The Black Gold Rush

     

With the price of WTI Crude Oil hovering at $49.90 a barrel, the market appears to be shaking off a tumultuous few years in the energy sector. Marked by substantially higher volatility and seemingly endless price declines, the oil markets monopolized the attention of investors as each tick was thought to signal recession one day and predict economic prosperity the next. While this cycle certainly resulted in a wild ride, it also serves as an excellent case study revealing the complexities involved in the seemingly simple concept of supply and demand within the oil markets.

To fully understand the origins of the recent oil supply glut, we must revisit the subprime mortgage crisis. By the end of December of 2008, WTI oil prices bottomed out at $31.41* a barrel as the world’s credit markets seized and stock prices plummeted. Sensing that a major intervention was necessary to salvage the U.S. economy, the Emergency Economic Stabilization Act of 2008 was signed into law by George W. Bush which infused $700 billion into the financial system. This stimulus package helped to stabilize the markets and started the slow but steady path to a recovery. As a result, by the middle of 2009 the stock market began to regain its footing and progressively started to reclaim losses.

 

A gradual recovery

As investor optimism increased, the price of oil proceeded to rise. By the end of 2010, oil prices had gradually see-sawed to $91 a barrel. In 2011, political unrest affecting Middle East countries including Egypt, Libya, and Yemen culminated in the “Arab Spring” which pushed prices even higher to $114.

From 2011 to 2014, geopolitical tensions continued to affect the energy sector. Especially influential were the conflicts in Iraq and Libya, as well as the tensions between Iran and the U.S. and its allies surrounding sanctions relating to their nuclear program. As a result, oil prices remained elevated and by January of 2014 the price for WTI crude was $98 a barrel. It was at this time, however, that oil production around the world exceeded demand. Consequently, inventories grew and word began to spread throughout the markets of a possible supply glut.

In response to this imbalance, major OPEC producers were expected to do as they had done in the past and reduce production to normalize prices. However, in a bid to force other producers out of business, Saudi Arabia instead opted for a price war. According to a Financial Times article published in July of 2015, “Riyadh self-reported crude oil production of 10.6m barrels a day in June, an increase of more than 200,000 b/d on the previous month and its highest level since records began.“

While this would appear to be an illogical economic misstep, the Saudis knew that they had to contend with a new factor in the energy market: U.S. shale oil.

 

American energy independence

In response to rising prices, American oil companies had begun to investigate more complex, expensive, and involved methods of oil extraction. Although these methods were once considered to be unprofitable, as prices rose they provided a viable means of production as improved technology allowed for more cost-effective and efficient oil extraction. Two of these methods were hydraulic fracturing and horizontal drilling.

Fracking and horizontal drilling contributed to a near doubling of U.S. oil production from 2010 to 2014. Likewise, an increase in Canadian oil sands production increased from 3.3 million barrels a day to 4.2 million in 2014, an increase of 27%. Furthermore, sanctions on Iran were lifted in an agreement that was reached on July 14, 2015, which allowed Iran to introduce its oil to new trading partners within the world markets and placed additional downward pressure on prices.

 

Battle of the oil giants

By the end of 2015, the oil market became a game of survival of the cheapest, where the producers with the lowest costs for oil extraction, particularly Middle Eastern countries, tried to force the higher cost producers out of the market. This move did not, however, result in the retreat that the Saudis had hoped for as non-OPEC countries proved to be more steadfast than they had anticipated. While U.S.-based oil companies faced immense pressure on earnings and balance sheets through write-downs, dividend cuts, layoffs, and rig closures, many of their more profitable rigs continued to pump in anticipation of higher prices down the road.

In January of 2016, however, there were finally signs of a possible turnaround. The Saudis released a statement indicating that the country was considering the sale of shares of Saudi Aramco, its state-owned oil company, in the largest proposed IPO in history. At a potential $2 trillion valuation, this was largely seen as a sign that the country was in dire need of additional funds. Additionally, it served as an indication that Saudi Arabia was ready to establish stability in the oil markets.

Furthermore, recent forest fires in Canada have reduced oil sands production by approximately 1 million barrels per day. In addition, weekly U.S. oil production fell from 9.6 million barrels in June of 2015 to 8.7 million as of the week starting May 20, 2016, a decline of 9.4%. Overall, U.S. inventories have fallen by 4.2 million barrels to 537.1 million barrels. Internationally, OPEC and Russia are said to be in talks to cooperate in reducing oil production, which has helped oil prices to recover to their current levels of approximately $49.

 

An intermission

We welcome the return to more normal oil price levels as it suggests that 1) the global economy is doing a bit better and 2) supply and demand are beginning to re-balance in the oil market. But the new found relative calm in the energy sector shouldn’t necessarily be taken as an all-clear signal. Volatility will likely continue. And the battle between US energy independence and Saudi market share isn’t over.

One of the main lessons of this saga is the importance of diversification in any investment portfolio. Spreading investment capital around different sectors of the stock market has allowed us to avoid a good deal of damage done by an energy sector that is down 24% over the last two years. Keeping energy investments to a relatively modest portion of our investment strategies helped control risk. And it allowed us to circle the wagons around a few high-quality energy stocks we believe will perform well over the long term.

Another lesson is that commodity price movements can be very difficult to predict. Yes, over the long-term, prices tend to move with fundamental factors like supply and demand. But even the largest, most successful oil companies and investors in the world were surprised by the recent price drop from $108/barrel to just $26/barrel. In the short run, predicting commodity prices is all the more fraught with rumors, speculators, headlines and day-to-day changes in market sentiment. Most of it is noise. So in the near-term we remain cautious and quality-oriented when it comes to energy investments. But longer-term, we are encouraged to see that oil supply & demand are finally in the process of re-balancing.   

 

Historical oil prices mentioned in this article reflect the WTI Cushing Crude Oil Spot Price obtained from Bloomberg for each respective valuation date.


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.