Oil in Flames: Game Changer?

J. Cannon Carr, Jr.

Chief Investment Officer

January 5, 2015

SUMMARY

The latter half of 2014 saw the second largest annual drop in oil prices ever, down 50%. Will the new environment be a game changer for the industry? We look at market share dynamics, production costs, and producer strengths/weaknesses to handicap the outcome. Our conclusions:

  • Over-supply will likely remain for an extended period, keeping oil prices historically low and flushing out weaker producers. But the broad impact is favorable: cheaper oil should help the global economy and keep inflation in check.
  • Successful US producers must have healthy balance sheets and efficient operating models to handle the re-pricing. While the shakeout is cloudy, our existing investments appear to have ample margin for error. Our research also sees incremental opportunity.
  • US shale production is here to stay. US firms are improving operations and have every incentive to address regulatory concerns of “fracking,” a controversial drilling technique. Continued success could shift the balance of power incrementally away from OPEC.
  • Russia certainly presents a wildcard. Its currency reserves and US-denominated debt could worsen a looming recession, if oil drops further. Contagion to other emerging markets is possible but appears manageable in most cases.

ANALYSIS

Our clients know that we do not use macro predictions or “big picture themes” to drive our investment decisions. Instead, we base our decisions on fundamental financial information that is objective and measurable. We believe this minimizes human error, helps us recognize valuation extremes, and improves our chances of buying at low prices and selling at higher prices.

Still, we must be vigilant for rare events that change an industry or render financial data less meaningful. We saw this when sweeping regulation changed the profit models of for-profit education stocks. It’s also why we historically tend not to invest in airlines, given the industry’s high fixed costs and lack of pricing power. We risk buying low and selling lower.

Amid the historic drop in oil prices, we thought we’d review the implications for the industry, sovereign nations, and our portfolios.

We’ll do so in three charts.

Chart 1: Trends in US Oil Production and Foreign Dependence on Oil

Message: Fracking Reinvigorates US Energy Strength

Oil

From 1970 to 2010, US oil production was falling (blue bars in chart) as consumption generally rose, creating a big consumption deficit (the orange bars in the chart) and making the US heavily reliant on foreign producers.

Of late, this picture has begun to change. Since 2000, US oil consumption has been dropping and natural gas production increasing, but the real story is that US oil production is up a whopping 31% since 2010, which has helped close our oil deficit by 18%.

This transformation is due to the rapid expansion of hydraulic fracturing, or “fracking,” a drilling technique1 used by US producers. Fracking offers two main benefits over conventional drilling: it is faster to set up drilling equipment, and it reaches untapped sources for oil and gas. Fracking now represents an estimated 20% of global production.

Chart 2: Crude Oil Market Share

Message: US and Russia now rival Saudi Arabia as producers; Game of Chicken in 2015?

Oil

After oil prices collapsed this fall (due to over-supply), Saudi Arabia, the de facto leader of the OPEC cartel, announced in November that OPEC will continue pumping oil, rather than curtailing it.

To put the decision in context, consider that Saudi Arabia’s market share has remained flat since 2000, while Russia and the US have caught up. The US has moved from 7% in 2010 to an estimated 12%-13% today.

What is the Saudi rationale for maintaining supply? To keep prices low and squash surging producers—namely, Russia, troublesome OPEC member Iran, and burgeoning shale drillers in the US. Flushing them out would put Saudi Arabia in a better position when oil prices improve.

See full PDF below.