This article first appeared at The McAlvany Intelligence Advisor on Wednesday, December 3, 2014:
One of the most famous homespun quotes Warren Buffett ever uttered is this: “Only when the tide goes out do you discover who’s been swimming naked.” With the decline in crude oil prices of nearly 50 percent since June, more and more people are finding themselves swimming naked, or they’re about to.
Consider the formerly invincible oil cartel, OPEC, which seems to be suffering from delusions of its former glory by taking on oil producers in America. Instead of cutting production in order to “stabilize” oil prices, the cartel, led by the aging big kahuna, Saudi Arabia, has decided to “encourage” its cartel members to follow the recommended production limits. Of course, no one does, and everyone knows it.
The game is simple: flood the market and force out of the game those who don’t have the staying power. Once those marginal players are gone, prices can be manipulated upward, to the benefit of the remaining players.
It worked in the past. Witness the oil crisis in the US in the 1970s. But that was then. This is now. As Tim Mullaney, writing for MarketWatch, explains, it’s a failing strategy:
There are at least three big problems with [OPEC’s] strategies. One, North American crude isn’t as expensive to produce as it used to be. Two, there’s more than you think in the pipeline to make it even cheaper. And third, OPEC nations, including Saudi Arabia, have squandered their [oil revenues] on welfare states [that they] can’t easily cut back.
If OPEC is assuming that they can drive crude oil prices low enough to end the shale revolution, they will shortly find out they are swimming naked. In North Dakota, for instance, the average cost to pull a barrel of oil out of the ground is $42. In McKenzie County, the average cost of the 72 oil rigs working there is just $30.
Compare that to Saudi Arabia, which, thanks to its welfare state, must have crude selling at $101 barrel to balance its budget, according to Goldman Sachs. Compare that to other cartel members which have much higher breakeven points. If the cartel presses the matter, it will likely wind up destroying some of the cartel members it allegedly is trying to help.
Mullaney suggested that Ali Al-Naimi, Saudi Arabia’s Minister of Petroleum and Mineral Resources and informal head of the cartel, take a little time out of his busy schedule and read Clayton Christensen’s updated book, The Innovator’s Dilemma. Without saying so, Mullaney is suggesting this as a post-mortem on a strategy that worked 40 years ago but can’t work now:
Think of the Saudi welfare state as oil’s brick-and-mortar stores: integral to an old business model [but] unsustainable in the new.
Just awakening to the new swimming hole in which oil producers are trying to stay afloat is Murray Edwards, the CEO of Canadian Natural Resources and reputed to be the 14th wealthiest man in Canada. When quizzed about how low crude oil prices might go, he responded:
On a given day you can have market fluctuations where prices fluctuate far more than the underlying economic value of the unit.
Prices could spike down to $30, $40. It got down to $35 in 2008, for a very short period of time.
Estimates are already coming in that if crude oil prices go down much lower and stay there much longer, they will take a full percentage point off of Canada’s gross domestic product. Its oil sands product is expensive to ship and refine, and consequently becomes less and less competitive in a market flooded with less expensive, easier and cheaper to refine product from places like, well, North Dakota.
Another observer about to discover that his shorts are wet is ebullient oil optimist and economist Mark Perry. He has gleefully reported the details of the shale revolution as it has evolved over the last half-dozen years, celebrating a nearly unending series of victories and statistical record setting. Perry rejoiced on Monday that oil production in Texas exceeded 3 million barrels per day (bpd) in September, making it (if it were a separate nation) the world’s seventh largest oil producer. Wrote Perry:
For oil output in Texas to increase from 2 million to more than 3 million bpd in less than two years … is undoubtedly one of the most remarkable energy success stories in US history.
Perry goes on to make a prediction that he may soon regret:
At the current pace of annual increases of more than 20%, daily Texas oil production is on track to surpass the 4 million barrel milestone by August of next year.
This is called “straight-line thinking in a curvilinear world” and reflects the assumption that as things were in the past, so they will continue in the future. He will soon learn the lesson that every investor in a bull market eventually learns: nothing ever grows to the sky.
Much of the explosion in America’s oil patch has been financed with dollars from investors, mutual funds, and pension plans seeking higher yields. They have been persuaded that, just like in the mortgage business that blew up less than ten years ago, risk assessments and credit ratings can be believed. They too will learn that what’s more important than the return ON their money is the return OF their money.
The junk bonds financing much of the shale revolution have always been risky, but until crude prices started falling through the floor, no one really cared. In 2008, junk bonds financing that revolution totaled just $210 billion. Today, it’s more than $1.3 trillion. And, according to the Financial Times, a third of those “energy debt” bonds are now classified as “distressed.” FT noted that some oil companies are having to go to the bank to borrow just to pay out their dividends, another practice that will disappear when the tide goes out far enough.
A few investors are waking up. Just since August, the energy sector in the US has gotten pounded, turning early gains into losses that now exceed 10 percent for the year, resulting in energy being the worst-performing sector in the S&P 500 Index.
Others holding onto shares of Petrobras, the semi-public energy company in Brazil, have gotten hammered as the stock has dropped from $32 a share less than three years ago to $9 currently. Petrobras, with revenues of $130 billion a year, owes more than $112 billion and is planning on borrowing another $100 billion to complete its build out of its huge Tupi and Jupiter oil fields. In its prospectus, the company claims that, once completed, the cost of lifting oil will be between $41 and $57 a barrel. But skeptics remember that Petrobras has a long history of overstating its results, with some of them concluding that lifting costs will exceed $130 a barrel instead.
The biggest swimmer in the ocean, however, is China. In October, a remarkable event occurred that was scarcely reported: China, a huge importer of crude to support its massive industrial development program, has now become a net exporter! Platts, a division of McGraw Hill Financial, announced that in October, oil imports to China dropped by 22% while oil exports surged by 30%. Platts said further that it expects China to become a net exporter of oil well into the future, reflecting its increasingly dismal economic condition. The communist leadership in that country has bought the Keynesian lie that it can bootstrap itself into prosperity, and has spent trillions in creating the new industrial state in preparation for all its newly emancipated citizens. Hardly a soul exists who hasn’t seen the eerie photos of empty cities waiting for them. Now, according to China’s own National Development Commission, some $6.8 trillion of that money has been wasted.
Buffett is right. When the reality check bounces, the underlying assumptions will be exposed to the light of day.
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