The Bearish Case for Oil – In Charts

In my last post I discussed why oil service companies could make for a great short play.  But there’s a huge caveat to that recommendation – oil prices need to continue their decline to make it work.  In this post, I’m going to try to make a bearish case for oil, supported by current charts and trends.  To give credit where it is due, I lifted most of this data from internet sources which are credited on the charts.

The price of oil, like all commodities, is determined by supply and demand.  For most of the noughties (the decade between 2000-2010), both of these factors were conspiring to drive oil prices higher.  On the supply side, declining oil production in North America along with flattening production at large oil fields in the Middle East were leading to concerns about peak oil.  Furthermore, the war in Iraq, along with the broader war on terrorism and instability in other oil exporting countries added a geopolitical risk premium to the price of oil.  At the same time, the US was enjoying a credit fueled boom as the country rebounded from the recession following the dot-com bubble, and fast growing emerging markets such as China and India seemed to have an insatiable demand for resources.  The rapidly rising price of crude seemed to do little to quench the resulting global appetite for oil.  These conditions have changed for the worse.

US oil supply rising

With the adoption of horizontal drilling and multistage fracturing technology, US oil supply increased dramatically over the past 5 years.  Although we are still well below the peak levels seen in the early 70s in absolute terms, it’s the rate US oil supply growth that has been nothing short of incredible.  What’s more significant is that the supply response to the high oil prices of the noughties has simply dwarfed that seen in the 80s after the 70’s oil crises.  This rising production trend looks set to continue, at least in the near term, as new production is being brought online.

Global oil production rising

In the high oil price years between 2005-2008, global oil supply was in a downward trend, giving some credence to those who espoused peak oil theory.  This trend has now reversed with new supplies coming not only from the US, but also from Canada, Brazil, Russia, and of course OPEC.

US oil demand falling

US oil consumption, on the other hand, has been falling.  The weak recovery in the US has not been enough to stimulate enough new oil demand to offset increasing energy efficiency.  The net result is lower demand in the US.

Global oil demand also falling

The picture for global demand looks just as bad.  While there has been continued growth in emerging markets, that has not been enough to offset demand destruction in the US and Europe.  Furthermore, with growth in China and India is showing signs of cooling, it is unlikely that this trend will reverse itself in the near future.

Price elasticity works both ways

Historically, oil prices have been relatively inelastic.  The global demand growth of the last decade could not be met by new supply, leading to upward price swings.  Well it now appears that supply has finally caught up while demand has cooled off, so we should expect to see price swings to the downside.

http://www.capgemini.com/blog/sustainability-blog/2012/02/oil-supply-economics

Record oil prices in 2008 were a bubble, reflated by loose monetary policy around the world

In retrospect, the massive oil price spike from 2005-2008 was an obvious bubble.  What’s incredible is that in spite of the weak supply/demand fundamentals described in this post, the oil bubble has actually reflated to levels not far from the 2008 peak.  I’m sure my readers (if I have any) will note that this is likely due to the large scale economic stimulus packages and extremely loose monetary policies pursued after the great recession of the last decade, and I won’t argue that point.  But it doesn’t change my view that oil prices are unsustainably high today.  With supply rising and demand falling, we should expect oil prices to fall to the cost of marginal supply.  Oil sands project economics become challenged at prices below $70-80 so if I were to take a guess I’d expect prices to fall to the low end of that range, or 20% below current levels of around $90.  Prices in the low $70s do not seem unreasonable to me, and even if they were realized the long term trend of higher prices that began in the early 2000s would remain intact.

A thesis for shorting Canadian oil service companies

With oil prices recently drifting lower, companies in the Canadian oil and gas exploration and production (E&P) business have seen significant share price declines.  Some of the more marginal names in the space have even seen precipitous share price drops of 50% or more.  While I don’t think the bottom is in quite yet for the sector, the risks of shorting the E&Ps at this point may not justify the potential rewards.  On the other hand, oil services companies are showing signs of weakness, which I believe will continue.

The thesis is as follows:

The three primary sources of capital for oil and gas E&Ps are equity, debt, and joint ventures.  All of these sources of financing are likely to become more difficult to secure if oil prices continue to decline.

Lower share prices make equity financing unattractive

Falling share prices make equity a more expensive way to raise capital as more shares need to be issued to raise the same amount of cash.  And while a high cost of equity does not always stop determined companies from raising money in the equity markets, it does limit the amount of capital that can be raised through share issuance.

Lower oil prices limit growth in credit lines

The oil and gas business is risky, and banks are usually unwilling to lend money to risky businesses without hard collateral.  In the E&P business, this collateral usually takes the form of oil and gas reserves.  The value of those reserves fluctuates with the price of oil and gas, and when prices are falling banks are more reluctant to extend loans.  Credit growth will therefore be limited.

Joint Venture financing may have peaked in 2012

The JV capital that has sustained much of the industry over the past few years will also be harder to come by as the Asian national oil companies (NOCs) that have driven recent JV activity already claimed their stakes.  Many of these NOCs were also willing to pay a premium to acquire technology and experience with unconventional oil and gas.  It is unlikely that future JV agreements will be as favorable to the Canadian E&P industry as this strategic technology premium falls off.

A larger share of future CAPEX will need to be internally funded

All of these factors will make financing exceedingly difficult for E&Ps in the near future, assuming oil prices continue to grind lower.  This means the industry will be forced to live within its cash flows – something it hasn’t had to do for a very long time.  Many companies have already started to make the transition to lower, internally driven CAPEX, but the big adjustment is yet to come.  I ran some numbers and found that the E&P sector is outspending operating cash flow by 10-15%.  This is before paying dividends or buying back shares!

Lower E&P CAPEX = Lower service industry revenue

The implications to the service industry are dire.  If E&Ps are forced to reign in spending by 10-15% (or more assuming they want to continue paying dividends or rebuild stretched balance sheets), we can expect revenue to the service industry to drop by at least that much.  Due to the asset heavy nature of the services industry, where small changes in utilization rates lead to massive swings in earnings, we could see these earnings at these companies get crushed. 

I don’t think share prices of service companies are adequately pricing in this risk.  While these companies may look cheap on a yield or P/E basis, they are classic value traps.  Earnings are a trailing measure - if you believe oil prices will drop, these companies are going to be money losers over the next few years.  And if you don’t, you are better off in the E&Ps, which look even cheaper by the same metrics.

Conclusions

If the thesis is correct, it sets up a fairly low risk trade – go long select E&Ps, and get short service companies.  If oil prices recover, the E&Ps will bounce back, limiting your downside risk on the trade.  If oil prices continue to drop, the E&Ps will get hit hard, but the service companies will be decimated.

Recommendations: Short FRC.TO, CFW.TO, TRW.TO, PD.TO.  Risk averse investors may want to pair with a long position in high quality E&Ps.