This Time, it’s Oil in The Spotlight…

The pain for commodities just doesn’t seem to let up. This time, it’s oil in the spotlight. Overnight, West Texas Intermediate fell more than 3.5%, closing at US$74.21 a barrel. Here’s the possible cause of the rout, from the Wall Street Journal:

U.S. oil prices fell below $75 a barrel Thursday as U.S. production soared to its highest in decades.

U.S. oil production rose above 9 million barrels a day in the week ended Nov. 7, the U.S. Energy Information Administration said Thursday. On a monthly basis, average production last exceeded 9 million barrels a day in 1986.

Hmmm…but the surge in US oil production only occurred because of previously high prices. High prices sparked the shale oil revolution, which has been the driving force behind the recovery in the US economy in recent years.

But now prices are down sharply…what does it mean? Well, in the short term, it means production will ramp up. Just as you’ve seen in the iron ore market, lower prices (after a boom) bring about production increases, as the producers need increased volume to make up for the price falls.

It’s the same in the oil space. The shale oil (and gas) industry spent billions investing in new production on the back of previously high prices. The only way they can generate a decent return on that capital in a falling price environment is to produce as much as they can. This is why, in the initial stages of a commodity price rout, production rates often increase.

Last month, the Financial Times reported on analysis done by consultancy Wood Mackenzie, which found that the break-even point for most US shale production was around $75 a barrel. Prices just dropped below that level last night.

So expect more furious production in the months ahead. Companies will do this on the expectation that prices are just in a momentary dip, and they if they can survive this period they’ll come out the other side.

But if prices languish for longer, by mid-next year you’ll see problems emerging in US shale oil. The revolution may be over no sooner than it started. Here’s what the FT had to say about it in October, before the latest price drop…

If prices continue to fall, however, the pressure on the industry will grow. The smaller and midsized oil and gas companies that led the shale revolution have been running at a cash flow deficit for years. Capital spending has exceeded companies’ operating cash flows.

The steep decline in production from shale wells – it can drop 60 per cent or more in the first year – means that companies have to keep drilling merely to maintain their output, let alone increase it.

If the funds for drilling dry up, then production will fall quickly and the US oil boom will go bust.

This goes back to a topic I discussed a few months ago. Energy is all about geopolitics. According to the US Energy Information Administration, Russia was the largest producer of oil in the world last year, producing 10.1 million barrels per day. Saudi Arabia came next, producing 9.6 million barrels per day. The US is in third positon and is nearly at the 9 million per day level now.

As you know, the US and Russia are fighting a proxy war in Ukraine. The US are a little concerned over Russia’s energy dominance, its developing energy relationship with China, and the all round perceived threat to US influence.

Given that US ally, the authoritarian state of Saudi Arabia, has all of a sudden come out and started talking the oil price down, it very much smells like the politics of oil are in play.

Trade sanctions on Russia, as well as a plunging price for their most important commodity, are a good way to take out your biggest perceived enemy. What’s in it for Saudi Arabia to help out? Well, they don’t like the look of Russia getting involved with Iran in developing gas fields, so any way to inflict harm on Iran through Russia is worth some short term pain to them.

And of course, they (as in the Saudi Royal family) continue to get support and legitimacy from the world’s superpower…the US.

Trying to lower the oil price to take out your enemy might seem like a smart thing to do. But there is no longer anyone with brains left in US foreign affairs. Lowering the price of oil to take out Russia will come with consequences, like taking out a major part of the domestic oil supply that provided US manufacturers with a competitive advantage.

Energy self-sufficiency in the US hasn’t fixed one of their most enduring problems though. Their monthly trade deficit is still stubbornly high. At the moment, it’s around US$43 billion per month. What happens to that figure if shale gas comes out of the equation in the next few years?

It means the trade deficit rises, which requires foreigners to finance it. But they’ve largely pulled the plug on financing US deficits in the past few years…in the case of oil producers, that’s because they no longer have surplus funds to recycle back into US treasuries.

There’s always Japan I suppose. While the market continues to believe the current insanity of the Bank of Japan is actually sound policy, the US should receive financing for its deficits somehow. I’m not sure how long this deluded belief will last though.

As far as Australia is concerned, what should we think about the falling oil price? It’s good right…falling prices at the pump and all that?

Well, that part is good. On a national scale though, I’m not sure how all those massively expensive, soon to come online LNG plants will deal with lower energy prices. According to some figures, at these prices, the projects won’t even cover their cost of capital.

That means they are destroying value. Think of it this way…if you buy a house and it costs you 5% to borrow the funds, your cost of capital is 5%. You therefore need a return of 5% or more to cover your cost of capital and ‘add value’, or wealth. Rental yields don’t cut it, so thankfully in Australia we have a world class Ponzi scheme to provide capital growth and the illusion of wealth creation. But I digress…

Getting back to the LNG projects, here is an article on the topic from The Australian a few weeks ago (again, before the latest price falls):

LOWER oil prices could put a stop to the nation’s future LNG projects, even ones that still stack up on paper, and cut up to $11 billion a year from increasingly LNG-reliant export revenue, ¬industry leaders and analysts say.

Brent crude prices that held above $US100 a barrel for most of the past three years have slumped dramatically since June, falling 25 per cent to a four-year low of about $US85 a barrel and, if ¬sustained, hitting the economics of six under-construction LNG plants, whose contract prices are linked to moves in oil.

If prices don’t bounce, industry experts and analysts say returns will be poor on most existing projects and any Australian future LNG projects will be questionable.

Adding to the hurdle of getting a new LNG project into construction at a time when shareholders are demanding greater discipline would be a big overall cashflow hit to the oil majors, which are the most likely proponents of new LNG projects.

Former senior BHP Billiton executive Alberto Calderon, who was a contender to replace chief executive Marius Kloppers last year, says a sustained period of $US80 oil would accelerate an inevitable move to lower LNG prices that would make most Australian LNG projects not return their cost of capital.

“The problem with Australian LNG is it has a break-even price of somewhere around $US14 (per million British thermal units),” Mr Calderon, BHP’s former chief commercial officer, told The Weekend Australian.

“An oil price of $US80 a barrel would translate to $US12 LNG, which is close to spot prices and which would hurt the LNG projects. Anything at below $US13.50 or $US14 means money is being lost.”

First iron ore, then LNG. What is it exactly that Australia managed to salvage from this once in a century commodity price boom? A $1 million shack in inner Sydney? Great.

Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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