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Page added on March 14, 2020

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Oil: Blood In The Streets

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Arguably one of the wildest months in oil history, it’s hard to imagine that less than a month ago oil prices were almost $55 / barrel Brent, and that less than a year ago, they were approaching $70 / barrel Brent. That drop in stock prices has shattered oil companies. Occidental Petroleum (NYSE: OXY) has dropped more than 85% from its mid-2018 highs. The company was once a shale darling and has lost more than $50 billion in market capitalization.

1 Year Oil Prices – Bloomberg Energy

Despite these difficulties, oil and natural gas have enormous long-term potential. As we’ll see throughout this article, low oil and natural gas prices will result in rapid drops in production, which will push up oil prices, at least toward breakeven. That recovery in prices will result in numerous investment opportunities arriving.

Oil Production Type Breakeven

The important answer to how long oil prices can remain low is based on the breakeven of major oil plays and the countries.

Global Liquid Supply Curve – Market Realist

The above image shows the “global liquid supply curve.” What that means – the average breakeven price (counting development) for the individual plays. On the x-axis, you can see how much production that play is responsible for. If you were wondering why Saudi Arabia could cut production so much, that should be clear from the $27 / barrel breakeven.

However, as you go further, you can see how a substantial portion of the world’s production (~65 million barrels / day) has an average ~$50 /barrel breakeven. The sources of oil that round up the top of production (~10 million barrels / day) have a breakeven closer to $70 / barrel. That helps to highlight the high breakeven prices needed.

Oil Well Shut-in Prices – Tiny MCE

In fact, with oil prices at $34 / barrel (Brent), prices have dropped so hard that some plays are starting to approach shut-in prices. What shut-in prices means is that development costs aside, it’s not even worth producing oil from existing fields. When prices are below operating costs, you might as well write the well off as a sunk cost. Outside of the Permian Basin, SCOOP/STACK, and Eagle Ford, effectively the remaining of U.S. shale isn’t profitable.

It’s worth noting that this doesn’t consider the rapid drop in natural gas prices that’s happened after this survey.

Image result for opec+ breakeven

OPEC Breakeven Price – Sam Analysis

Past raw field development prices, one last oil production type breakeven we want to talk about is the fiscal breakeven for OPEC. It might surprise you to learn that a significant percentage of OPEC nations are dictatorships, and as a result, they give their people significant social handouts. When oil prices crash, as happened with Venezuela, that can occasionally destroy the government.

Iran, for example, produces several million barrels / day, and with citizen anger over COVID-19 cases and shooting down a plane, some believe Saudi Arabia’s oil production cuts are to hurt Iran. Iran could be the next Venezuela. If it does, expect massive amounts of production to be removed from the market.

However, the larger point here is that while OPEC countries might have low raw production costs as we saw above, they need much higher prices to balance their fiscal budgets. Saudi Arabia’s breakeven is near $100 / barrel, so at $35 / barrel, the company is negative almost $240 billion / year when you account for government spending. With a $680 billion GDP, it doesn’t take long for the need to keep market share to fall below the need to maintain prices.

Russia, interestingly enough, has one of the lowest breakeven prices, and could actually handle a longer oil crash than Saudi Arabia. Maybe they saw this coming. Their central bank prepared a budget last year in the event that oil prices hit $25 / barrel this year. These oil production breakevens are something incredibly important to pay attention to because it leads us to our next section, an oil production drop.

Oil Estimated Volume Changes

To start this section, let’s talk about potential sources of demand and supply changes. Our two major potential sources of demand drop are a recession and COVID-19. Our corresponding potential source of a production increase is OPEC.

Let’s start with OPEC because it’s nice and simple. Overall OPEC spare capacity is estimated at 2.3 million barrels / day. Russia spare capacity is estimated at 300,000 barrels / day. Simultaneously, OPEC, maybe in a war of words, maybe seriously, is planning to expand its spare capacity by 2 million barrels / day. Overall, let’s average that out, since that’s a few years away, and say that the total potential to increase production is 3.6 million barrels / day.

Realistically it will be more like 2.6 million barrels / day in 2020, 3.6 million barrels a day by 2021-2022, and 4.6 million barrels a day by the mid-2020s. Developing hundred thousand barrel oil fields is slow and capital intensive, even when you have the financial firepower of countries behind you. The massive Al Shaheen oil field off Qatar, the wealthiest country per capita, took 3-4 years to bring online. That was back when oil was much easier to find.

Correspondingly, demand drops can come from a recession or COVID-19, but a recession is much more predictable. This is much less significant than one might think. In 2008, during what was unarguably the worst financial crisis since the 1930s, oil demand only dropped by a 1.5 million barrel / day average for the year. By 2010, it was back above 2008 levels, and significantly above its 2009 lows. Prices fluctuated much more, but volumes never did.

And for our last and least predictable source of a demand drop, we can look at COVID-19. COVID-19 is interesting. China, at the peak of the full country shutdown, saw oil consumption drop by 3 million barrels / day or 20%. Does that imply a 20% worldwide oil demand drop? Obviously not. China already has started seeing its consumption going back up, and the virus is still spreading. That’s because the virus doesn’t peak everywhere across the world all at once.

So far, as China recovers, new virus hotspots are emerging. Europe, South Korea, and Iran are emerging as the likely next major hot spots. Together, they consume ~20 million barrels / day (so 20% is ~4 million barrels / day). Given the delays in their emergence as hot spots, along with the fact that China only took ~2-3 months for consumption to start to recover, and the fact that the entire world only consumes ~100 million barrels / day, we think that assuming that 20 million barrels / day are under “quarantine” at any given time is a reasonable assumption.

Let’s assume, if the virus spreads, ~3 million barrels / day of consumption are removed from the system. Market analysts have been behind on their predictions, however, the overall first quarter production drop estimate from Wood Mackenzie is 2.7 million barrels / day. So, our number is slightly more pessimistic, but not by much.

Now, adding together all our sources of demand drop, we get a worst-case consumption drop of 4.5 million barrels / day (virus + recession). And we get a worst-case supply increase (for 2020) of ~3.6 million barrels / day. We’re giving OPEC the benefit of the doubt here and assuming they can rapidly increase production by 1 million barrels / day. From this, we get a net 8.1 million barrels / day supply deficit. That’s massive.

However, it’s worth noting that ~1 million barrels / day of this won’t happen until capacity expansion plans are complete. Additionally, COVID-19 is currently seen as a fairly stable virus, with a vaccine expected to come in the next few months to year as they pass trials. At the same time, COVID-19 treatments are being explored, with Phase 3 trials coming in the next few weeks.

So, we’ll assume that the ~3 million barrels / day in COVID-19 decline will last a maximum of one year. The same is true for the recession, 2010 oil consumption was higher than 2008 with the dip in 2009. So that 8.1 million barrels / day is more realistically like 7 million barrels / day in 2020 and ~3 million barrels / day in 2021, as the virus disappears. All this also doesn’t count 1-2 potential million barrels / day in normal demand growth. From 2008 – 2010, through the recession, demand increased by 0.8 million barrels / day.

Now let’s look at some potential production declines. For reference, U.S. shale oil decline is what OPEC and Russia are so disappointed about.

U.S. oil production, mainly from shale wells that are quickly brought online, is expected to fall off a cliff. At $35 / barrel WTI (still $4 / barrel above current prices), U.S. production is expected to fall a net 3.2 million barrels / day in 2020 alone. That rapidly gets us to that ~3 million barrels / day in 2021, not counting any demand growth. Basically, assuming a pessimistic scenario, by 2021 oil markets will have started to balance themselves.

That doesn’t count forecasts for additional worldwide demand declines. Plenty of other countries and regions have strong decline rates and aren’t profitable. More offshore rates of decline, such as the Gulf of Mexico, are at ~16%. Gulf of Mexico breakeven rates recently fell below $50 / barrel, an impressive feat, but still high enough that producers won’t be rushing to drill new wells. Given ~2 million barrels / day in production that alone is another 300k barrels / day that could be removed each year if drilling stops.

Across the world, at $35 / barrel, that same story will repeat itself. And it’s because, as we saw from the breakeven chart, it’s fundamentally not profitable to drill at current prices. Of course, that’s what OPEC and Russia want – they want market share back. They’re hoping, when prices recover, eventually, shale producers don’t drill so quickly. 2016 showed they were wrong. Maybe the third time will be the charm (202x).

Oil Crash Duration Estimate

So, let’s try and estimate a duration for prices to recover to the $50-60 / barrel Brent range. As we saw above, 2021-2022 is probably the latest that it would be until production started to balance itself out and prices started to recover. We personally believe that by second half 2021, Brent crude prices will be back to ~$60 / barrel. $50-60 / barrel is an important threshold because it’s not so high that people start drilling as much as possible, but it’s high enough that the majors can earn money.

However, the crash could be even shorter than that. Let’s look at some older oil crashes which had more rapid recoveries.

Year Peak Decline Duration Until Peak Decline Duration Until Recovery
2007 70% 7 months 7 months
1996 60% 23 months 13 months
1984 50% 4 months 12 months
2014 70% 18 months 30 months
2020 45% 3 months unknown

It’s worth noting that all these declines aren’t a recovery until the pre-crash price which in a lot of cases was artificially high and temporary, but simply a recovery back to a reasonable steady-state price.

As can be seen, our 15-21-month estimate isn’t abnormal for a recovery in oil prices. Most recoveries have been around that. It’s also worth noting a shorter decline tends to lead to a shorter recovery – and this is one of the fastest declines so far. Therefore, the recovery can be faster. However, with that said, COVID-19 is unprecedented.

Still with our average estimation of a 2021 recovery (~15-21-months from now) that means that a recovery could be quick or quicker. An average of a year and a half isn’t long for a financially-sound company and it could indicate the market has overreacted.

Investment Opportunities

For investors who want to simply invest in energy, BlackRock Energy & Resources Trust (BGR) could be a safe way to play the market. BGR is a great CEF that has exposure to most of the oil giants such as BP (BP), Exxon Mobil (XOM), ConocoPhilips (COP), Chevron (CVX) and Royal Dutch Shell (NYSE:RDS.A) (RDS.B). BGR currently trades at a discount of 2% and yields 13%.

However, here we’ll highlight two other companies you can invest in. Each has its own risks and is worthy of multiple full articles of analysis by themselves. However, this should be a good starting point.

1- Occidental Petroleum

Occidental Petroleum has seen its stock price drop by more than 85% since mid-2018 on the back of what was arguably the worst acquisition of all time with Anadarko. The company has been forced to cut its dividend from $0.79 to $0.11 / quarter and cut its capital spending by ~$1.3 billion annually below its breakeven rates.

However, the company’s new breakeven is “in the low $30s / barrel WTI” not counting the company’s hedges. The company’s hedges, through a three-way cost less collar to add $10 / barrel for 300,000 barrels / day in production in 2020. Across the company’s entire production that’s nearly $3 / barrel above current prices from the hedging.

That’s perfect because it means the company’s actual WTI breakeven is ~$28-29 / barrel WTI or ~$3-4 / barrel (~10%) below current prices. The company has significant debt, but it also has room to cut its dividend further if needed (saving ~$500 million annually if it chooses too or ~$1.5/ barrel). So the company has the financial strength to breakeven at current prices, which means while shareholder rewards won’t be there, it could weather a long oil crisis.

Last, it was worth noting that previously, at $40 / barrel WTI, Occidental Petroleum was breaking even with its old dividend. At $50 / barrel WTI it could increase production. But with its old dividend at almost 30% based on current prices, and the company able to cover that at $40 / barrel WTI, that means even with a slight recovery in oil prices in 12 months, the company could generate significant shareholder rewards. Remember, we’re expecting $55 WTI by second half 2020.

2- GeoPark

Another company we want to discuss as a potential investment is GeoPark (NYSE: GPRK). Small-cap companies tend to be punished more than large cap and the company’s stock has dropped more than 50% in recent months.

GeoPark Break Even – GeoPark Investor Presentation

However, GeoPark has one of the lowest breakeven rates among small-cap oil companies with 90% of its production cash flow positive at $25-30 / barrel Brent. That means, at current prices, the company is breaking even. It’s making ~$5 / barrel or ~$70 million / year, which is enough to help cover around half of the company’s capital spending. The company does have a low-oil-price maintenance capital spending plan that should actually allow it to breakeven at current prices.

Now who would want to own a company not fully covering its entire capital spending let alone rewarding shareholders? No one. But as we discussed above, oil prices won’t stay at ~$30 / barrel forever, that’s not financially feasible. At $50 / barrel, the company will be generating netbacks at ~$20-25 / barrel (~$300 million annually).

That’s almost half the company’s market capitalization. Of course, by the time that happens, the company won’t be worth $600 million any more. It’ll be worth, $1 billion-plus, and that’s when you as a shareholder get rewarded.

Conclusion

Oil prices have been devastated since the start of the OPEC and Russia oil price war. That, combined with the potential for demand drops from COVID-19 and a recession, could place strong negative pressure on oil prices. However, despite that, with 2020 shale demand expected to drop 3.2 million barrels / day in the U.S. alone, with additional declines worldwide, the market should balance itself out.

As we can see above, by 2H 2021, the market can be expected to recover. That’s in line with other analyst predictions and the historic length of crashes. Occidental Petroleum and GeoPark are two rational ways to play this – they each have enormous potential in the event of a recovery that’s more likely than not. That potential is significant, however there’s many additional opportunities out there. Let us know what you think in the comments below.

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3 Comments on "Oil: Blood In The Streets"

  1. makati1 on Sat, 14th Mar 2020 5:52 pm 

    “Oil: Blood In The Streets” And about time!

  2. fwsmj on Sun, 15th Mar 2020 1:32 am 

    muzzie stabbed killed 3 aussies
    when people’s trial of global muzzies convict and sentenct to death, there’ll purge of global muzzies.

    lovers of muzzie gonna love but ohters will enjoy the purge, muzzies will retaliate by roasting muzzie lovers but muzzie lovers gona love

  3. Theedrich on Sun, 15th Mar 2020 2:40 am 

    The main threat to recovery: Biden the Demented. This senile favorite of the Negroes, who is rapidly losing whatever mental ability (besides extorting money from foreign countries for his family members) he ever had, is drifting ineluctably toward the Sanders-Pelosi socialist cliff.  It now appears likely that the Dems will actually win the 2020 presidential campaign and possibly also take over the Senate.  With Biden as a mindless plaything of the DeepState in the White House, we may soon find ourselves in a new war to chastize the nasties of the world, as these are defined by the omniscient colonoscopists at the Yid-heavy Council of Foreign Relations and other dog-waggers of the Imperial Court.

    As everyone knows, the Imperial power competition is now characterized by a combo of celebrity politics and stupendous bribery floating atop a bottomless sea of money.  The fake-news organizations are run by multi-billionaire Yids with their genetically programmed hatred of everything White.  And the Sinistral sales pitch is aimed at the limbic systems of the lowest IQs, who will be constituting an ever-growing, largely imported majority of the nation.  The Democrat objective is to destroy the nation with more and more outhouselanders in order to “save” it.  The Left is assisted in this by the metastasizing sloth and genosuicidism of the Whites who once had a survival instinct.

    Thus we can expect that the reins of power will be conferred on a mentally decaying dotard whose first act will be to grant legal immunity to his own criminal son and brothers.  Thereafter he will do whatever his anti-White stringpullers tell him to do.

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