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Oil Slick “The oil industry is like a ship with its center of gravity above the water line, says Jeremy Elden of Germany’s Commerzbank. It can sail smoothly for years, but capsize suddenly in rough seas – and do so quite rapidly. An unprecedented combination of excess supply and weak demand has created just such rough seas in the past year.”

Oil Price Collapse $140 $120 $100 $80 $60 $40 Jan-12

May-12

Sep-12

Source: Energy Information Administration

Jan-13

May-13 WTI

Sep-13

Jan-14

May-14

Sep-14

Jan-15

Brent

Jeremy Elden’s comment about a rapid capsize certainly captures the dramatic collapse in oil prices over the last eight months with prices falling more than 50% based on increasing supply and weakening demand. “Thanks to new technology and productivity gains, you might expect the price of oil, like that of most other commodities, to fall slowly over the years.”

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Crude Oil Production Monthly - Thousand Barrels per Day

10,000 9,000 8,000 7,000 6,000 5,000

U.S. Field Crude Oil Production

Source: Energy Information Administration

The technological advances associated with hydraulic fracturing have resulted in a rapid increase in oil production across the United States. Over the past three years, daily oil output has climbed 50%, raising total daily oil production for the U.S. above nine million barrels per day. “Crude is gushing from the ground…The world is awash with the stuff, and it is likely to remain so.”

Global Liquid Fuels (million barrels per day) 95

6

93

5 4

91

3 89 87

0.8

1.2

0.8

0.7

0.3

1.0

2 0.5

0.1

85 2014-Q1

2014-Q2

2014-Q3

Inventory Accumulation (RHS)

2014-Q4

2015-Q1

2015-Q2

Global Production (LHS)

2015-Q3

1 0

2015-Q4

Global Consumption (LHS)

Source: Energy Information Administration

In the Energy Information Administration’s Short-Term Energy Outlook published in January 2015, they report the average daily production during 2014 exceeded average daily consumption by 780,000 barrels and project this imbalance will persist for much of 2015. “…Every oil firm will have to slash its exploration budget. Few investments outside of the Middle East will any longer make sense.”

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Average Weekly U.s. Oil Rig Count 1,800 1,600 1,400 1,200 1,000 June

August

October

December

Current (2/6/15)

Source: Baker Huges Hughes

Since peaking in October, the weekly U.S. rig count published by Baker Hughes has declined nearly 30% as all exploration & production companies are forced to review the profitability of new and existing operations. While the data above captures the current state of the oil markets, all four quotes are from the March 4th, 1999 edition of The Economist when the price of oil was $11.20/barrel. Since then, oil has increased 350%, cumulatively, or approximately 10% annually, despite the recent 50%+ collapse. This is by no means a recommendation to invest in oil or an expectation that prices are going to move rapidly higher, but rather a cautionary reminder that the energy sector, like nearly everything in investing, has a repeating boom/bust cycle driven by the economics of supply and demand. When Prince Alwaleed Bin Talal, chairman of Kingdom Holdings in Saudi Arabia makes statements like “the world will never again see the price of oil at $100 per barrel,” he is trying to dissuade the marginal supplier from investing in new production. In the current environment, the marginal supplier are U.S. shale drillers (frackers) and as illustrated above by the dramatic decline in the number of U.S. oil rigs, the dissuasion has been heard. The U.S. fracking industry has some unique characteristics that could change the dynamics of this boom/bust cycle going forward. Conventional field development can take up to a year to produce and typically have a lifespan of 20-25 years, thus investment decisions are based on expected prices over the next 20 years, not current pricing. Conversely, shale drillers through fracking technology can complete wells in less than a month in some situations and will receive the bulk of the well’s output within the first twelve months, making the current/nearterm prices more important when evaluating investment decisions. While excess supply will likely continue over the near-term and prices could fall even further, I expect the supply/demand imbalance to stabilize relatively quickly given the dramatic decline in U.S. oil rigs, significant reduction in new production capital spending, rapid depletion of existing fracked wells and the likely increase in demand driven by lower prices. Conversely, I expect future price increases to be slower than normal due to the shorter lead time required for new production and the increasing amounts of U.S. fracking oil that can be profitably produced at a new higher price level.

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While a potentially more stable oil price environment should be a long-term benefit, the nearterm economic/investment consequences could be significant. Within the U.S., anyone that has filled up their car with gas can see the primary benefit of falling oil prices. Moody’s Analytics estimates that a $10 decline in the price of oil increases the amount of income available for spending on other goods and services by $30 billion. Thus, the $50 oil price decrease could potentially add $150 billion to consumer spending. However, history has shown this excess spending capacity takes time to enter the system. Offsetting these gains will be the negative GDP impact of reduced capital spending within the Energy sector. Goldman Sachs’ Amanda Sneider reports the energy sector has accounted for approximately one-third of recent S&P 500 capex. Additionally, lower energy related profits and significant reductions in employment will likely provide additional headwinds for the economy. From an investment standpoint, if energy prices remain low for an extended period of time, there could be some big winners and unfortunately some big losers. Loser Standpoint – Many energy related companies took advantage of low interest rates and easy access to debt overleveraging balance sheets. JP Morgan reported on January 8th, “no sector has ever issued so much dollar volume in the high-yield market over such a short period of time.” JP Morgan further notes, “the high-yield energy sector currently comprises 13.50% of the broad high-yield market.” Continued price weakness will likely force many of these firms out of business creating heightened volatility within the broad high-yield bond market. Winner Standpoint – Energy companies that were not seduced by cheap leverage and have strong/flexible balance sheets are likely to have the opportunity to pick up very high quality assets that have been poorly financed at discount prices from the “losers.” These survivors will be the firms that will eventually turn these assets into marginal production as prices rise in the future. Similar to the technology bust where the sector grew stronger by the subtraction of the weakest, any consolidation within the energy sector transferring high quality assets to the strongest management teams/companies potentially is a long-term big win for investors. Finally, outside the U.S., the impact dispersion across the emerging markets will be wide. Many emerging regions rely on oil revenue to fund federal budgets and those countries have been under significant pressure over the last few months. Hardest hit has been Russia. Oil exports account for approximately 50% of Russia’s federal budget, which is “balanced” at $100/ barrel. Combined with the existing sanctions surrounding Ukraine, the ruble has collapsed. The dramatic collapse in oil prices in 1997/1998 was a key contributor to Russia’s default in 1998 and outside of its significant, but declining reserves, it doesn’t appear they have learned many lessons. According to The Economist, the budget break-even points for other countries are Iran ($136/barrel), Venezuela ($120/barrel), Nigeria ($118/barrel) and Saudi Arabia ($93/barrel). On the opposite end of this spectrum will be countries that rely on oil imports, most notably China and India. According to Julian Evans-Prichard, China economist at Capital Economics, “a 30% fall in oil prices will boost Chinese GDP by about 1% next year.” Overall, I feel the energy sector will come out of this stronger and better positioned for future oil price swings. There will likely be some short-term pain if prices remain low or go lower, but

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if you can identify the long-term survivors, the potential for significant gains over the next energy cycle is conceivable. Written by Jim Underwood, CFA, Chief Portfolio Strategist, Welch Hornsby

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