Oil Fundamentals

Most readers know what I'm going to say. World oil supply flows from three big geographic regions: North America, Russia, and the Middle East. Two-thirds of that supply is consumed by OCED members U.S., Japan, Korea, Germany and the rest of Europe. Throughout the past several decades, world oil supply/demand looked like this:

High prices boosted supply in the United States from unconventional plays in North Dakota, Texas Eagle Ford and Permian, Oklahoma Mississippian Lime, Colorado Niobrara, and Canadian heavy bitumen. We began to brag about "energy independence" in North America. Then the bottom fell out -- not only for shale frackers, but globally. This Goldman Sachs chart shows the estimated break-even for worldwide oil assets:

Bottom line: No one can profitably produce oil at $30 bbl. Mega projects like Kashagan won't make a penny of profit under $125. Bakken shale needs $70 to survive. So the first takeaway is more layoffs, capex cuts, consolidation, and likelihood of HY defaults in the shale space. Whiting and Continental are in a world of hurt, suspended frac ops. Imagine what that's done to the oil service sector led by Baker Hughes and Halliburton.

My friend Dominic Frisby at Moneyweek thinks there's a buying opportunity in small caps. I doubt it. The basic problem is collapsed demand for gasoline:

I won't try to guess the equilibrium price for U.S. gasoline. Most retailers live or die on their convenience store food and drink sales. Gas could be $1 or $3, and it would still be a struggle to keep their doors open. Major brands quit the retail market years ago. No profit in it. The refining business suffered a similar retrenchment, partly on regulatory burdens, but mostly because their ROI outlook evaporated. No matter which segment of the supply chain you investigate, oil is dead. Super-tankers are parked full of oil offshore Galveston and others are taking the long way around South Africa instead of using the fast route through Suez. Cushing is full to the brim. Folks are talking about building more storage for unwanted oil.

How does that square with Peak Oil? -- easily. Proved reserves haven't grown. Conventional oil production is still declining. Russia, Saudi Arabia, and Norway are pumping at a loss. We could shuffle through statistics from minor producers like Libya and Mexico for a much darker picture of world production, but what's the point? Oil is a highly concentrated resource. The future largely depends on state-owned oil companies in the cockpit of Middle East wars and goofy state-owned producers in South America. Oil geology hasn't changed.

Areas of opportunity still exist in Burma, Newfoundland, Lara Sea, and Antartica (!) -- but it's not a good time to spend tens of billions on an offshore development, unless it's a rule of law American play in deep water Gulf of Mexico. Watch Exxon (XOM), Chevron (CVX) and Shell (RDS-A). If they commit to a big new project in the Lower Tertiary or the Perdido Fold Belt, it's a safe bet at $50 bbl, if we ever see $50 again. Industry projections four years ago were fairy dust.

The fundamental problem is household income and financial repression, with a whole lot of unemployment and rising cost of living that's been concealed by BLS. When the unemployed use up their jobless benefits, they disappear statistically. Declining workforce participation tells the awful truth. But infinitely worse are "hedonic" adjustments to cost of living.

For instance, the BLS has determined that since no one makes or sells conventional TV sets any more and consumers are forced to buy digital flat screen TVs that cost five times more, an imaginary hedonic quality gain makes your new $1250 flat screen cheaper than a $250 Zenith sold twenty years ago.

“LCD direct view and plasma televisions have prices that are about 70% greater than CRT televisions, all other characteristics being equal. When an item is replaced and it is possible to apply the hedonic model, the CPI estimates what the price of the new version of item would have been if it had been in the CPI sample in the previous period. To obtain that estimate, the previous period price of the old version is adjusted using the value of the change in characteristics between the two versions.” [BLS Hedonic Quality FAQ]

The pox on oil production and purchasing power to support E&P in search of new supplies are ruinous government policies at home and abroad. No one who I know wants to work in Saudi Arabia, Russia, Venezuela, West Africa, Egypt, or Burma. The flood of new graduates from petroleum geology centers of excellence like Colorado School of Mines and Texas A&M are staring at a collapsed Oil Patch at home. Tens of thousands of highly skilled people were laid off in the past 18 months as firms struggle to survive. If you count the tank truck drivers and roughnecks, it's over 100,000 out of work.

Your best bet is shorting an A&D fire sale and discounting distressed debt -- or buy a crony capitalist Alternative Energy play backed by government subsidy. Shale is dead money.

No position in any stocks mentioned, no plans to initiate a trade.

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Alan Von Altendorf 8 years ago Author's comment
Joe Economy 8 years ago Member's comment

The oil business is doomed to die eventually since oil reserves will run out completely or become economically non viable because it will cost more to drill than to refine and sell. The big oil companies should diversify in their own future collapse by buying into the alternative fuel generation business be that hybrid car technology or wind turbine power or solar power. That way they can still make money by investing in an evolving energy business.

Craig Newman 8 years ago Member's comment

Enjoyed this, thanks.

Alan Von Altendorf 8 years ago Author's comment

Sorry about the typos. Failing eyesight.