Shale 1 – OPEC 0

So, the market was just sort of tap dancing its way through this past short holiday week, setting more new record highs as we learned that the 3rd quarter GDP growth came in even better than expected. Thanksgiving Friday is always a half day for the markets, so many traders and other market folk simply elected to make it a four-day break.
And then…
On Thanksgiving Day, over in Vienna, Austria, the 12 members of the Organization of Oil Exporting Countries (OPEC) met to decide if the group would take steps to support the global price of crude oil. That price is represented by the prevailing price of Brent North Sea crude. In June, it was just over $115 per barrel. On Wednesday, that price had dropped about 30% from that high to just under $80 per barrel. This is particularly tough for three-quarters of the OPEC members who have budgets based on much higher prices.
In times gone by, the Saudis had always stepped up to the pump and either upped – or cut – their own production enough to cause the markets to stabilize where they wanted. However, at the conclusion of this meeting, the Saudi oil minister was quoted as saying he believed that “the oil market will stabilize itself eventually.”

Welcome to the new world of oil

With that phrase, the Saudis and, by extension, OPEC, acknowledged that the US and, to a large extent, Canada, are now the new swing producer. The OPECs won’t be where market balance is coming from. Instead, welcome to the world of market pricing.
As a result, crude cratered on Friday.
Quick reason is that, it appeared that the market will now be establishing prices in an environment where US crude production is at record highs and global demand growth for new energy has slowed. The Financial Times reported that US imports from OPEC members is at the lowest level in just about 30 years. Their biggest collective customer is gone…almost all thanks to the geniuses who have developed the shale fields.

So, basic economics says when you have a lot of something (oil, in this case) and the demand is down, the price has to drop until you get a price both sides can agree to. That price happened to hit the lowest level in four and one-half years on Friday before closing somewhat higher.

Lower prices will spur a crash in the US shale industry

That’s not me – that’s a guy named Leonid Fedun. Leonid is a board member at Lukoil which is the second-largest oil producer in Russia. He says, in a totally non-biased manner, I’m very sure, that “the shale boom is on a par with the dot.com boom.” He added that “In 2016, when OPEC completes this objective of cleaning up the American marginal market, the oil price will start growing again.”

First of all, the crude market is going to have to find a range to settle into. That’s not determined by anyone’s calendar – not even one at Lukoil. It will be interesting to watch. Next, shale has real products that have built-in demand – a trait that was not found in many of those dot issues.
This may be what’s behind Leonid’s comments, however. With the new market-based pricing and massive US natural gas production being readied for global export, this really takes away a lot of pricing leverage the Russians have had for some time in Europe. Ukrainian gas sales come to mind…

Investing

The one effect closest to home from this crude price reduction is the bonus we all have been realizing at the local gas station. According to Dr. Ed Yardeni, the gas price drop from June until last Wednesday has saved us consumers $150 Billion. Just in time for the holidays – a fact not lost on the retailers shares on Friday.
Basically, any company in the energy biz seemed to get sold. It obviously wasn’t based on fundamentals.
According to S&P, the Energy Sector of the S&P500 Index officially entered into a bear market after having dropped over 6% on Friday. On the other hand, the Dow Transports hit an intraday record. Airlines, FedEx, UPS, trucking companies and cruise lines are major fuel users so this would be huge for direct benefits to their bottom lines so their shares took off.

The exceptions were the railroads and barge lines. They’re major haulers of crude so, apparently, traders decided that production would now fall close to zero, based on how some of those shares were hit Friday. This is trading – not logic, please understand.

The companies in the upstream part of the crude biz – that part that’s involved in exploration and production – got hit big time due to the amount of capital they’ve set aside for new production…at higher price levels. Offshore drillers were especially targeted, it seemed.
Even the midstream MLPs got hit – and they’re really not affected by the product price. With infrastructure needs way above current capabilities, seems to me this sector has big longer-term potential.
Interestingly, even those companies positioning themselves as alternatives got sold. Cheaper oil really pulls the rug out from under the pricing that makes most of those even begin to work now. Solar stocks were especially hit.

Low prices will stop the shale

My good buddies at CNBC were quick to put out a headline Friday saying, “Will OPEC bankrupt US shale producers?” (Leonid wishes that were true.)
There seems to be a lot of confusion on at what price our shale fields get shut in. Hint – not here… Here’s a couple sources upon which I base that.
The Financial Times used the price of Brent crude to provide examples of the effect of different prices on different economies. For instance, Venezuela needs oil to be $160 per barrel to balance its budget. Russia needs $110 to get its in balance, while the Saudis need it at $90.  (They each can make money per barrel at much lower levels but, since their economies are majorly oil-based, that’s why the big difference.)

The Times says that the breakeven for the lowest cost US shale projects is $40.  Further, the International Energy Agency says only 4% of our total shale production needs to be at $80, or more, for them to be profitable.

For the Bakken Field in North Dakota, the IEA says that most production there remains profitable at about $42 per barrel.
And now, with the new ‘super-fracking” technology coming on, efficiencies will improve even more, helping to extend the production lives of the fields. We’re just getting started…

No whale oil and candles

We aren’t going back to those as our main sources of light or heat, to be sure. Oil isn’t going to zero….though it can go lower. I remember when we lived in Anchorage in the mid-80s when the price of an average red salmon of $8 was just about the same as an entire barrel of crude.
More realistically, the fact that so many of these great world class energy companies have been temporarily marked down seems to make this a very significant opportunity for you to do some cherry picking. Buying low is a good thing.

Focus on the good names with solid dividends and then enjoy the ride back up when the market begins to rise again. In the meantime, you’ll be earning a very fine dividend return while you wait.
Welcome to the new challenges and opportunities this change is bringing us. We’ll be talking much more about these soon, I’m sure…

Cheers!

Mike