- December 4, 2019
- Posted by: Art Berman
- Category: header-menu
Buy low, sell high.
That’s the key to understanding the waxing and waning of investor enthusiasm for oil over the last 5 years.
The popular story is that investors have abandoned oil markets because the business hasn’t been profitable. That is complete nonsense.
Investors didn’t care a bit about negative cash flow when oil prices were in the toilet in 2016 and companies were going bankrupt. That’s because oil prices could only go higher. Free money.
Investor flight began when prices approached and then, exceeded the cost of the marginal barrel–about $60 per barrel for WTI. No more free money.
Smart capitalists were not investing in the companies but rather, were playing their stock or collecting a coupon on their bonds. Free cash flow was not part of their calculus. Neither was debt.
The stock play was better than casino gambling. WTI price almost tripled from $26 in early 2016 to $76 by late 2018 (Figure 1). Buying and selling tight oil company stocks was a great way to ride that wave without the risks of commodity trading.
In 2016 and the first half of 2017, tight oil share prices actually out-performed WTI. As oil prices moved higher, share prices performed at about the same level as WTI. After oil prices collapsed in late 2018, share prices substantially under-performed WTI.
An investor who bought shares of tight oil companies (Table 1) in 2016 and held them until late 2018 would have made an average profit of 181%. By moving in and out of stocks during higher frequency price fluctuation, even greater profits were possible.
Companies routinely offered secondary shares and bonds whenever they needed additional capital for drilling. Investors were eager to buy considering that 10-year treasury bond yields averaged only 2.4% during this period.
Tight oil rig counts consequently tripled between May 2016 and March 2018. 345 horizontal rigs were added while WTI price was less than $60 per barrel. Once oil price exceeded $60 per barrel, rig counts flattened.
Since oil prices collapsed in late 2014, markets have consistently signaled that $60 per barrel is the appropriate equilibrium price for WTI. The blue yield curve in Figure 3 shows the WTI comparative inventory-price yield curve. The $60 intersection of the yield curve with the 5-year average (y-axis) represents the market clearing price of the marginal WTI barrel.
Sentiment-driven excursions are as important as values that fall on the yield curve because they reflect price-discovery responses to factors outside of supply-demand fundamentals.
The 2H 2018 excursion in Figure 3 was largely in anticipation U.S. oil sanctions on Iran. When President Trump reneged on those sanctions in October, markets reacted with the largest price collapse since 2014-2015.
WTI price fell from $75 in early October to $45 in December (Figure 4). Although the price change was less extreme than 4 years earlier, the rate of change was 25% greater. The signal to producers and investors could not have been stronger: continued production growth was no longer acceptable.
OPEC+ will meet this week to decide whether to extend or increase production cuts that have been in place for the last three years. For the first time, there is some momentum to abandon the cuts. World production is about 1 mmb/d less than before the price collapse.
U.S. tight oil rig count has fallen 15% and it seems likely that output will flatten or fall. OPEC’s worry is that continued or deeper production cuts will result in higher prices that may reverse this welcomed trend in the shale patch.
I believe the opposite is true. Tight oil production is almost entirely dependent on the availability of outside capital. Higher oil prices have resulted in less, not more, capital to U.S. companies. If OPEC+ abandons restraint, oil prices will almost certainly fall. The surest way to re-open the flood of money to the shale plays would be much lower oil prices.
Buy low, sell high.