Oil Prices – Drilling For Bargains In A Value-Depleted Market by Worth Wray & David Hay, Evergreen Gavekal
“Investing is the only business I know where when things go on sale, people run out of the store.”
— Former UNC Endowment Chief, Mark W. Yusko
This month’s EVA Chartbook explores the recent corrections in energy and energy-related securities which have collapsed along with oil prices over the past year. As you can see in the chart to the right – which shows the growth of $100 invested in US equity, energy stocks, and Master Limited Partnerships (MLPs) from the 2009 trough to today – these assets have fallen off a cliff compared to the lofty S&P 500.
Seth Klarman: Investing Is Art First, Craft Second And Science Third
While sentiment remains extremely negative on energy assets – with credit spreads and valuations priced for both continued weakness in oil prices and widespread failures in energy-related businesses – we believe the underlying fundamentals are beginning to look extremely attractive on a medium-term basis. Even in the event that oil prices collapse further (which is certainly possible under a variety of scenarios), we believe widespread dividend and/or distribution cuts are far less likely than the market currently seems to believe, particularly with blue chip energy stocks and MLPs.
As a result, these beaten-up securities – if bought and owned with great care – may present some of the best long-term income and total return opportunities in the world today. Patient investors who have remained conservative and held high cash balances in the face of lofty valuations have earned the right to tap into pockets of value in an otherwise bubbly equity market. As in horizontal drilling, exploiting these isolated value pockets will require great skill – not to mention emotional discipline in the face of near-term volatility – but we believe the long-term opportunities are worth the short-term risks.
Global Energy Outlook
The Cure for Low Prices is Low Prices
- According to the US Energy Information Administration (EIA), world oil production as of October 1, 2015 is roughly 95.6 million barrels/day. World consumption is roughly 94.4 million barrels/day.
- From April through September 2015, excess supply has fallen from 1.7 million barrels/day to 1.2 million barrels/day… which means 98.7% of today’s oil supply is currently being used.
- Today’s 1.2 million barrels/day supply glut is nothing compared to the roughly 16 million barrels/day glut in the mid-1980s, so excess supply should run off relatively quickly due to well depletion and production cuts.
- Translation: Don’t expect oil prices to remain very low for very long.
Production from Existing Oil Wells Declines Over Time
- Even without production cuts (which we are already seeing) global oil supplies should naturally correct over time. In fact, global oil producers must replace 4-5 million barrels/day just to maintain the current production rate of 95.6 barrels per day.
- For example, US shale wells tend to decline by 70% to 90% in the first year of operation, meaning that shale production starts to decline meaningfully without ongoing development spending.
- Reserve depletion is also a major factor. As you can see in the chart above, the North Sea’s oil production has fallen by 58% from roughly 6.4 million barrels per day in 1999 to less than 2.7 million barrels today. Similarly, Mexico has seen production fall by 37% from nearly 3.5 million barrels per day in 2005 to 2.2 million today. Also, Alaska’s Prudhoe Bay production (not shown in the charts above) has dropped 83% from 1.5 million barrels per day in 1988 to only 250,000 today.
Non-OPEC Oil Firms are Already Slashing Production
- In an effort to protect their market share, OPEC countries – particularly Saudi Arabia – are forcing higher-cost, non-OPEC producers out of the global energy market. As you can see in the chart on the left, the active rig count outside of OPEC has already fallen by roughly 25% (the gray line).
- Recent adjustments is happening in the United States, which has become the swing producer in recent years. According to EIA estimates, US oil output has already fallen by roughly 600,000 barrels per day with another 500,000 barrels per day in production cuts on the horizon.
- Iran’s re-entry to global markets – expected to increase production by roughly 1 million barrels per day over the next year – will likely force more production cuts in higher cost oil fields.
See full PDF below.