. The cure for low prices is low prices.
The bottom line is that there will be a great time to buy oil companies, but it is not yet.
What we are witnessing now is the worst energy crash since the 1980?s, when new supplies from the North Sea, Mexico and Alaska all hit at the same time. The price of oil eventually crashed from $42 to $8.
I remember it well, because Morgan Stanley then set up a private partnership that bought commercial real estate in Houston for ten cents on the dollar. The eventual return on this fund was over 1,000%.
This time it is more complicated. Prices lived over $100 for so long that it sucked in an unprecedented amount of capital into new drilling, some $100 billion worth. As a result, sources were brought online from parts of the world as diverse as Russia, the Arctic, Central Asia, Africa, the Canadian tar sands and remote and very expensive offshore platforms.
Yergin believes that Saudi Arabia can survive for three years with prices at current levels. After that, it will burn through its $150 billion of foreign exchange reserves, and could face a crisis. Clearly, the Kingdom is betting that prices will recover with its market share based strategy before then. They are playing for the long haul.
The transition of power to the new King Salman was engineered by a committee of senior family members, and has been very orderly. However, King Salman, a Sunni, will have his hands full. The current takeover of Yemen by a hostile Shiite minority, the Houthis, is a major concern. Yemen shares a 1,100 mile border with Saudi Arabia.
Daniel says that a year ago, there was a lot of geopolitical risk priced into oil, with multiple crises in the Ukraine, Syria, Libya and Iraq frightening consumers, so trading levitated over $100 for years. Delta Airlines Inc. (DAL) even went to the length of buying its own refiner to keep fuel prices from rising further.
US oil producers have a unique advantage over competitors in that they can cut costs faster than any other competitors in the world. On the other hand, they are eventually going head to head against the Saudis, whose average cost of production is a mere $5/barrel.
A native of my own hometown of Los Angeles, Yergin started his professional career as a lecturer at Harvard University. He founded Cambridge Energy in 1982 with a $7.00 investment in a file cabinet at the Good Will. He later sold Cambridge Energy to the consulting group IHS Inc. for a small fortune.
To buy The Prize at discount Amazon pricing, please click here.
Be nice to investors on the way up, because you always meet them again on the way down. This is the harsh reality of those who have placed their money in the fracking space this year.
The hottest sector in the market for the first half of the year, investors have recently fallen on hard times, with the price of oil collapsing from a $107 high in June to under $77 this morning, a haircut of some 28% in just five months.
Prices just seem to be immune to all the good news that is thrown at them, be it ISIL, the Ukraine, or Syria.
It wasn?t supposed to be like that. Using this revolutionary new technology, drillers are in the process of ramping up US domestic oil production from 6 million to 10 million barrels a day.
The implications for the American economy have been extraordinarily positive. It has created a hiring boom in the oil patch states, which has substantially reduced blue-collar unemployment. It has added several points to US GDP growth.
It has also reduced our dependence on energy imports, from a peak of 30 quadrillion Btu?s in 2005 to only 13 quadrillion Btu?s at the end of last year. We are probably shipping in under 10 quadrillion Btu?s right now, a plunge of 66% from the top in only 9 years.
The foreign exchange markets have taken note. Falling imports means sending hundreds of billions of dollars less to hostile sellers abroad. Am I the only one who has noticed that we are funding both sides of all the Middle Eastern conflicts? The upshot has been the igniting of a huge bull market in the US dollar that will continue for decades.
That has justified the withdrawal of US military forces in this volatile part of the world, creating enormous savings in defense spending, rapidly bringing the US Federal budget into balance.
The oil boom has also provided ample fodder for the stock market, with the major indexes tripling off the 2009 bottom. Energy plays, especially those revolving around fracking infrastructure, took the lead.
Readers lapped up my recommendations in the area. Cheniere Energy (LNG) soared from $6 to $85. Linn Energy (LINE) ratcheted up from $7 to $36. Occidental Petroleum moved by leaps and bounds, from $35 to $110.
Is the party now over? Are we to dump our energy holdings in the wake of the recent calamitous falls in prices?
I think not.
One of the purposes of this letter is to assist readers in separating out the wheat from the chaff on the information front, both the kind that bombards us from the media, and the more mundane variety emailed to us by brokers.
When I see the quality of this data, I want to throw up my hands and cry. Pundits speculate that the troubles stem from Saudi Arabia?s desire to put Russia, Iran, the US fracking industry, and all alternative energy projects out of business by pummeling prices.
The only problem is that these experts have never been to Saudi Arabia, Iran, the Barnett Shale, and wouldn?t know which end of a solar panel to face towards the sun. Best case, they are guessing, worst case, they are making it up to fill up airtime. And you want to invest your life savings based on what they are telling you?
I call this bullpuckey.
I have traveled in the Middle East for 46 years. I covered the neighborhood wars for The Economist magazine during the 1970?s.
When representing Morgan Stanley in the firm?s dealings with the Saudi royal family in the 1980?s, I paused to stick my finger in the crack in the Riyadh city gate left by a spear thrown by King Abdul Aziz al Saud when he captured the city in the 1920?s, creating modern Saudi Arabia.
They only mistake I made in my Texas fracking investments is that I sold out too soon in 2005, when natural gas traded at $5 and missed the spike to $17.
So let me tell you about the price of oil.
There are a few tried and true rules about this industry. It is far bigger than you realize. It has taken 150 years to build. Nothing ever happens in a hurry. Any changes here take decades and billions of dollars to implement.
Nobody has ever controlled the market, just chipped away at the margins. Oh, and occasionally the stuff blows up and kills you.
As one time Vladimir Lenin advisor and Occidental Petroleum founder, the late Dr. Armand Hammer, once told me, ?Follow the oil. Everything springs from there.?
China is the big factor that most people are missing. Media coverage has been unremittingly negative. But their energy imports have never stopped rising, whether the economy is up, down, or going nowhere, which in any case are rigged, guessed, or manufactured. The major cities still suffer brownouts in the summer, and the government has ordered offices to limit air conditioning to a sweltering 82 degrees.
Chinese oil demand doubled to 8 million barrels a day from 2000-2010, and will double again in the current decade. This assumes that Chinese standards of living reach only a fraction of our own. Lack of critical infrastructure and storage prevents it from rising faster.
Any fall in American purchases of Middle Eastern oil are immediately offset by new sales to Asia. Some 80% of Persian Gulf oil now goes to Asia, and soon it will be 100%. This is why the Middle Kingdom has suddenly started investing in aircraft carriers.
So, we are not entering a prolonged, never ending collapse in oil prices. Run that theory past senior management at Exxon Mobil (XOM) and Occidental (OXY), as I have done, and you?ll summon a great guffaw.
It will reorganize, restructure, and move into new technologies and markets, as they have already done with fracking. My theory is that they will buy the entire alternative energy industry the second it become sustainably profitable. It certainly has the cash and the management and engineering expertise to do so.
What we are really seeing is the growing up of the fracking industry, from rambunctious teenage years to a more mature young adulthood. This is its first real recession.
For years I have heard complaints of rocketing costs and endless shortages of key supplies and equipment. This setback will shake out over-leveraged marginal players and allow costs to settle back to earth.
Roustabouts who recently made a stratospheric $200,000 a year will go back to earning $70,000. This will all be great for industry profitability.
What all of this means is that we are entering a generational opportunity to get into energy investments of every description. After all, it is the only sector in the market that is now cheap which, unlike coal, has a reasonable opportunity to recover.
Oil will probably hit a low sometime next year. Where is anybody?s guess, so don?t bother asking me. It is unknowable.
When it does, I?ll be shooting out the Trade Alerts as fast as I can write them.
Where to focus? I?ll unfurl the roll call of the usual suspects. They include Occidental Petroleum (OXY), Exxon Mobil (XOM), Devon Energy (DVN), Anadarko Petroleum (APC) Cabot Oil & Gas (COG), and the ProShares 2X Ultra Oil & Gas ETF (DIG).
Fracking investments should be especially immune to the downturn, because their primary product is natural gas, which has not fallen anywhere as much as Texas tea. Oil was always just a byproduct and a bonus.
CH4 was the main show, which has rocketed by an eye popping 29% to $4.57 in the past two weeks, thanks to the return of the polar vortex this winter. We are now close to the highs for the year in natural gas.
The cost of production of domestic US oil runs everywhere from $28 a barrel for older legacy fields, to $100 for recent deep offshore. Many recent developments were brought on-stream around the $70-$80 area. So $76 a barrel is not the end of the world.
On the other hand, natural gas uniformly cost just under $2/Btu, and that number is falling. Producers are currently getting more than double that in the market.
And while on the subject of this simple molecule, don?t let ground water pollution ever both you. It does happen, but it?s an easy fix.
Of the 50 cases of pollution investigated by MIT, most were found to be the result of subcontractor incompetence, natural causes, or pollution that occurred 50 or more years ago. Properly regulated, it shouldn?t be happening at all.
When I fracked in the Barnett Shale 15 years ago, we used greywater, or runoff from irrigation, to accelerate our underground expositions. The industry has since gotten fancy, bringing in highly toxic chemicals like Guar Gum, Petroleum Distillates, Triethanolamine Zirconate, and Potassium Metaborate.
However, the marginal production gains of using these new additives are not worth the environmental risk. Scale back on the most toxic chemicals and go back to groundwater, and the environmental, as well as the political opposition melts away.
By the way, can any readers tell me if my favorite restaurant in Kuwait, the ship Al Boom, is still in business? The lamb kabob there was to die for.
Don?t Throw Out the Baby with the Bathwater
With the recent collapse in oil prices, down a whopping $20 in just four months, I am starting to get a lot of emails from followers looking for Trade Alerts to buy the energy companies.
After all, energy is one of my three core industries in which to invest over the next two decades. Why not now?
The short answer is: Not yet. Don?t ever confuse a stock that has gone down a lot with ?cheap.?
The share prices for this sector are getting so low, they are starting to redefine the meaning of ?bargain.? The major integrated oil companies are now trading under book value with single digit multiples.
They are now at liquidation values, assuming that the fall in the price of Texas tea halts at $80. Those are valuations almost as low as Apple (AAPL) saw a year ago.
The absence of my Trade Alerts in this fertile field is happing because things could get worse for oil before they get better. There is now a war for market share occurring between the world?s second and third largest producers, Saudi Arabia and Russia (the US is now number 1).
Both countries desperately depend of rising prices and export volumes to maintain domestic political stability. When that doesn?t happen, budget deficits explode, spending gets cut, revolutions occur, and governments fall.
And these aren?t countries that send former leaders to country clubs to practice their golf swings in retirement. Firing squads are more the order of the day. In fact, countries maintaining high oil revenues is a matter of personal survival for their leaders.
Until recently, I would have said that China would step in and put a floor under the market to fuel their insatiable demand for energy. But they have run out of storage, and are unable to take more.
There is just no place to put it. They have even resorted to long-term charters of ultra large tankers, like the 434,000 tonne TI Europe, purely to build reserves.
The shake out is especially bad in the offshore sector, the planet?s most expensive source of crude. A glut of new drilling rigs is about to hit the market, ordered during more prosperous times years ago, while existing ones can be snapped up for 60 cents on the dollar.
Oil suffers from the additional damnation in that it is being dragged down by the global commodity collapse. Unless an asset class is made out of paper and pays an interest rate or a dividend, it is getting dissed to an unbelievable degree.
All of this means that the price of oil could fall further before we hit bottom and bounce. Now that $90 has been decisively broken, $80 is in the cards, and possibly $70 on a spike.
If you had told me when I was fracking for natural gas in the Barnett Shale 15 years ago that this process would ultimately cause the collapse of Russia and Saudi Arabia, me and my roustabout buddies would have said you were nuts. Yet, that is precisely what seems to be happening.
If there is one thing saving Texas tea, it is that the US can?t build energy infrastructure fast enough to get burgeoning new supplies to market. After the Keystone Pipeline got stalled by regulatory roadblocks, giant 100 car oil trains sprang out of nowhere overnight.
So many railcars have been diverted to the oil trade that farmers are now having trouble getting a record grain crop to market. This is why railroads have been booming (click here for ?Railroads Are Breaking Out All Over?).
The energy research house, Raymond James, recently put out an estimate that domestic American oil production (USO) would rise to 9.1 million barrels a day by 2015. That means its share of total consumption will leap to 46% of our total 20 million barrels a day habit. These are game changing numbers.
Names like the Eagle Ford Shale, Haynesville, and the Bakken Shale, once obscure references on geological maps, are now a major force in the country?s energy picture.
Ten years ago, North Dakota was suffering from depopulation. Now, itinerate oil workers must brave -40 degree winter temperatures in their recreational vehicles pursuing their $150,000 a year jobs.
The value of this extra 3.5 million barrels/day works out to $115 billion a year at current prices (3.5 million X 365 X $90). That will drop America?s trade deficit by nearly 25% over the next three years, and almost wipe out our current account deficit.
Needless to say, this is a hugely dollar positive development, and my own Trade Alerts have profitably been reflecting that.
This 3.5 million barrels will also offset much of the growth in China?s oil demand for the next three years. Fewer oil exports to the US also vastly expand the standby production capacity of Saudi Arabia.
If you want proof of the impact this will have on the economy, look no further than the coal (KOL), which has been falling in a rising market. Power plant conversion from coal to natural gas (UNG) is accelerating at a dramatic pace. That leaves China as the remaining buyer, and their economy is slowing.
It all makes the current price of oil at $90 look a little rich. As with the last oil spike four years ago, this one is occurring in the face of a supply glut. Cushing, Oklahoma is awash in Texas tea, and the Strategic Petroleum Reserve stashed away in salt domes in Texas and Louisiana is at its maximum capacity of 727 million barrels.
It was concerns about war with Syria, Iran, ISIL, and the Ukraine that took prices to $107 in the spring. My oil industry friends tell me this fear premium added $30-$40 to the price of crude. That premium is now disappearing.
It seems that every time a new group grabs an oil field in the Middle East, they ramp up production, rather than destroy it, so they can milk it for the cash. This is why 15 tankers are afloat around the world carrying Kurdish crude to sell on the black market.
Once Europe and Asia return to a solid growth track, oil will recover to $100 a barrel or more. Until then, discretion is the better part of valor, and I?ll be sitting on those Trade Alerts.
It is also why I am keeping oil companies with major onshore domestic assets, like Exxon Mobil (XOM) and Occidental Petroleum (OXY), in my long term model portfolio.
Sorry, but We?re Full
My annual electric bill here in sunny San Francisco comes to $4,800 a year. Since the California power authorities have set a goal of 33% alternative energy sources by 2020, PG&E (PGE) has the most aggressive green energy program in the country (click here for ?The Solar Boom in California?. More expensive solar, wind, geothermal, and biodiesel power sources mean that my electric bill may rise by $300 a year to about $5,100.
Now let?s look at my gasoline bill. Driving 15,000 miles a year, my old Toyota Highlander Hybrid used 600 gallons a year, which at $4/gallon for gas cost me $2,400/year. So my annual combined electric power/gasoline bill was $7,500.
My new Tesla Model S-1 (TSLA) will cost me $180/year in battery charges to cover the same distance. By switching to the Tesla, my total energy cost plunges to $4,980 a year, down 34%. That?s a big saving. Now you know why alternative energy is so popular in the Golden State.
There is an additional sweetener, which I?m not even counting. I also spent $1,000/year on maintenance on my old car, including tune-ups and oil changes. The Tesla will cost me nothing, as there are no oil changes or tune ups, and my engine drops from using 1,000 overcooked parts to just eleven. We?re basically talking tire rotations only for the first 100,000 miles.
There is a further enormous pay off down the road. We are currently spending $100 billion a year in cash up front fighting our wars in the Middle East, or $273 million a day! Add to that another $200 billion in back end costs, including wear and tear on capital equipment, and lifetime medical care for 5 million veterans, some of whom are severely torn up.
We import 7.5 million barrels of oil each day, or 2.7 billion barrels a year, worth $270 billion at $100/barrel (click here for the US Energy Information Agency stats). Some 2 million b/d, or 730 million barrels/year worth $60 billion comes from the Middle East. That means we are paying a de facto tax which amounts to $136/barrel, taking the true price for Saudi crude up to a staggering $219/barrel!
We are literally spending $100 billion a year so we can buy $60 billion worth of oil, and that?s not counting the lives lost. Even worse, 80% of total Persian Gulf exports now go to Asia, so we are now spending this money to assure China?s supplies, not ours. Only a government could come up with such an idiotic plan.
There is another factor to count in. Anyone in the oil industry will tell you that, of the current $100 price for crude, $30 is a risk premium driven by fears of instability in the Middle East. The Strategic Petroleum Reserve, every available tanker, and thousands of rail cars are all chocked full with unwanted oil. This is why prices remain high.
The International Energy Agency says the world is now using 90 million b/d, or 32 billion barrels a year worth $3.2 trillion. This means that the risk premium is costing global consumers $960 billion/year. If we abandon that oil source, the risk premium should fall substantially, or disappear completely. What instability there becomes China?s headache, not ours.
If enough of the country converts to alternatives and adopts major conservation measures, then we can quit importing oil from that violent part of the world.? No more sending our president to bow and shake hands with King Abdullah. Oil prices would fall, our military budget would drop, the federal budget deficit would shrink, and our taxes would likely get cut.
One Tesla shrinks demand for 750 gallons of gasoline, or 1,500 gallons of oil per year. That means that we need?20.4 million?electric vehicles on the road to eliminate the need for the 2 million b/d we are importing from the Middle East. The Department of Energy has provided a $1.6 billion loan to build a Nissan Leaf plant in Smyrna, Tennessee.
Add that to the?million Chevy Volts, Tesla S-1?s, Mitsubishi iMiEV?s, and other electric cars hitting the market in the next few years. Also taking a bite out of our oil consumption are the 2 million hybrids now on the road to be joined by a third million in the next two years. That goal is not so far off.
Yes, these are simplistic, back of the envelope calculations that don?t take into account other national security considerations, or our presence on the global stage. But these numbers show that even a modest conversion to alternatives can have an outsized impact on the bigger picture.
By the way, please don?t tell Exxon Mobil (XOM) or BP (BP) I told you this. They get 80% of their earnings from importing oil to the US. I don?t want to get a knock on the door in the middle of the night.
Is This Worth It?