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Oil Plunges As China Spooks Global Markets: Time To Buy?

This article is more than 8 years old.

The world has never been more hooked on oil than it is now. Get a piece of the business while it's cheap. 

The oil market is in free fall, with West Texas Intermediate and Brent crude down 12% in the first trading week of the year to less than $33 a barrel. Shares of America’s oil frackers are falling as well. In the past month Continental Resources is off 28%, Devon Energy down 20%, Anadarko Petroleum 24%. The next oilpatch bankruptcy looks likely to be SandRidge Energy, delisted from the NYSE yesterday after its stock hit 15 cents.

Why is this happening now? China’s market freak out is igniting fears of that its economy has hit stall speed. Chinese oil demand has flattened in recent months, and if economic contagion sweeps across the emerging markets and into the OECD, it’s not outrageous to think WTI or Brent could hit $25 before this is over.

Capitulation can’t come soon enough. As John England, head of oil and gas consulting at Deloitte , wrote in a note last week, the industry has now gone through the five stages of grief:

Denial — “This is just a blip and won’t last long.” (This view died by March.)

Anger — “It’s OPEC’s fault” (for producing as much as they can … a lot like U.S. producers).

Bargaining — “If only we had invested for returns, not growth, for the past five years.”

Depression — “Cash flows continue to diminish, and balance sheets continue to weaken.”

Acceptance — “I guess we’d better prepare to ride this out for as long as it takes.” (The current view.)

All that’s left now is hope. It’s not much of a strategy, but it beats the alternative.

And yet there’s still plenty reason for hope. If you're a long-term investor. My resolution for 2016 is to try and take a more holistic and constructive view of the oil bust. Yes we’ve seen 250,000 layoffs, dozens of bankruptcies and restructurings, hundreds of billions in stock and bond values wiped out. But oil is not dead or dying. It’s not even sick. It’s just in the trough of a natural cycle.

Consider this: the world oil market it bigger than it’s ever been. Demand, at 94 million barrels per day, has never been higher. Supply is also at all time highs, running about 95.5 million bpd, according to EIA and OPEC data. It’s that oversupply that’s causing the despair, and filling up storage tanks.

Low prices spurred demand growth of 1.5 million bpd last year, says WoodMackenzie, which forecasts another 1.2 million bpd of added demand this year. Sales of luxury SUVs surged 17% in 2015.

The more that people get hooked on oil, the more money to be made on it in the long run. That’s why the Gulf states have been keen to consolidate market share in the down turn. In 2015 Saudi Arabia, Kuwait and the United Arab Emirates produced oil at record levels. They can withstand a little pain because even at current prices their oil is wildly profitable. Saudi Aramco’s average cost per barrel is less than $6, according to those in the know. Their marginal cost is $20. Even at current prices that’s highly profitable. Not profitable enough to pay for all their social programs, but smoothing out the volatility is what $700 billion in retained earnings is for. The Saudis are playing the long game, which is why as American oil companies are forced to lay off and cut back, Saudi Aramco has kept investment steady and is even advertising job openings (check out @AramcoJobs on Twitter).

Of course most other petro-states and oil companies don’t have big cash cushions to fall back on, so that’s where corporate Darwinism comes in. The strong survive; the weak die off, and a cycle of creative destruction unfolds. The industry evolves in new and unexpected ways and the cycle starts all over again. Trees need pruning in order to grow bigger and stronger. The process only hurts if you’re the branch that gets cut off. “The endgame is an oil and gas industry that will be stronger, leaner and built to last,” says John England of Deloitte.

Let's hope the bust goes on just long enough to bring lasting change to Venezuela, where plunging oil revenues combined with rampant corruption and unsustainable social programs has already handed electoral defeat to the party of President Nicolas Maduro. The Venezuelan people owe it to themselves to sweep out the Chavistas and install leaders who can more responsibly develop their 100+ billion barrels of oil.

In Nigeria, too, President Muhammadu Buhari has already shown far more courage than his predecessors in cracking down on rampant oil sector corruption. He has stated that “mind-boggling” sums have been stolen, with proceeds from oil sales diverted to personal accounts instead of the treasury.

It’s less likely that low oil prices will lead to regime change in Russia or Iran. President Vladimir Putin looks safe in his seat. Meanwhile the mullahs of Iran cleverly arranged a lifeline by agreeing to negotiate on their nukes with John Kerry. If all goes as planned Tehran will soon receive a $100 billion windfall and get cleared to ramp up oil exports.

In the short-term, global oil market share is a zero-sum game; what’s good for Iran is bad for U.S. companies. But long-term the outlook for American oil is far better than just a few years ago. Think back to 2006, when it appeared that all the “easy oil” was gone and the future of the industry lay in the Canadian oil sands and in every deeper waters. U.S. oil production bottomed out in 2008 at 5 million barrels per day. At the time virtually no one believed that U.S. output would grow again, rather the future would be all about achieving as shallow a decline as possible. Less than 8 years later domestic production is at 9.3 million bpd — a boom of historic proportions. In less than a decade the United States nearly doubled its global oil market share. And even now that Lower 48 production has rolled over into decline, we’re still producing at a level unmatched since 1973.

And future growth is all teed up. American drillers don’t even need $100 a barrel anymore. The bust has made them more disciplined; costs are down about 20% across the board. The deeper companies cut now, the sooner the nightmare will be over. Companies slashed capital investment in 2015. Cowen & Company oil analyst James Crandall expects a repeat in 2016. He surveyed 450 companies and found that they expect to reduce global capex 17% to about $450 billion. Cuts of 24% are planned in North America, with even deeper cuts in Latin America, with Pemex down 41%, Pdvsa 28% and Petrobras 23%. And there’s room to the downside, writes Crandall — the average oil price that companies used for 2016 budgeting was $48.50 (nearly 50% higher than today’s price).

Those cuts to investment have begun to show up in current production data, with U.S. output down about 400,000 bpd from the peak last April. Analysts expect U.S. production to fall another 600,000 bpd or so this year, with enough declines around the rest of the world to finally wipe out that oversupply by 2017.

And that’s when it will get interesting. Bernstein Research calculates that the industry’s capex cuts have removed 3 million bpd of future supplies from the medium term. Add to that roughly 4 million bpd of natural declines from the world’s existing fields as reservoirs are depleted — and it’s not hard to imagine supplies growing uncomfortably tight in just a few years.

What’s the right price of crude oil? Bernstein figures that the full-cycle, all-in, marginal cost per barrel is on the order of $78. That’s where the price will have to go back to after the excess is worked off in order to incentivize new supply.

Now’s the time to start dollar-cost averaging into oil companies. Bernstein’s buy list includes EOG Resources , Cobalt International Energy , Anadarko Petroleum and Devon Energy. Another good way to go is with the Vanguard Energy Fund (VGENX) — at $39 per share it’s down almost to its 2009 low. Top holdings include Exxon Mobil , Chevron , Pioneer Natural Resources , EOG Resources and Occidental Petroleum . The no-load fund’s expense ratio is 37 basis points. There’s also an ETF version (VDE).

Yes there's still some pain ahead for oil companies, but the best time to be adding to a position is when everyone else is capitulating.

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