R-Oil-ler Coaster

I am not a roller coaster fan. When I was younger, my parents would take us on an annual trip to an amusement park for weekend getaways.  One of the main attractions was a wooden roller coaster with a drop of ~100 feet after an initial climb of the same distance. After a slow ascent up the incline, you would pause, or nearly pause, at the top for a brief second, then hurtle downward before coasting around several curves and small dips. I really enjoyed the smooth ride around the curves after the fall, but the drop was more drama than 13-year-old me was up for. According to Goldman Sachs, the oil industry moves in phases that remind me of that roller coaster.

In April of 2018, Goldman Sachs released a research report describing the oil and gas industry as moving through 3 distinct phases in an ~30 year cycle.  Those phases were the Expansion, Contraction, and Restraint phases.  In the Expansion phase, there is a real or perceived shortage of capacity to produce more oil. New entrants are drawn to production of the hydrocarbon and prices rise, with plentiful money for the ventures available through debt and equity financing.  The Contraction phase sees a drop in commodity prices as sufficient supplies are brought online to reduce the need for further investment.  A confluence of long-term capacity to produce, transport, and store oil along with a reduction of the inventory overbuild, moves the industry into the Restraint phase. The Restraint phase sees further industry consolidation, as large operators with tightly controlled and integrated operations and low capital costs come to control more of the industry’s assets and production.

The roller coaster template is easy to see as the long incline, Expansion, is followed by a rapid plunge, Contraction, and the less volatile coast to the end, Restraint. Examining annual oil prices provided by BP going to back to 1861, shows prices spiking to over $100/Bbl (adjusted to 2018 dollars) only three times since it’s discovery.  Each spike follows the roller coaster pattern.

It is my belief that the Contraction phase of this ride has not fully completed yet.  The average price going back to 1861, using the data referenced above, is $36/Bbl.  Average prices going back to OPEC’s initiation in 1960 is $50/Bbl. The post-OPEC average price calculation includes 2 of the 3 $100/Bbl price spikes, however, and which could point to a run-rate price much closer to the long-term average.

Price has stayed consistently higher than both of these price levels after bottoming in 2015-2016.  Price action over the past 4-5 years shows WTI oil prices with support around $45/Bbl and resistance in the $60/Bbl range, although pricing was greater than $60 for much of 2018.  I believe that until price returns to longer-term averages, another leg of the Contraction phase will likely complete on the way to the Expansion phase.

Disclaimer: I have owned shares of OILD, an inverse oil price ETF, in the past and expect to again at any point in time.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

Truth Shall Set You Free(Fall)

A long time ago in a high school far, far away, I passed or failed classes based on whether my grades on tests and homework assignments met certain absolute grading criteria.  If I understood the subject well enough and could remember this information on tests, I would receive superlative scores on my report card.  Scholastic performance by anyone else in the classes was theoretically irrelevant, as my grades were based on my individual knowledge and performance.  Upon entering college, I found that many professors chose to assign grades according to a bell (or other distribution) curve, meant to reflect the relative performance of the entire body of students in these classes, rather than an absolute performance standard.  This system was intended to be more equitable and reflect the quality of instruction, as well as student effort.  Such systems are certainly capable of being gamed, however.  If a top student had a poor showing, or could be convinced to underperform, students in the middle of the pack were in an excellent position to post a good score, without having excellent absolute performance.

Saudi Arabia, with support from the other ROPEC (Russia + OPEC) nations, is the curve-setting, A+ student of the oil producing world.  They are able to extract oil for a price below $5/bbl, with most of the world’s oil well extraction costs and break evens at several multiples of this number.  The curve that oil prices are graded on is something called comparative inventory and the underperformance item used by Saudi Arabia to lower the curve for everyone else is production cuts. 

Comparative Inventory

Art Berman, a geological consultant in the oil and gas sector, maintains an oil pricing model based on comparative inventory that is used in presentations to industry groups and leadership of exploration and production companies and capital groups in the energy sector.  Over the past 5 years, Art’s work shows that oil prices have moved up and down in conjunction with rising and falling levels of comparative inventory.  Comparative inventory, in this case, is the difference between 5-year average amounts and the current inventory level.  Although not as rigorous as Art’s models, graphing U.S. petroleum and products vs 5-year average levels using EIA inventory data allows one to quickly ascertain the general validity of his work.

The A+ student, Saudi Arabia, manipulates U.S. comparative inventories by increasing or decreasing their own production levels, which results in stockpiles in the U.S. moving up and down.  In 2014, Saudi Arabia boosted production at a time when U.S. shale production was recording impressive production gains, contributing to the realization of massive domestic actual and comparative inventory levels.  Crude pricing has tended to move in opposition to large changes in comparative inventories.  Inventory levels are near the 5-year average at present, which indicates that crude pricing could be quite volatile over the next few weeks and months if a new trend in inventories is established. 

Inventory Plus…

Given the enhanced chance of price volatility, what factor(s) could function as a catalyst to swing prices either up or down? Outside of sociopolitical factors, a significant change in U.S. comparative inventories would most likely shift prices a good amount.  A summary glance at the markets would indicate that inventories have been brought into alignment, assuming comparative inventories are used as the benchmark metric, and prices are similar to year ago levels, near the halfway point between recent highs and lows. These 2 factors alone would seem to portend a fairly stable trading range in the near future.  If inventories swung much higher, however, we would expect prices to drop.

There is a lightly discussed change in U.S. export laws that could result in such an impact.  Year-end 2015 saw the United States remove a 40-year ban on oil exports that was passed in 1975 to counteract the OPEC oil embargo and work to alleviate a supply shortage.  Exports had actually risen to around 500,000 Bbls/d from minimal levels during 2014 and 2015, and have shot up by over 5 times this amount to around 2,750,000 Bbls/d since passage of the bill that removed the export ban. 

Removal of the export ban has opened a release valve for domestic production that has prevented almost 3,000,000 Bbls/d from being added to inventory levels.  Comparative inventories would be at significantly positive levels if exports were added to domestic storage.


Adding exports to currently high inventory levels shows that pricing volatility should have downside price risk if current production levels are maintained or increased.  Saudi Arabia has lowered the curve by decreasing production since 2015, but if U.S production continues to increase and take export market share, it seems likely that Saudi Arabia will eventually quite putting wrong answers in the box and absolute performance will achieve relevancy once again.

Where are we?

Oil is a cyclical commodity that moves in multi-year and multi-decade cycles related to the supply/demand balance.  I believe that the key long-term driver is the industry’s capital investment cycle.  We are following up a period of extreme levels of capital investment in the sector, and I do not believe that the effects of this quite large capital infusion have been fully exploited and utilized just yet, as the assets used for extraction and transmission of the hydrocarbon molecules tend to have very long functional lives.  The charts and graphs below are presented to show where we currently are in the cycle, with context around longer-term inventory and production levels.

United States Production

United States production has grown 130% in less than 10 years, from approximately 5.4MMbbls/d to 12.0MMbbls/d.  Peak Oil Theory suggested that the supposed secular decline in U.S. production was emblematic of a more significant worldwide peak in total production that had been reached, or would be shortly.  The combination and application of directional drilling and hydraulic fracturing to U.S. tight oil deposits appears to have disproven peak oil for the U.S., or at least pushed it significantly into the future.

United States Inventory vs Production

As you can see, over the long run, U.S. inventory levels have been quite stable.  Inventories increased moderately, as prices rose dramatically during the mid to late 2000s.  Domestic inventories hit multi-year peaks in 2010 and 2011, but then exploded much higher in 2015-2016.  Inventory levels dropped as U.S. drilling activity slowed, but remained at historically elevated levels and began increasing again toward the end of 2018. 

United States Imports

The impact of the shale drilling wave can clearly be seen in U.S. imports as well.  The only major exporter to the U.S. to increase shipments to the U.S. during this time was Canada.  Overall, imports from countries with major exports to the U.S. are down 33% from their annual peak in 2005. December 2018 data was not yet available as this post was being composed, so these results will moderate just a bit.

United States Inventory vs Production vs Imports

Combining the trends for U.S. Inventory, Production, and Imports into a single graphic paints a compelling picture of current oil market dynamics and offers a suggestion of how things may play out going forward.  The drastic increase in production and inventories, combined with the dramatic reduction in inventories implies that foreign producers, including OPEC, will be under significant pressure to maintain production levels and market share.

Disclaimer: I have owned shares of OILD, an inverse oil price ETF, in the past and expect to again at any point in time.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

A Time to Gather or Cast Away Oil?

According to The Byrds and Solomon, there is a time to cast away stones and a time to gather stones together; a time to embrace and a time to refrain from embracing.  As Solomon elucidates further, to every endeavor, time and judgment are necessary for beneficial outcomes.  Commodity assets tend to have great swings in value between periods of relatively high demand/inadequate supply and low demand/excessive supply.  Great fortunes can be made or lost on these commodity swings, with time and judgment determining factors in the outcome achieved.

Oil, as the most actively traded commodity, offers perhaps the greatest opportunity for financial gain or loss.  Oil entered a sharp bear market during the summer of 2014 when it began a slide from around $100/bbl to a level in the $40 – $50 range for a sustained period of time.  From the end of 2017 until late 2018, oil advanced dramatically from ~$50/bbl to $75/bbl.   When oil prices were at or near the crest of the decade long bull market from the mid-2000s to 2014, a great deal of the public commentary on the oil price direction indicated a belief that oil prices would remain at those levels or increase going forward.  The commentary now appears to be split between a belief that the oil price will stay lower for longer and projections of a return to significantly higher prices somewhat near those of the recent bull market highs.  The central question facing potential investors and speculators seeking capital appreciation and safety is which of these perspectives will prove to be the most accurate in upcoming months and years.

The case for an extended period of low prices was articulated quite persuasively by Shawn Driscoll of T. Rowe Price in their New Era Fund 2015 annual report released on December 31, 2015:

“As illustrated on page 2, oil prices above $40 per barrel in 2013 dollars are considered unusual in a historical context. Nothing ends a structural upcycle in commodities like high prices, which tend to attract curious and creative minds, technology innovation, and tremendous capital. Charts like the one on page 2 are among the numerous reasons why we believe we have returned to a “new normal” in oil/commodity prices, which looks a lot like the pre-2000 normal, excluding periodic spikes.”

The chart referenced in the quote is shown below.

The chart above shows quite clearly that the oil market experiences tremendous surges in price and, eventually, subsequent crashes/retracements.  A couple of additional characteristics of the market are also visible.  There tends to be roughly decade-long periods of rising or higher prices followed by periods of falling or lower prices. For example, following the price spikes and crashes around the discovery of oil, the price per barrel stayed in a fairly tight range near $20 from the late 1870s until the early 1890s. Prices rose from there and stayed elevated until the early 1900s.  These types of markets were repeated again with low prices until about 1911 and rising prices from then until around 1921.  Prices at or near the $100 mark in 21st century dollars are extremely rare, having occurred only 3 times since 1861.  The lower-for-longer school of thought espouses that the recent price spike is more of a historical anomaly than a new price paradigm and that the price per barrel will most likely settle in closer to the long-term average price of $30-40 bbl.

The second school of thought purports that recent bull market prices are more indicative of future price action, especially in the intermediate term, than historical price charts. In a recent market outlook update, Raymond James’ Pavel Molchanov advocates for a cyclical peak price of $93/bbl in 2020, with a normalized price of $75 following. This outlook is predicated primarily on the perspective that the market’s supply capabilities are insufficient to maintain current inventory levels in the short-term and a higher long-term price as necessary to support supply functions.  I believe this to be a representative expression of this second school of thought.

Inherent in the assumptions of this line of thinking is that something fundamental has changed about the markets to necessitate a higher price than the long-term average.  Given that two of the three price surges above $100 bbl have occurred in the past 45 years and that prices were significantly higher than the long-term average during much of this time, questioning the viability of very long-dated price estimations is indeed valid, but it is my belief that the lower-for-longer assumptions most confirm to reality. 

If this is indeed the most correct market perspective going forward, oil price volatility to the upside can provide opportunities to make very nice profits by shorting oil, as the prices correct to trend.  The New Era Fund’s 2018 annual report mentions $40-50/bbl as a likely long-term average price range, which  appears reasonable given oil’s price moves over the past 3-4 years.  If price approaches or exceeds $60/bbl, I believe that oil becomes an exceptional short opportunity by use of ETFs or futures options.  A price decrease of $15, from $60 to $45 provides a move of 25%, with the potential for much more if a test of the 2008 and 2016 lows at or below $30/bbl are achieved.

Happy Fishing!

Disclaimer: I currently own shares of OILD, an inverse oil price ETF

I am not a financial services professional. All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

Whale Hunting

…you could make a million dollars. He showed me that if you applied yourself, great things could happen. It is very easy to miss the point that you can really do it. — Bruce Kovner

Interview in Market Wizards by Jack Schwager

The purpose of the writing on this site will be to identify investment themes with high payoff potential that are executable and understandable by investors who are not financial industry professionals.

One of my favorite memories from my teenage years was catching a 4 lb smallmouth bass out of the back of a flat-bottomed boat while floating down a river near our home. I was not a great fisherman and would typically catch non-keeper bass or small sun perch, if anything at all. My brother and dad were with me in the boat, saw the fish as it swam by, and encouraged me to cast back toward it as we floated downstream. I did so, and hooked the biggest fish that I remember catching during that time.

The goal of my writing on this site will be to perform a similar function for readers: Identify interesting opportunities and help give courage to make an attempt that could help you catch a whale – or something large enough to make your day, even if it doesn’t break any records.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.