Thoughts On Oil December 2014

Thoughts On Oil

17 Mile General Write-Up

December 14, 2014


Over the last several weeks I have outlined my thoughts on oil and oil-related equities extensively via Twitter; and while tremendously valuable for feedback purposes (I am sure at the expense of the patience of anyone who follows me…), it is time to put my thoughts together into relatively coherent written form.

BACKGROUND

Mostly by luck, I have largely avoided the carnage in the Energy patch since mid-2014. I had a moderate size position in DVN until early August, but closed the position in order to add to VRX. In addition to DVN, I found OXY and HES to be relatively attractive “event” candidates with oil hovering around $100, but never established positions for one reason or another. I highlight $100 oil because admittedly I was lulled into comfort with that price level due to XOM’s use of that range for CAPEX budgeting purposes for the next five years (I believe XOM technically uses $110).

Truthfully however, commodity-based investments bother me, as intrinsic values are very difficult to ascertain with any degree of accuracy. If I cannot establish, with a high degree of certainty, at the time of position initiation that I will aggressively add to a position in the event of a large-scale decline, then confidence in the intrinsic value calculation is severely lacking. As such, I try to limit commodity exposure to event-driven situations (Though at the right price, XOM would be a tremendous long-term investment – hopefully more on that to come!!).

I am not even remotely going to brag about largely being on the sidelines for the entirety of the oil price slaughter, as I am usually the one getting slaughtered; but I must admit it has been a fascinating mental experience watching it unfold and being able to objectively analyze the situation without any exposure to it. While I am a value-oriented contrarian at heart looking to “buy when others are fearful”, I am extremely thankful for the training I have received in technical, macro and cycle analysis, as it has prevented me from “prematurely accumulating” oil assets.

Really up through the now-fateful post-Thanksgiving OPEC meeting, I have been physically and mentally firmly on the proverbial sidelines. It was not until I began discussing California Resources (NYSE: CRC) on Twitter with @well_mont that I began developing a mentally bullish bent toward oil and related equities. In short, as long as oil does not crater to $30, I believe the spin-off dynamics with CRC make it a highly compelling short- to medium-term investment. However, the more I began contemplating the true extent of the drop in oil, the more bullish I have become on the commodity itself in the short-term. (Where I have likely erred thus far, however, is letting my extreme bullishness toward CRC leak into my thoughts on oil. For example, I mentioned several days ago on Twitter that I was “uber bullish” on oil in the short-term. Based on feedback received, that was likely too strong of language given my long-term bearish stance on the commodity.) Onto the “analysis”…

LONG-TERM BEAR

I am a big believer in cycle analysis, particularly for assets as subject to boom-and-bust cycles as commodities. The quote “high prices eventually take care of high prices” says it all, in my opinion. In the late 1990s/early 2000s, commodities had seen over a decade of low investment as a result of low prices; and once the supply/demand equation reached a tipping point, prices began to rise. Over the following decade+, relatively high commodity prices fostered a massive commodity investment boom as producers looked to capture, however limited, the then-available “economic profit”. Based on the price behavior of the commodity complex in aggregate since late 2011 however, I believe the supply/demand equation has reached its “late 1990s/early 2000s” moment, but in reverse. While oil largely resisted the initial decline in aggregate commodity prices, it has since succumbed in violent fashion. More than likely it will be difficult for oil to escape the gravity of a long-term down trend in aggregate commodity prices.

The caveat to this long-term view – and it is admittedly a big one – is that, as Jeremy Grantham has harped on ad nauseum the last several years, the world has drilled the cheapest, most productive wells and thus oil is only becoming more expensive to drill in real terms, not cheaper as the “high prices take care of high prices” thesis assumes. In GMO’s 3Q14 Letter, Grantham says that the marginal cost of production rose from approximately $15 per BBL in 1998 to between $70 and $90 today, far above the long-term real trend of $16. While certainly an eye-popping rise in marginal cost, I find it difficult to believe that over a decade of enormous capital investment has not seen the demand for capital equipment & services far exceed supply, thus driving up the marginal cost. Take deep water driller Transocean Ltd. (NYSE: RIG) for instance – its stock price has plummeted from over $50 in late 2013 to under $20. Perhaps this decline is indicative of lower earnings power driven by an oversupplied deep water drilling rig market? Perhaps the cost of XOM’s deep water drilling programs will decline as a result of rig day rates dropping from over $500,000 to say under $400,000? Perhaps the high & mighty oil field service companies with exploding margins will see a decline in revenue as capital projects are curtailed, thus leading to a lower cost of drilling on land in the U.S. Lower 48 shales? I am far from an expert, so I could be way out over my skis here; but with all due respect to Mr. Grantham, I believe he is underestimating the power of human ingenuity. What would he have predicted for the world as it reached “peak wood” in 1900?

That said however, I could not agree more with Grantham (from the above-referenced 3Q14 letter):

“…I am willing to concede that the outlook for oil and energy is the most complicated puzzle I have ever come across: it is wheels within wheels, but with each spinning in a different time frame. As Spock would say, “Fascinating!” How this ultra-complicated tug of war plays out in the next 10 years or so is anyone’s guess. My guess is that oil prices will bounce around for most or all of the next 10 to 15 years as first one side of this tug of war moves ahead and then the other, with perhaps another 2008-type spike (or two) in the price of oil, after which prices will plateau and decline as electric vehicles take over and, one by one, oil’s remaining uses are slowly replaced.”

SHORT-TERM BULL

WTI Inflation-Adjusted Price Chart

Given my long-term bearishness on oil, my short-term bullishness is truly short-term, as in 3 to 6 months (pulling a time frame out of the air). As such, it is likely inappropriate to label my bullishness “uber” since attempting to time an oversold crashing market can be like picking up pennies in front of a steamroller. However, in the case of oil, I believe the steamroller is a bit further down the road than the market currently believes…

While numerous factors are at play – U.S. Lower 48 production, OPEC, China, Europe, the USD, etc. – the fact that oil has now declined more than gold has since its 2011 peak is indicative of how truly oversold the oil market is at present. Gold has virtually no utility thus little means by which to “value” it, yet has declined by “only” 40% since the 2011 peak at its recent 52-week low. As of Friday’s low, oil is down by approximately 45% in less than six months. Obviously starting point context matters…

At its peak of $183 as represented by the GLD, gold was near its all-time inflation-adjusted high. In contrast, at the June 2014 peak of $106, oil as represented by WTI was ~73% of the all-time inflation-adjusted high set in 2008 and ~91% of the 2011 peak. Further, at the 2008 ATH of $146, oil traded for ~2.2 times its marginal cost (assuming a ~11% CAGR since the Grantham-cited $15 cost in 1998, 3% inflation), whereas at the recent $106 peak it traded for “only” 1.3 times its marginal cost. POINT BEING: oil, an asset with enormous utility and ascertainable value was not egregiously overvalued and/or overbought prior to the recent 45% decline; yet gold, an “asset” with extremely limited utility and ascertainable value, is down “only” 40% from being incredibly “over-bought” at its inflation-adjusted ATH in 2011.

This is just a long-winded way of saying that oil is extremely oversold. Perhaps long-term fundamentals trump near-term sentiment and trading conditions and oil continues on a straight line to $30/BBL. Who knows. But with oil arguably undervalued on a marginal cost basis at current levels and the global economy in relatively good health – thus not subject to a severe demand shock ala 2H08 – the case can be made that a sentiment-re-balancing bear market rally is at hand with oil down ~45% from its June 2014 peak.

As per usual amidst market mayhem, it is difficult to anticipate the event that will spark a rally. Perhaps it is a favorable oil inventories report or market-friendly chatter out of OPEC; again who knows. My guess would be that, given the severely overweight USD positioning in global currency markets, even a two-month consolidation in the USD rally could spark a rally in commodities in general, and oil specifically. Counter-intuitively, an ECB QE announcement could reverse the USD rally on the “belief” that full-fledged QE in the EZ would enhance real growth in the region, thus driving near-term strength in the EUR. Again, not an expert – just some outside-the-box thoughts on what could happen.

CONCLUSION

This is a ridiculous amount of ink spilled to arrive at the conclusion that: there is limited downside to the price of oil from here, and as such, an investment in CRC is an attractive set-up from current levels, as the spin-off dynamics A) create upside IRR potential in the event oil fails to rally; B) downside protection in the event oil continues to decline; and C) outsized IRR potential in the event oil rallies.

I am also watching ATLS as a potential event/special situation investment. Major h/t to @BluegrassCap on this one.

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