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No Crude Oil Recovery In 2015

While guests on CNBS CNBC and Bloomberg are busy encouraging you to buy oil names which are down over 50%, I wouldn't expect to reap any big rewards any time soon.  In fact I believe there will be much more pain ahead, depending on the strength of the company you chose.  Iran sanctions may be giving it a boost near term but once they're lifted (or eased) their production is expected to double which is once again, bearish for this oversupplied market

While everyone is in agreement that crude oil is in a bear market, quite often one strategy is to buy the laggard and anticipate it to outperform the following year.  The trouble with crude oil however, are the fundamentals.

  1. U.S. consumer Demand (figure 1)  Consumption has been dropping since 2000 thanks to more fuel efficient autos and younger Americans (millennials born from 1980 to early 2000s) being drawn to work in and the lifestyles of large metropolitan areas.  Baby boomers (born 1946-1964 or 51-69 years of age) will contribute less and less to overall GDP and consumption as they continue to approach retirement age.  Gen Xers (children of baby boomers) being the only ones migrating to the suburbs as they have children, pay at the pump and handle the long commute to the office each day.
  2. Production is up; way up (figure 2 to right)  The U.S. has been ramping up black gold producing rig counts and oil production since 2000 back to levels not seen in 30 years and projections are that these levels will continue to at least 2020.  Abundant supply shall continue.
  3. OPEC feels the least pressure from an operating standpoint to cut production as they have the lowest cost to operate worldwide.  They have stated they are completely comfortable with lower crude oil pricing will not cut back production unless someone else joins in the fun (hint to Russia and Venezuela) but this chess game could remain in check for quite some time.
  4. What we are witnessing is mean reversion in crude oil or price reverting back to a long term average in price. (see chart 3 below left)  While there are numerous investing strategies when a stock reverts to the mean, an entire "sector" reverting to the mean can translate into an underlying problem.  According to Investopedia mean reversion......
........has led to many investing strategies involving the purchase or sale of stocks or other securities whose recent performance has greatly differed from their historical averages. However, a change in returns could be a sign that the company no longer has the same prospects it once did,

Now wrap your head around this.  According to the BLS, in the U.S. alone, there are technically over 9,000 companies cranking out crude oil ,so one can only imagine how many exist world wide.  Just mind blowing.  F

or the sake of this theory, let's weed out the shell corporations and Mom & Pop operations with a pumper out on their back 40.  If we look at just names publicly-traded in U.S. markets and include oil service names who will also be affected by lower prices and lower demand, there are over 700 according an Ameritrade screener.  

The First Domino Is The Price

So let's say prices snap back but then continue drop and do not recover.  A company only has "so much" in cash reserves to continue to operate.  As they watch their market cap evaporate, they have limited options:

  1. Cut capital expenditures which we've already begun to witness with projects worth billions more in jeopardy of postponement.  Just in October alone, shale drilling permits dropped 15% in an area which had seen permits double from a year prior.
  2. As cash from operations shrink with price, they can sell assets however this is obviously unsustainable.
  3. Increase their stock buyback program in an effort to "buoy" their stock price.  While this can work in a bullish environment, when the market is bearish and you repurchase more than is being bought, it's a cash drain.
  4. Cut their dividend to save money unless they're able to get outside funding (not likely given forecasts).  Funds will not like that one bit.  Immediately funds will trim their positions even further than they already have seeking yield elsewhere.  This has (I believe) already begun as Seadrill Ltd. (NYSE: SDRL) and North Atlantic Drilling Ltd. (NYSE: NADL) announced that the two companies would be suspending dividends.  Many are anticipating a cut in RIG's dividend (currently at 16%) but even supposedly strong players such as ESV (10%) have suffered a huge drop in share price.
  5. They'll be forced to cut their forecast - more stock price pain
  6. They'll be forced to eventually lower their prices to attract new or retain current customers.  More pain in earnings and this can cause price wars.  Remember airfare wars?  Great for the consumer but killer for a balance sheet.
  7. Restructure, reorganize, layoff and cut costs.
  8. Pray a supply disruption, OPEC to cut production or for M&A to ramp up in the space and shrink the field of competitors.

Debt Debt Baby

The low-interest-rate environment and continued central bank stimulus have helped energy companies ramp their capex via cheap, ubiquitous financing. Consequently, debt levels in the energy sector have soared.  For example, Linn Energy, LLC (LINE), a favorite stock for yield hogs due to its 10%-plus yield, has increased its long-term debt levels from $2.7 billion at the end of 2010 to $9.6 billion currently.

The Energy Information Administration (EIA) estimates that, in the last year alone, major oil and natural gas companies added over $100 billion in net debt.

It's no better across the pond where a third of Britain's listed oil and gas companies are in danger of running out of working capital and even going bankrupt amid a slump in the value of crude, according to new research. Financial risk management group Company Watch believes that 70pc of the UK’s publicly listed oil exploration and production companies are now unprofitable, racking up significant losses in the region of £1.8bn.

Ratings agency Standard & Poor’s recently flagged its concern of some of Europe’s biggest oil and gas groups such as Royal Dutch Shell, BP and BG Group. Its primary worry is debt levels which it says have jumped from a combined $162.9bn (£105bn) for the five largest European companies in the sector at the end of 2008 to an estimated $240bn in 2014.

Martin S. Fridson, a prominent figure in the high-yield bond market, sees as much as $1.6 trillion in high-yield defaults coming in a surge that he expects to begin shortly.

We are already beginning to see the beginning of what I believe will be more pain ahead as Seadrill Ltd. (NYSE: SDRL) and North Atlantic Drilling Ltd. (NYSE: NADL) announced that the two companies would be suspending dividends.

So barring any disruption in supply, I believe we won't see crude oil with any true, long term rebound in 2015.  In fact, with no rebound in price we'll not only see Capex and dividends continue to be cut, but there will be defaults.  I believe M&A is on the way and yes, failures, Bankruptcies and more dividend/buyback cuts.  If you're a long term investor, sure go ahead and buy some shares (making certain they're financially strong) but don't expect a substantial return any time soon.  Just pray your company survives or is bought out.  Many will not survive.

(As a side note, TheMotleyFool has an interesting article on off shore drillers which may be of interest to long term investors.  I love to bottom feed and the author makes a great point about retiring rigs.  Check it out and let me know what you think)

The good news is once the smoke clears we will have fewer players on the oil field, prices will rise organically based on demand and competitive pricing and you, the consumer will benefit in the interim.

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