Why I think oil prices will not revert to the mean

Manage
17

My background in this and why I started this thread: In 2004 after studying most of what I could find about shale well horizontal drilling and hydraulic fracking I contracted with an oil and gas development company to drill 10 wells on our 340 acre ranch in the middle of the Barnett shale. Since I am an engineer I was very intrigued by the fracking technology and have studied it and the industry for over 12 years now. I have kept up with many of the larger company’s actions and plans. I have direct information from companies in Texas that are moving from Texas to other countries dozens of their drilling rigs, their fracking rigs, and their drilling and fracking teams.

Many of the drillers are highly leveraged and with the lower price of oil, the drilling is not very profitable in the US. However, there are a number of foreign countries that are desperate to reduce their dependence on imported oil. They are paying high premiums to bring in teams and equipment. By relocating their teams and equipment the drillers that have marginal profits in the US can continue to cover their loans, keep their best teams employed, and still make a profit. As long as there is a demand and they can make a profit their moto is “Drill, baby drill”.

As of the end of 2014 the estimate is that less than 2% of the recoverable shale gas & oil has been recovered in the US. A shale well is estimated to have a 40 to 50 year economic life with existing technology. In the Barnett shale in Texas, which started the horizontal drilling and fracking technology over 15 years ago, some of the wells that are over 10 years old had declined to 20 or 30% of their initial production. However, a number of them have been experimentally re-fracked with their production doubling from their declined levels. That implies that the life of a well may be even longer than initially estimated.

The US is currently the only country that is producing shale oil and gas in a significant commercial volume. There are 137 shale formation that have had exploratory drilling in 41 countries outside of the US, and they have an estimated 345 Billion barrels of oil and 7300 Trillion Cubic feet of gas. That is 10 times the amount estimated in the US. That data doesn’t include the many known shale formations that haven’t yet had experimental wells or the many countries in which there is no information about shale formations.

As long as there is ANY profit in drilling these shale formations, they WILL be drilled. With that background, does anyone still think the price of oil will go back to $100 within the next decade? Here is a summary of shale gas & oil formations worldwide with a map of the known areas (the data is a year and half old):

http://www.eia.gov/todayinenergy/detail.cfm?id=14431

Drill, Baby Drill!

18

Denny,

there are countries in which fracking will probably not take place in the next 10-15 years because of concerns about the environmental impact.
Germany is one of them (I do not think this will have a big influence on the oil and gas prices).

The correct prices of energy include the likely environmental impact of production and consumption for the next thousands of years (including greenhouse effect). But these prices will be probably not recognized as soon.

Do not drill, Baby!

Matthias

19

Sorry to be opinionated here, I just could not hold it back!
First of all, I follow Dennys Argument, I think the same way.
I am a huge fan of solar, wind and other alternative energy’s but I think, there needs to be a very high productivity boost in them, otherwise there growth will go much lower. Same with battery driven cars like teslas. I got a solar roof that is heavily subsidized by the german governance (get 25c per unit, Market Price is 14c!), I lower my utility bill with this from 300 to 150 euro for a 320 Square Meter House.
I had an conversation with an industry specialist and a geologist and hey just laughed at “Peak Oil”. Geological Oil and Gas Production is a constant process (like growing Woods) and new estimates Show that only 8% of all reserves worldwide have been drilled and mined (they add sand oil to the equation), even the left-liberal wing Spiegel German magazine, that I read since 1984 every week, just confirmed this and they confirmed that fracking (done well) makes no harm to the environment (and fracking is possible in Germany, only every project needs to be allowed by the local government).
And I have to admit, I also hope Denny is right, since I changed my mind on the whole subject, since cheap energy is going to boost hopefully this decades economy big time. I hope that if prices stay low, it will give us a long lasting bull market.
And the wind and solar lovers (I am one of them and I hope they get much more efficient) got to be fair to the Drillers, they adapted adorable monster big time (and I thank them for that!) and kick ass now and I believe the theory that they will in the future and a lot of them could not care less about oil at 40 (okay that is bit exaggerated, LOL!).
If global warming is made by humans (what is probable), well then it can not be hindered. People are not going to do the (may be short term) economical wrong thing just to hinder global warming, no political process will this make happen nowhere in the world, I think Germany is no exception here with a huge bet on alternative energy (but so far we produce even much more carbo, since the coal based production is up very much). We will probably have to adapt to global warming and we will find solutions here too.
So I just ordered a BMW 335i with 306 horsepower (still energy efficient, but they got much more energy efficient cars) and will have some fun now!
Congrats to the Drillers!
Drill, Drill Baby Drill!!!

20

Is the recent steep drop in oil prices solely due to supply and demand? While relatively flat, or even reduced, world consumption and slight increase in world production supports this thesis, food for thought is there very well may be political implications just as equally responsible. The Saudi (and other Mid East producers), Europe and America political interest may all be a little different, but aligned to drive oil prices lower. In part, I would not fail to consider that there are political pressures to drive the price down to punish Russia for its recent aggressions.

If we only had to analyze supply and demand in the near term for investing our job would be a cakewalk.

21

Delete. Sorry pure opinion

22

Wow Denny, you are truly multi-faceted. I didn’t know you were an oil man, too!

The price of oil can be and has been, very volatile, as shown in the chart below from Jim Stack and InvesTech Research. As expected, oil declines during bear markets and recessions are primarily due to shrinking demand. However, as Mr. Stack shows, it is not unusual for oil to decrease in price during bull markets as well, and this is the sixth time this has occurred over the past 32 years.

The chart shows that the price of oil does not stay down for long, but is it possible that ‘this time IS different?’ However, before any rebound, it is likely (from a technical standpoint) that oil is near to a test of the prior bottom of about $40/barrel reached during the 2007-2009 recession. That decline was on the order of 75% as oil fell from $148/barrel. The $40.11 level is a 61.8% Fibonacci-level decline from $105 prior to the drop. Oversold oscillators are now rising from very deep levels, so oil may have found a floor.

If nothing else, it will be very nice for a while if oil stays at these levels, as U.S. gasoline prices will probably fall to under $2/gallon. That would equate to about a $1200 per year bonanza to every family in America.

Will the price of oil stay permanently low, as Denny posits? That would be wonderful, on many levels. Not only the positive benefits to the world economy, but it will ultimately upset the world’s power dynamics. No longer would the Middle East be relevant to global affairs and no longer would the Saudi’s have every one of us by the 'short hairs.’ The U.S. and the rest of the world could let the Middle East religious zealots decimate themselves, as we would no longer have an interest in the region. Russia would no longer be a threat to start WW3 over oil territory in the arctic.

One thing is sure if oil stays low; it will certainly shake up the dynamics of investing. Energy costs have a major impact on corporate profits, with some companies affected far more than others. If this plays out as Denny suggests, there will be big winners and big losers.

If T. Boone is right, then we will know one way or another within 12-18 months. Since the 1980s, I haven’t heard Boone be wrong on too many things regarding oil. On the other hand, his reasoning that “Oil producers in West Texas and North Dakota “can’t drill for $45 oil,” doesn’t hold water if fracking is going to be the dominant technology worldwide. Texas or N.D. don’t hold much sway over the profit motives across the rest of the world. I would love to see more stats on the worldwide rate of adoption of fracking, rather than just stats on potential oil in the worldwide rock formations.

However, like dwpeters, I think my time is better spent identifying and reacting to what is happening right in front of me, rather than speculating on the future. Whether the price stays down or not, there are dislocations occurring right now. As a value investor, I always embrace any opportunity to find mispricing due to over-reaction.

23

If you actually want to trade oil, I still think technical systems are much likely better to do well for ‘ordinary people’ then attempts at fundamental analysis. To do fundamental analysis well, we’d have to accurately estimate things like:
a) Real reserves
b) Tax policy changes around energy in all world countries
c) Economic growth rates in all world countries
d) Technological leaps in 1. oil discovery and extraction, 2. alternative energy production, 3. energy efficiency in industy
e) Environmental storms and weather
f) Extreme weather and ‘war’ events in oil producing (and consuming countries).
g) Etc.

Basically, I think fundamental forescasting in this way is close to impossible.

I do have to agree with the comments that oil/gas prices don’t include the price of externalities and that we “should” impose a carbon tax at this point in the US if we believe there is even some probability that climate scientists are correct and use the tax profits to incentivize more sustainable long-term answers (likely also to be growth industries). It’s not accurate to me to say that people will never do anything in their long-term interests if it has short-term costs or is politically difficult. History does not support this position. Look at progress made on ozone protection (the Montreal Protocol), bans and restrictions on ending slavery / civil rights, lessening kids smoking, bans on children working in unsafe factores, the creation of a social safety net - including insurance for older people who have worked for their lives which also exists in many / most countries. People may not like the levels of these things… or may even imagine they want them gone, but most people don’t and regardless of political views, I view them as clear evidence that people can band together politically to implement ‘difficult’ changes with real economic costs. There is a signficant body of evidence that shows that the more efficient energy companies actually have better performing stocks. There are tremendous numbers of people working to move the world towards a more sustainable future. We may choose not to care or participate, but their work is worthy of mention.

24

In the U.S. property owners own mineral rights. In other countries it’s the government that gets the profit from minerals. That is why fracking was developed in the U.S. and is not being done elsewhere. Citizens don’t like to have their property disrupted to give profits to the government, and politicians are not in the business of making money for their governments either; they are in the business of getting power. So why would a foreign governments upset the landowners to drill? The incentive is not there for the most part.

25

I am a big fan of Martin Armstrong. I still believe we will see oil price at $30-$35 low point before a significant rebound to say $60-$$70

http://armstrongeconomics.com/armstrong_economics_blog/

26

A link to an interview with Saudi prince Prince Alwaleed, who also happens to be a multibillionaire investor:

http://www.bloomberg.com/news/2015-01-23/oil-prices-won-t-return-to-100-saudi-prince-alwaleed.html

Seems we are in good company Denny.

27

If Denny is right, then the bet to take is on the companies that do the drilling/fracking. I believe that during the gold rush a lot of money was made by those that sold picks and shovels. And wasn’t this the start of Levi’s jeans? Can anyone recommend major companies in this space to watch? Whether oil prices rise or not the strong companies in this space may still do well.

28

Ten years ago, Peak Oil, the time that the total worldwide supply would start declining never to come back, was thought to be around 2008 to 2010 which therefor would support higher oil prices into the future. That is no longer the case. In 2014 the supply is higher than ever before, with no actual sign of slowing down. The only change over the last 6 months is a small reduction in the rate of expansion of supply.

  1. It only took a small oversupply of world oil to push the price much lower. If the oversupply continues over a long time the price will stay low for a long time.

  2. “The United States production of petroleum has, in fact, jumped from about 5 million barrels a day (mb/d) in 2008 to more than 9 mb/d.” That is an 80% increase in only 6 years, and it is caused by the increase in horizontal drilling and fracking.

  3. Something that I had not pointed out in previous posts is that since the technology of fracking shale has been so successful, about 3 years ago some old conventional oil reserves that had assumed to have little production left have begun tests using horizontal drilling. Many of these reserves do not even require fracking. The result is that the production has risen significantly in the test wells, adding new life to old oil reserves. So it is not just shale oil that is extending the time of Peak Oil. The cost of drilling (and fracking when needed) conventional oil reserves is much less that shale rock. They are shallower, and softer strata.

  4. Only 3% of the known US shale has been drilled. Many large regions have not even been tested yet. Land and royalty owners all over the US don’t care that the cost of oil is low. They want their land drilled so that they will start getting a royalty income. That puts pressure on drillers that already have long term leases to go ahead and drill. The low cost of oil has also significantly reduced the cost of drilling and fracking. Drillers no longer can charge high premiums on the leases of their equipment and teams since there is no longer a high demand for them.

  5. There was a steady decline in drilling rigs in the Barnett shale starting 2 years ago. This has been used by many to point out that there was a rapid decline in the production of fracked wells. However, the decline in drilling rigs was caused by the discovery that the shale in the Bakken, the Eagle Ford, and the Permian Basin and others have much higher supplies of oil in the shale than the Barnett has. That caused many of the drillers that didn’t have long term contracts in the Barnett to move to the more lucrative shale regions. (My wells lost 42% of their first month’s production by the end of the first year. They have declined only an additional 27% over the last 6 years since the 1st year with a very gradual decline over the last 2 years).

  6. Although production per well declines rapidly the first few years, it levels off and has a very gradual decline after that. If a well declines too much, it can simply be re-fracked increasing its production again. The cost of re-fracking is 10% of the cost of initial drilling and fracking.

  7. Since the excess oil supply has occurred, the drop in oil price has caused suppliers to start withholding oil from the market and storing their excess oil in barges, tankers, land based tanks, and even underground salt domes betting on a future price increase. As many long term contracts continue to require pumping oil, these storages will start to fill up. Then it will be hard to reduce the supply. Eventually this stored oil will have to be sold keeping the price from rising very far.

  8. Countries that are desperate to reduce their dependency on imported oil will be willing to pay premiums to drilling companies to drill their shale. Some drilling companies are already moving overseas.

  9. Now that the world has seen the advantage of drilling shale, the only thing holding back drilling shale in other countries is the time it takes to add the equipment, expertise, and the current low price. The higher the price goes, the faster the world wide shale will be drilled. Wherever there is a profit to be made, the shale WILL be drilled.

  10. When new technology changes the status of a commodity, the price of that commodity will not revert to the mean. Technical analysis is useless when that happens, and it would be foolish to continue to follow TA until the new technology caused the changes to stabilize and mature.

I think that there is too many unknowns and too much risk now to chase oil. I prefer sectors without massive changes occurring than to try and catch a falling knife. Maybe in six months to a year there will be sufficient info on actual reductions in production to justify investing in oil. Although I would love for the world to wean itself from gas & oil, the current low price is extending the time when that will finally happen.

29

Denny,

It’s all interesting and thanks. You clearly know a good amount about oil. I make no claims to know anything about oil and agree that it’s a tough time to be a fundamental investor in the space. And for mere mortals (like me), not a bad time to underweight it.

I don’t agree that technical systems in general don’t work in times of technological change. Fundamental systems break down here as the technology is now different. Technical based ‘mean reversion systems’ can, and often do, break down. But, many types of technical trading systems (for example the classical ‘break out’ variety ‘turtle trend following systems) tend to do very, very well in these time of major market dislocation. In fact these’ big changes in markets’ type events are their biggest years. And managed futures trend followers had their best year since 2008 in 2014. Rising volatility and the big down move in energy were main return drivers for the smaller shops. Many technical systems thrive on large moves and/or volatility.

Best,
Tom

Best,
Tom

30

Thanks for all your insights into this topic.

So are you filtering out the energy sector completely in all your portfolio re-balances currently? I’m somewhat new to P123 modeling, but even before the oil collapse I groan every time a screener gives me an energy sector stock. I hate using traditional momentum and value screening on a sector that is so tightly correlated to a singular commodity price that has so many factors involved in the pricing other than traditional supply and demand, not the least of which being the world’s most powerful cartel.

31

I disagree with much of that. In the US, there are MANY horizontal wells that extend over a mile horizontally from the well site. In Arlington TX where I live there are drill pads with over a dozen wells drilled in all directions from a single pad of only a few acres in size. So, over a square mile of land can be drilled from one drill pad. Many drill pads are on city property, the city wants the royalties, and the wells extend under the lake (city property) and hundreds of homes on private property. So there is very little if any disruption on citizens property.

Where a country’s government owns the mineral rights the citizens have no say over drilling under their property if there will be no disruption on their property. It is always easy to either find a potential drill pad on government property or one where the owner is willing to be paid for the use of a few acres.

I can’t imagine that the politicians in a country that is desperate to reduce the need for foreign oil would block drilling that will have a significant increase in the country’s GDP. I would think instead that the politicians would be trying to figure out how they could fill their pockets with profits from the oil.

The only impediment that I see would be the desire from many citizens in developed countries to reduce the countries carbon footprint to improve air quality and reduce global warming. Many undeveloped countries have so far shown that they couldn’t care less.

32

Tom, I agree that there are probably a number of TA approaches that will work well at this time with oil. A year from now I will be able to tell you which ones. :smiley: If you want to recommend a specific one we can monitor it over the next year and see how it works.

Inman, There has been a dozen rebounds on the price of oil since the high in June, only to move lower each time. There are too many better choices in the Ports to worry about where Oil is going. the Ports can’t read the news. My R2G ports have underperformed partially due to buying energy stocks over and over last year. Although my Ports continue to recommend energy, I am rejecting them and getting the next best recommendation which is always only a fraction of a rank point below the energy stock.

33

Denny you taught us to look at the evidence (such as backtests) :).

Here is the evidence:

  • Fracking began in the U.S. in 2003. The U.S. still leads the world in fracking by FAR although a select few countries have just barely begun to slowly introduce fracking. What’s taking everyone else so long? My theory: Incentives matter. Fracking might increase a government’s tax revenue but so does paying your taxes. Does anyone look forward to pay their taxes so that the government will money? No. Government officials don’t care either–unless they have self interests involved.

  • [quote]
    I can’t imagine that the politicians in a country that is desperate to reduce the need for foreign oil would block drilling that will have a significant increase in the country’s GDP.
    [/quote]That makes sense–or does it? Look at what Venezuela is doing. The Venezuelian government nationalized oil fields from private enterprise. So what happened? The state run oil company is giving jobs based on politics and has not developed a single new oil field. Private oil drillers are trying to leave Venezuela. The government officials got what they wanted; many oil workers very loyal to the party. High inflation? Economic doldrums? Blame the market speculators. Blame the greedy energy companies. Blame the U.S. Blame everyone but the government of Venezuela.

  • I have to admit that I don’t fully understand why fracking takes place on U.S. government properties. I have a theory that once fracking becomes accepted elsewhere (because it makes former property owners very rich) the citizens don’t complain if the it’s done on government property either.

P.S. I am not making a prediction about oil prices. I don’t think that anyone really knows; there are too many variables. Very few macro hedge funds make enough money to make it worthwhile; and they have bright people studying this kind of thing all day.

34

Contrary to popular belief, the technology is not new. It has been in use in Canada since the 1960s. There are several countries across Europe and elsewhere that have banned fracking. You can see the status here: http://en.wikipedia.org/wiki/Hydraulic_fracturing_by_country

With the rising US Dollar, the expense to initiate fracking, the low gas price and most of Europe in Austerity, it doesn’t make much sense for countries to start fracking now. As for the price of oil, we have been in this position before. Back in the 1990s, OPEC countries were cheating on their limits and the same thing occurred with Saudi Arabia allowing the oil price drop. They sent a message then (oil producers get your act together) and they are sending one now (frackers can be bankrupted anytime Saudi Arabia pleases).

History will repeat itself. The price of oil will stay down for ten years. New fracking initiatives will disappear. Americans will trade in their Prius and return to buying gas guzzlers.

But… don’t underestimate the power of greed. Eventually, the oil producing countries will get together and form a new agreement, and the cycle will repeat.

As for now, invest in tanker companies. Investors are already starting to stockpile oil on tankers, waiting for the price to go up.

Steve

35

Clarification: Notice the red chart. The rest of the world has still barely adopted horizontal fracking ten years later. Why? Does the U.S. have a monopoly on good engineers? (That’s a rhetorical question.)

36

In November 1946, Stanolind researcher tested using a liquid to create fractures in the Hugoton natural gas field in southwestern Kansas. Water mixed with napalm left over from World War II, and used to reduce friction, was used. It was successful. The Stanolind team called it a “hydrafrac treatment” and was awarded several patents for the invention. It was exclusively licensed to the Halliburton Oil Well Cementing Company for a time.

The modern era of hydraulic fracturing began in June 1998, at a well several miles north of Fort Worth. A completion engineer, working for Mitchell Energy & Development (that had been drilling in the area since 1981), had proposed using large amounts of water and pressure to break up the Barnett Shale. At that time all the wells were vertical. Most of the shale layer varied from a few hundred feet thick to almost 1000 feet in some areas. However with the vertical wells only the thickest shale areas were economical. The wells had to drill down 6 to 7 thousand feet to reach the shale and if it was only a few hundred feet thick there wasn’t enough to justify the cost to drill the first 6 thousand feet.

It wasn’t until 2002 > 2003 when Mitchell developed better ways to turn and control the location of the drill pipe did horizontal drilling began to have success. That made the thinner shale layers of 200 ft. thick profitable since Mitchell could drill down 6000 ft., turn the drill pipe 90 Degrees on a 500 ft. radius and then drill horizontal 1000 ft. or more through the center of the shale layer.

The only nation outside North America that is actively embracing fracking is the UK, where exploration is said to have discovered massive new deposits. The Brits are writing the regulations and mapping a master plan for developing those fields, especially since the North Sea fields are starting to see declining output.

If you want to see an animated map of the Barnett shale drilling from 1981 through 2010 download the below link:

http://www.eia.gov/pub/oil_gas/natural_gas/analysis_publications/maps/barnettshaleanim.zip

The black dots are the vertical wells and the red dots are the horizontal wells. You can see the explosion of new wells after 2004 when many new drillers entered the market. Notice also the beginning of wells drilled in the urban areas of downtown Fort Worth. My wells were drilled in 2007 & 2008.