Tuesday, December 30, 2014

Oil - part 1

Oil has dropped nearly 50% in the past 6 months, due to an estimated  1m bpd excess, over 92m bpd usage.  Oil prices swing wildly with small changes in supply or demand, as it can't be stored cheaply or safely.

In theory, a commodity glut ends when the price falls below the cash cost of marginal producers, eventually pushing them out:

(Source - Business Insider)

I believe US tight oil (shale) producers are the marginal producers. They are high on the cost curve.  And individual shale oil wells have a very rapid decline in production:

This means they need to constantly drill new wells every year to maintain current production levels.  For the successful ones, their business model is to have the initial production spurt in the first few years pay off the well (usually at hedged prices), after which the the remaining tail end of production (even if only hundreds or tens of barrels per day) is mostly profit.  For the weaker ones, with bad acreage or too much debt, the constant need for capex to re-drill will kill them.

No one knows what the real tight oil production costs are:

  • Costs are always falling, due to new techniques such as horizontal drilling, multi-well pads, and  wide short fracks.
  • There is no single cost number we can use: every single well must be evaluated individually, due to differing location, technology and fracking techniques used.
  • I could not approximate EOG's past few year's production volumes with the above decline curve, they're far higher than it suggests they should be.
For now, lower prices mean that everybody drills more.  Individual US companies drill to pay off debt and keep their leases.  The poor shitty countries that depend on oil revenue will produce more of the stuff to try to pay their bills.  We won't know when it ends, or at what price US production numbers drop, until after it happens.

In the long term:
  • Supply is controlled by the Saudis. Even with the cheapest production costs, they have a large welfare payments to make. Their projected 2015 budget has a shortfall of nearly USD 40bn at an estimated oil price of $55-60 per barrel.  They have about $750bn reserves.  They can't do this forever - maybe 5 years at $40 oil.  They reportedly did want to initially cut production, but increased it instead after they could not agree with Russia.
  • I think the future oil price will be capped at $70-80.  Even after US tight oil companies go bust, production can start up again in a matter of weeks or months if prices rise.
  • This means fewer new deep water projects.  It makes no sense risking hundreds of millions upfront to explore and produce, when you know where the oil is in the continental US and land rigs can be deployed for less than 10m each.
So I believe that oil will recover to a sustainable cost ($60-$70) in 1-4 years.  Unless we get a US recession - the current upswing is now 5 years old - or a hard landing in China - about a 1/3rd chance - in which case prices remain low longer.

At some point, the price falls far enough to say an asset undervalued.  For a commodity its based on marginal production costs.  I'm going to pick WTI $40.  No guarantee it will reach there, but if it does, production costs mean it must increase eventually.  Around that point, I'd look to buy strong companies that can survive the downturn.

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