Koenig Investment Advisory Market Update – December 2014
Global oil prices were above $110 per barrel in June of this year. They have declined to below $70 per barrel since then. There are a number of factors as to why prices have declined. Demand for oil has declined in the U.S. as vehicles have continued to be more fuel efficient. Demand elsewhere in the world has also slowed. The biggest single factor influencing oil prices is U.S. oil production in Texas and North Dakota. About 20,000 new wells have been drilled since 2010, increasing the daily U.S. oil production to almost 9 million barrels per day. In comparison, Saudi Arabia is producing around 10 million barrels a day. [1]
On Thanksgiving Day (November 27th) OPEC held a meeting to discuss oil production from member nations. A number of members wanted to reduce oil output to help firm up prices. Saudi Arabia had a different agenda. They wanted to make no change in oil output in order to push prices lower, inflicting economic pain on higher cost oil producers, specifically the U.S. In the aftermath of this meeting we have seen oil prices continue to fall and no resolution to these conflicting agendas is in sight.
The global decline in oil prices means a giant wealth transfer of $1.5 trillion.[2] Funds that would have flowed to the Middle East are now flowing to the United States, Europe and Japan. The average American who spent $3000 on gas in 2013 may now see an $800 annual savings.1 In the United States we could see some additional growth in 2015 GDP from lower oil prices. In addition, big oil importing countries like India, Japan and Europe will likely see significant savings and an economic benefit of lower oil prices.
Oil exporting countries like Russia, Venezuela and those in the Middle East will have less money to fund their respective governments. Russia and Venezuela in particular are being significantly impacted by lower oil prices. These countries rely heavily on oil exports to balance their government balance sheets. In January of this year, it took just over 30 Rouble to buy 1 U.S. Dollar, today it takes around 54.[3] The Rouble losing nearly 50% of its value against the U.S. dollar is a huge setback for Russia.
The current decline in oil prices will impact companies like Exxon and Shell, who will likely reduce their exploration budgets going forward. Much of the price adjustment burden will fall on the U.S. shale industry. Harold Hamm, CEO of Continental Resources and a major player in North Dakota’s Bakken oil fields, has said he can cope with oil above $50 a barrel.[4] In Texas, where wells tend to be closer to existing pipelines, the breakeven on oil production may be somewhat less than $50 a barrel. If oil prices stay between $65 and $70 a barrel we will likely see production growth slow. At $60 a barrel production growth could come to a stop. When oil prices decline, energy firms tend to cut their exploration budgets first, followed by production cuts. These production cuts will be what help stabilize oil prices.
To give an example of drilling costs, Exxon and Russia’s Rosneft Company recently spent two months and $700 million drilling a single well in the Kara Sea, North of Siberia. Although successful at finding oil, it will take years and billions of dollars before the project is complete.[5] In contrast, a shale oil well can be drilled in a week at a cost of $1.5 million.1 Shale oil producers have gained efficiencies in drilling and operations allowing them to significantly lower their costs. Given the fairly new nature of this business, further efficiencies are likely to continue.
A year out we will likely see a slowdown in shale oil production. Some frontier areas in shale oil such as Oklahoma, areas outside the Bakken in North Dakota, Eagle Ford and the Permian Basin in Texas will likely be hard hit as companies in these areas tend to be late players with heavily leveraged balance sheets. Longer term adversity will likely make shale oil producers stronger as it will prompt a new round of innovation in a fairly young industry. Down the road with a recovery in oil prices, new wells in Texas and North Dakota can be brought online in weeks not years.
We often remind people that in early 2008 oil was roughly $135 a barrel and by the year end was trading near $33 a barrel. We believe oil prices will continue to be volatile, not seeking a stable price until mid-2015.
While most of our clients do not have significant exposure to oil and gas producers such as Exxon, Shell, etc. we do hold a number of pipeline companies in client accounts. Oil and gas pipeline companies operate like a toll road. The major pipeline companies like Energy Transfer Partners, Enterprise Products and Magellan Midstream are largely pure transportation plays where their costs to customers is not related to the price of oil or gas. Some smaller pipeline companies have oil exploration aspects to their business and the oil price decline has impacted their share prices. Master Limited Partnerships (MLPs) in the pipeline business have seen price declines because they are part of the energy sector as a whole, not because investors expect to see a significant reduction in corporate earnings. MLPs remain a strong dividend paying holding that we expect to keep in portfolios for the longer-term.
Overall, we see lower oil prices as a positive, especially to the US, Europe and other developed oil importing nations.
[1] www.economist.com Sheikhs v shale, December 6th 2014
[2] www.washingtonpost.com Key facts about the great oil crash of 2014, December 1st 2014
[3] www.xe.com USD per 1 RUB
[4] www.economist.com In a bind, December 6th 2014
[5] www.ft.com Rosneft and ExxonMobil strike oil in Artic well, September 27th 2014