Weekly Market Assessment
How long is oil going to trade at these depressed levels? This of course is the million dollar question that everyone right now wants to know. However, there are certain ingredients that go into creating the oil market balance or imbalance that might help answer this question. One of the first topics I want to discuss is capital expenditures, which are funds used by a companies to acquire or upgrade physical assets such as property, or equipment. It is often used to undertake new projects or investments by the firm. In oil exploration and production the capital needed to find and extract the commodity requires a ridiculous amount of money. Capital spending is the lifeblood to drilling companies ability to continue on their quest to pull more oil out of the ground. Cutting this creates a huge problem in the short term and of course an even larger problem in the long term, as an oversupplied crude market becomes under-invested which leads to an under-supplied oil market.
So what has helped cause this flush of new capital into the energy sector? The monetary policies of the great Federal Reserve of course. It's low interest rate policies helped fuel the industry with what seemed like endless funding at low rates never before seen. This helped the well oiled drilling machines continue on their quest to find and drill new wells that were needed to replace declining production in legacy wells. This caused the crude market to become oversupplied by what has been termed the North American Shale Revolution.
This unconventional drilling known as fracking, brought to the market an additional 4 or so million barrels per day over the past 5 years. Coincidence that this correlates to the Feds Quantitative Easing program that started around the same time? Unconventional shale basins, also known as tight oil has lead the United States to become the third largest oil producer in the world! Yes, that is true and many still can't believe that. However, it has come at a cost as now the crude market has collapsed on itself and many companies are suffering because the cost to produce a barrel of oil is more than the actual price of a barrel in some locations.
So, just how oversupplied is the crude oil market? The current estimated supply is around 97.6 million barrels per day compared to current demand around 95.4 million barrels per day. Now, this is constantly changing and being revised, because it is extremely difficult to measure both numbers and explains why investing in this commodity is one of the most difficult. Some argue that the market is not flooded with oil and believe the oversupply is just around 500,000 barrels, while others believe it's closer to 2 million barrels. Market sentiment also plays a big part as markets overshoot to the downside as well as to the upside. Amazing to see what a half a million barrels to two million barrels can do to a market that once traded at $104 and now trades in the low $30's. Imagine if the markets got a hint we were under-supplied!
[depicted in the chart above, you can see CapEx for the world's largest oil producers has been expanding... however, CapEx is about to fall off a cliff, when this happens, can you imagine what oil production will do...]
How can this excess crude be put back in balance? Well, take away the funding and cut capital expenditures (capex). Today, both of these levers have been pulled. Banks have begun to stop lending and companies have slashed their capex budgets by more than 25%. This of course is what creates a major problem for future much needed oil production and why current oil prices are unsustainable.
The annual worldwide demand for oil is 34 billion barrels, this requires billions of dollars to maintain the constant demand. According to Rystad Energy, a Norway energy consultant states, "that while the oil industry worldwide needs to replace 34 billion barrels of crude annually--equal to current consumption--investment decisions for only 8 billion barrels were made in 2015." Wow! The OPEC cartel along with every major investment firm and analyst confirms that worldwide capex has been cut by $200 billion this year and it looks like another $115 billion will be cut in 2016. The almost full stop in spending is going to catch up with us. If future exploration and production projects don't come online to fill the decline in production, while demand remains robust, the current price of crude will have no choice but to rise to incentivize producers to put drilling rigs back to work!
So who is cutting capex? Every oil related company is, from major integrated oil companies like Shell and Exxon Mobil to some of the smallest exploration and production companies, no one has been able to dodge this bullet. They have no choice but to cut capex to protect their balance sheets. Energy investment bank, Tudor Pickering Holt & Co. recently said, "roughly 150 oil and gas projects have been delayed or cancelled globally over the last 18 months, jeopardizing a combined 13 million barrels per day of future oil production." They go on to say, "that the deferred projects--which exclude U.S. shale -- hold some 125 billion barrels of oil."
When the decision is made to reduce capital spending, then the obvious assumption is that production will be negatively affected. When and if the crude market becomes under supplied, it takes drilling rigs in the U.S around 4 months from the time the drill bit breaks the ground to the time oil starts flowing to the surface and in other regions it could take months or years to green-light a drilling project. The lag time between bringing oil to the market could become worse the longer we stay at these depressed levels. So it's not like turning on a switch and voila, excess oil in the tank. The scary part that makes it worse, is when fear enters the market that prices are going to rise, consumers react by what many industry watchers call "topping off the tank" occurs and the already under-supplied market becomes even more under-supplied. A vicious cycle that is only cured through rising oil prices!
Will 2016 be the year oil recovers? Some industry watchers and even corporate CEO's are sounding the alarm bell saying, "in a few years there's a good chance the demand-supply ratio once again will be out of whack -but this time there will be too much demand for too little crude." This is not the first time we have been trading at prices this low and sooner rather than later the decisions the oil industry has been forced to make today are going to come back and haunt us tomorrow.
Making the Watchlist: Below are the stocks that I will be looking at over the coming months. I will provide the the current stock price and why I am watching them. I will comment on them as I continue to keep an eye on them. You will be able to see and follow their growth and/or decline. Chart links may be attached.
See What I'm Trading:You can now view all my real-time trades by following this link, BlackPacific Capital1. This new site shows my trades, in real time the minute they are bought and sold. Below you can also click on the stock symbols, trade strategy or prices which will lead you to this new site. The site offers a full risk/return profile and video detailing the strategy of the trade. Note: When looking at the option positions every contract equals 100 shares.
BlackPacific Capital has created three funds. The first is the Total Return Fund and the other is the Growth Fund. Both of these funds will be compared against the S&P 500. Both will hold a total of no more than five companies each. The Total Return Fund is a low turnover fund where every holding must have a dividend and be undervalued to its peers. The growth fund is made up of momentum high growth stocks where the turnover rate is much higher. Below are their Weekly and Year to Date returns. For more information and to see the holdings in each fund click here.
New holdings and liquidated positions: I have added BHP Billiton and Hess Corporation to the Energy Fund. I opened the BHP position at $24.25, while locking in a dividend yield at 10% and Hess Corp at $47.25 while locking in a dividend yield at 2%.
S&P 500 Return
Year to Date: -1.62%
Total Return Fund Return
Year to Date: -4.34%
Year to Date: 13.41%
Year to Date:-7.41%