How History is Repeating Itself in the Oil Industry
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How History is Repeating Itself in the Oil Industry

by | published December 11th, 2018

The roller coaster that is the oil market is beginning to give me motion sickness.

In October, we saw the biggest drop in prices since 2015, and ever since, the markets continued to swing wildly.

Now, normally, discussions of crude oil prices take their departure from what Brent levels – the London benchmark and the primary yardstick used in global oil sales – are telling us.

The other benchmark, West Texas Intermediate (WTI), is the standard for contracts set in New York – a more immediate way of assessing the U.S. production environment.

Now, WTI may be better known in the U.S., but it is not the figure that drives international oil sales. However, on occasion, it is instructive on some more direct implications of note to American investors.

WTI finally posted a gain last week (3.3% through close of trade on Friday), arresting for a bit what has been a noticeable retreat (down 14.7% for the month).

However, a darker side of the picture is emerging…

Through the Looking Glass

What my specialized Energy Capital Research Group (ECRG) team has been tracking over the past several weeks looks oddly familiar. In fact, the sector is rotating back into a potentially serious problem.

Of course, each “problem” in the energy sector represents a corresponding investment opportunity.

But the what I am seeing today stands in almost mirror-imaging parallel to what I wrote here in Oil and Energy Investor some three and a half years ago (This “Bubble” Is Set to Kick Off New Energy Profits, May 15, 2015).

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Keep in mind when you read this that the price of WTI was some $10 higher per barrel at the time than it was yesterday morning.

“There is a major energy debt bubble rapidly forming and it will put some significant pressure on the sector moving forward. Make no mistake, there will be fewer oil producers in the U.S. at the end of the year than there were at the beginning…even if the overall pricing trajectory remains pointed up.

Now, that is not necessarily a bad thing from our investment standpoint. Well-positioned and managed producers will be acquiring choice drilling assets and leases at discount and that will raise both their bottom lines and our profitability.

Yet the terrain is changing.

The bout this week with rising bond yields has once again put added pressure on the Achilles heel of most small operators. Most American E&P (exportation and production) companies have been cash poor over the past decade, regardless of the price of oil.

Essentially, this means it has cost them more to fund ongoing operations than they have realized in revenues. When prices for oil have been $75 or higher, this spread has made little difference. In such an environment, it is usually better to fund the bulk of forward operations out of rolling over debt than from tapping cash.

Especially if the company is publicly traded. In a higher (and stable oil pricing situation), cash proceeds translated into a higher offered dividend constitute a better return for the company’s share value than a rapid retirement of debt.

Yet this remains all about the price commanded for the commodity.

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Remember, the price you see flashing as a bug in the corner of your TV screen is a futures contract price (actually the rate for next month deliveries). The company taking it out of the ground, however, makes a lower price.

The first pricing stage is at the wellhead. This comprises the transfer of oil coming out of the ground to a distributor (a wholesaler). That is what the operator realizes as revenue but it is hardly the final price. Rather, the price is then adjusted upward as it transits to a refinery (the primary end user of the raw material crude) and on as finished oil products to retail consumers.

Depending on the grade of oil produced (based on factors such as weight, sulfur content, impurities), the producing company is making a lot less. At $60 a barrel, the average U.S. producer is making somewhere around $50.

And that means even with overall prices improving, they are not rising fast enough to avoid an oncoming squeeze.

Energy debt is found at the upper end of the high yield debt curve. That is often referred to as junk bond territory – issuances below investment grade. Since this debt has a higher risk of default, it provides a lower face value and a higher interest rate.

That is simply a risk premium – the issuing company realizes lower funding and has to pay more to receive it. To stay afloat, leveraged oil companies need to be able to: (1) roll existing debt over; and (2) access debt markets for additional funding

Unfortunately, as oil prices retreated some 60% between August of last year and into February of 2015, the yield curve exploded at the end used by oil companies. As junk bond yield rates increased, energy yields expanded even quicker.

The current recovery in oil prices has helped a little but the pricing floor it is not rising quickly enough for the most vulnerable.

Currently, there is almost $1 trillion of such oil company junk bonds outstanding. And the interest commanded on new issuances is accelerating. As of last week, oil company annualized interest rates stood at between 12% and 15%. As bond interest rates in general were rising this week, energy bond rates were deteriorating even more.

How bad? Very aggregate figures are not always indicative of what is really happening in the debt market. Except in this case. Bond interest rate changes are quoted on basis points. Each 1% revision is divided into 100 basis points. That allows us to calculate a convenient yardstick of how one particular component of the market is faring against a broader spectrum of debt.

My estimates are indicating a significant bubble forming in indebted oil companies’ abilities to weather the debt storm. Each 1 basis point rise in investment grade debt yield has translated into a (quite generalized) rise of almost 2 basis points in junk bonds.

But the rise is almost twice that for energy junk bonds.

The conclusion is direct: high risk interest rates are almost doubling over safer bonds, while the energy portion of the junk market is experiencing a rise approaching four times safer debt.

Of course, much of this is a function of a massive re-pricing in global debt, at least some of this being a market deciding (not always for the best of reasons) to do the Fed’s job for them. The continuing acceleration in debt yields, therefore, is not likely to continue at such a pace for much longer.

But it has already done some significant damage to the most exposed oil producers.

To survive during periods of low prices, companies need to hedge. That means they will take out futures contracts on their own forward production. But actual market prices for the product at contract expiration need to match the hedge (and the combined series of options companies will take on that contract).

And for that to happen, the breakeven for the cost of operations versus the market price of the oil produced must be at a level allowing for the debt load to remain manageable.

That is becoming more difficult. My current projections put the breakeven at about $74 a barrel by July [2015] for the bulk of shale and tight oil production in the U.S. This is the primary contributor to the new production surpluses experienced.

And the M&A [mergers and acquisitions] will be proving us with some nice opportunities to make profits from the energy debt bubble.”

That was then.

This is now.

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Production Cuts and Profits

Today, the price of crude is lower.

The breakeven market price is better now than in 2015 (averaging about $58), yet it remains well below what producers are currently realizing at the wellhead. The companies will increasingly rely on hedging contracts forward. But, absent a major advance in market price levels, the same crisis experienced in 2015 will recur.

Oh yes, there is now more company debt today than three and a half years ago and virtually all of it is the highest of the high risk.

Offsets are not in the cards. The period of lowering effective operating costs is over. Much of those declines came from pushing reductions upstream and forcing oil field service companies to swallow lower margins to keep in business.

We are now back to a more familiar inflationary cost cycle among drillers and associated providers.

The production cuts announced last Friday in Vienna may well put a floor under further declines. But I am already seeing a problem developing.

In the present environment, commitments to new drilling will take a back seat to creaming production from existing wells.

This sets the stage for a supply balance problem as early as the second or third quarter of next year.

And of course, we will be quite ready to reap the profits when that happens.

Sincerely,


Kent

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  1. December 11th, 2018 at 18:47 | #1

    Good oil call!!

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