FACTS & TRENDS

The Saudis created the chaos and said that they will not stop the bleeding on their own. Their apparent goal is to rationalize the oil producing industry by forcing the high cost producers out. On the surface, these are essentially Canada’s oil sands, Mexico’s deep oil and U.S. shale producers which together produce some 10 million b/d at incremental costs over $60/bbl..

If so, the Saudi strategy is flawed because of several miscalculations:

1. It assumes that U.S. producers will walk away or idly sit there and wait for higher prices. This is a bold bet against American engineers and entrepreneurs who have time and again demonstrated that they can improve technology and drive costs down. As reported by Niall Ferguson, the break-even price for the median North American shale development is now $57 compared with $70 in summer 2013. Additional measures to lower costs across the entire producing chain are underway. Technological improvements will continue to increase productivity at the wellheads.
2. Canada’s oil sand business is really a mining industry with high upfront capital costs and operating costs below $50/bbl, even below $40 for the most efficient operators. Current and planned production for the next 2 years has already incurred the large initial capital costs. While longer term projects might be slowed or stalled due to current low prices, oil sand production will keep rising. A total of 14 new oil sands projects in Canada are scheduled to start next year with a combined capacity of 266,000b/d, according to data published by Oilsands Review. If necessary, Canadian provincial governments have in the past supported their oil producers with temporary tax or royalty breaks.
3. The 15% decline in the Canadian dollar against the U.S. dollar cushions part or the 50% drop in the U.S. dollar price for Canadian producers. The Mexican peso has also lost close to 15% to the U.S. dollar since June.

However, the most important error is to calculate production costs for sovereign countries excluding their social expenditures. This game of chickens essentially pits efficient, generally well managed private companies against mainly autocratic governments saddled with large social expenditures needed to keep their population quiet.

Following the 2011 Arab Spring, the Saudi government boosted its defense and social spending to prevent any idea of spring in Saudi Arabia. Sixty-five percent of the 30 million Saudis are under the age of 30 and youth unemployment is stubbornly high at 29%. The Kingdom also increased its foreign aid to other Arab countries in order to maintain geopolitical stability in the region. The Saudi government is trying to make oil producers believe it can live without $140 billion in annual oil export revenues, a nearly 20% cut in GDP. If we consider Saudi Arabia’s budget, its effective production cost is amongst the highest in the world. RBC Capital charted the fiscal break even prices across MENA (Middle East and North Africa) countries:

Slashing spending is a politically risky option given the security challenges at home and the high levels of turmoil in the region. Obviously, Saudi Arabia could run a budget deficit like in 2009 and borrow or dip in its huge reserves to finance it. However, this would only differ the costs and eventually weaken the leadership. Last summer, the IMF, still using oil prices ranging between $101.6 per barrel in 2015 and $91.8 in 2019, warned that

Government deposits at SAMA [Saudi Arabian Monetary Agency] are projected to drop by about 55 percent between 2013 and 2019 and in 2019 would be sufficient to cover six and a half months of spending.

The IMF then calculated that if oil prices fall $25 below the Fund’s $100-$105 reference case, with no spending adjustment, Saudi government reserves will be entirely depleted by 2018. In effect, Saudi Arabia is far from the powerful oil leader most people think. The Kingdom’s long-term survival is highly dependant on high oil prices.

In total, OPEC exports 24 millions b/d of crude oil. A $50 price drop means an annual revenue decline of $438 billion, or 12.5% of OPEC’s combined GDP (6% for Iran, 19% for Iraq, 14.4% for Libya, 7.8% for Nigeria, 12.4% for UAE, 20.3% for Kuwait and 9.5% for Venezuela). Petroleum exports account for 70% of all OPEC exports (85% in SA, 96% in Venezuela, 94% in Nigeria, 100% in Iraq). As a result, the flow of U.S. dollars in OPEC countries has dried up by about $500 billion annualized (including petroleum products) while their imports total $880 billion per year. Talk about a forex imbalance.

While the world has been able to adjust and live with $100 oil, it is doubtful that most OPEC countries can live with $50 oil for very long.

Saudi Arabia will not win the game of chickens with the USA. Whatever “economic” gains they score elsewhere, they seem marginal compared with the costs incurred. Enter the political game as summarized by Niall Ferguson:

An Arab official gave the game away in Vienna when he reportedly said: “If in the process, you shave 30% off Iran’s income, fine. If in the process, you shave 30% off Russia’s income, fine.” (…)

Unlike in the 1980s, when the U.S. clearly pressed the Saudis to cut oil prices to squeeze the Soviet Union, today the Saudis (and Emiratis) seem to be the geopolitical playmakers. Their targets are regimes—in particular Iran’s, but also Russia’s—that have been on the opposing side of the great sectarian war that is raging for control of the post-American Middle East. The essential question is: Can the Saudis hurt the Iranians more than the U.S. has been helping them by easing sanctions in its desperation for a nuclear deal? My bet is that the answer is yes—and that 2015 will see instability in Iran, Russia and Venezuela.

Russia and Venezuela are already in recession and things will get a lot worse. Venezuela is a weak chick in this game but Russia is a strong and combative rooster.

Russia’s oil and gas revenues account for over 50% of federal budget revenues and over 70% of total exports. Russia’s problem is less with the oil price decline given that the ruble has sunk 40% since June, enabling the government to continue to collect enough oil taxes to cover pensions and other budget obligations, but with Western sanctions which severely limit Russia’s access to global capital markets.

Perversely, since exports are now its only source of hard currency, Russia cannot really afford to reduce its oil exports. In fact, to the extent that the nascent recession reduces domestic oil consumption, Russian exports of oil and oil products could actually increase during 2015. Yet, Russian cuts were clearly required by the Saudis last November:

The Kingdom is not going to give up market share at this time for anybody and allow producers whether in Russia, Nigeria, Iran and other places to sell to Saudi customers because we cut our production,” Prince Turki said during a visit to London.

“If there is a reasonably guaranteed oversight of production quotas – if they ever are agreed with and someone can definitively say there will never be under-the-table selling of the oil from these other countries – maybe then I think Saudi Arabia and other oil producers would be willing to cut down production,” he said. (Reuters, Dec.2, 2014).

Most observers estimate that the current global oil market is oversupplied by about 1mmb/d. In effect, global supply rose by 4.4mmb/d since 2012 while demand grew only by 3.4mmb/d. Global demand grew 0.7mmb/d in 2014 but supply surged 1.7mmb/d, most of the surge occurring last summer when Libyan production rapidly and unexpectedly leapt by 0.7mmb/d between June and October.

An important point is that demand continues to rise with forecasts hovering around +1.0mmb/d (+1.0%) in each of 2015 and 2016, roughly the average of the past 3 years. If nothing else changes, the current surplus will be absorbed within a year, which explains the consensus view that oil prices will climb again during the second half of 2015.

But, in reality, “nothing else” rarely remains unchanged.

On the demand side, the risk appears more on the upside for 2015 as the Western world and China (together 51% of global demand) enjoy much lower energy prices.

However, the game of chickens is being played on the supply side.

• U.S. oil production surged 2.5mmb/d (+27%) in the last 2 years. Current forecasts are for production to rise 1.1mmb/d in 2015 (U.S. EIA: +1.3mmb/d) after rising 0.9mmb/d in the 6 months to September 2014. Upside surprises are unlikely.
• Russian production is seen unchanged at 10.9mmb/d. Some small upside potential but big downside if a deal with OPEC is reached.
• Saudi Arabia will hold its position as long as possible. But it will chicken out and cut if “nothing else” changes.
• Venezuela: clearly no increase but potential decline if country implodes and social unrest erupts.

Here’s where it gets interesting:

• Libya’s production has been extraordinarily impacted by the civil war that began in February 2011. From January 2014 to November 2014, Libya’s crude oil production averaged 450,000 bbl/d. Forecasting 2015 production is a fool’s game even though we can safely assume it will be within the 0.4-1.4mmb/d range.

In case you have not been following the events in Northern Africa, here’s a good summary of the situation in Libya, oil’s new swing producer:

Libya is already in a state of near anarchy, and there is nothing to indicate that the situation is set to improve in the near term. It is literally a country torn asunder, with two competing governments backed by rival regional powers. In August, the elected parliament was forced to flee the capital, Tripoli, following an assault by a coalition of opposition groups, including heavily armed militias from the western city of Misrata and a variety of Islamist groups from the east of the country. Fighting under the banner Libyan Dawn, and receiving financial support from Qatar, they have established a rival government in Tripoli and have seized control of key infrastructure in the capital.

Meanwhile, the elected government, calling itself the House of Representatives (HOR), has found sanctuary in the far eastern city of Tobruk and is receiving support from the UAE and Egypt. UAE fighter jets have bombed Libyan Dawn positions in Tripoli and Benghazi on multiple occasions since August. Compounding the
country’s woes, the head of the US Africa command warned earlier this month that ISIS had recently established training camps in Libya’s eastern region.

Production has already fallen back in Libya since the summer. In recent weeks, output has ceased at the El Sharara and El Feel fields in the West of the country because of fighting in the vicinity of the facilities. Prior to the shut down last month, El Sharara was producing around 300Kb/d and El Feel output at 120Kb/d. We believe that production could fall even further in the coming months. (RBC Capital)

• Being in Africa, let’s look at Nigeria which produced 1.9mmb/d in 2014:

Nigeria is probably at the greatest risk of significant social unrest in this price environment and such a development in turn could negatively impact oil production. In a country plagued by deep regional and religious divisions, oil revenue is literally the glue that binds the fractious elites together. Nigeria has experienced coups in previous low price environments due in part to drying up patronage funds.

While the country currently bases its budget on a US$77 oil price, the extra revenues are deposited in the excess crude account (ECA). In theory, the ECA is supposed to ensure macroeconomic stability by allowing the government to be able to keep spending steady during periods of oil price fluctuation. However, in
practice it has been used to keep powerful politicians and military officials loyal to the government. Nigeria’s highly respected finance minister announced last month that the ECA, which stood at nearly US$22bn in 2008 (World Bank), would likely be empty by the end of December in part because of billion dollar transfers to state governors.

The lack of extra cash could prove to be especially painful as the country heads into national elections on February 14, 2015. Nigerian elections are costly affairs and ECA funds in the past have been used to pad election war chests. In addition to raiding the ECA accounts, elites have also turned to crude theft as a way to help finance elections. Not only do crude theft levels spike around elections, but also, more production is shut in because of the  infrastructure damage that accompanies theft as well as the increase in generalized election related violence around production facilities.

For example, fighting between armed gangs in Warri caused Shell and Chevron to halt operations at three facilities in the run-up to the 2003 polls, resulting in the temporary loss of 800Kb/d of production. With less oil money around to grease the election machinery, crude theft and production outages could easily exceed
levels seen in prior polls. Also, given that the military is already over-stretched fighting a virulent Islamist insurgency in the north, it will be hard pressed to contain any rise in unrest around the February elections. Hence, Nigeria is a place where the price route may actually lead to unintended production losses.

• Iran produces nearly 3.4mmb/d but exports only one third of it given its high domestic consumption. Iran produced 4.2mmb/d in 2011, before U.S. sanctions began to bite.  The failure of negotiations to reach a final nuclear settlement on November 24 [2014] means that Iranian exports may not rise in 2015. Furthermore, there is a significant chance that the Republican-controlled US Congress will seek to further restrict Iranian crude exports in the coming year. The “Nuclear Weapon Free Iran Act of 2013” which calls for Iran to completely dismantle its domestic nuclear program and cease all support for terrorist groups, could well reach the Senate floor this year. Given the Republican majority, the bill will almost undoubtedly pass, possibly with a veto-proof majority. If Iran refuses to comply, the legislation mandates that all countries must make a 30% cut in their Iranian crude imports one year after the legislation is enacted and move to a de minimis level of imports after two years.

That said, the collapse in oil prices and the coming changes in the U.S. political setup may be having an effect:

Iranian President Hassan Rouhani has begun the new year by preparing his countrymen for the compromises Iran will need to make to strike a nuclear deal with the rest of the world. (…)

Rouhani’s most important point in a speech in Tehran on Sunday was that his country’s ideals “are not linked to centrifuges but to our heart and determination.” That’s a poetic way of saying that the number of uranium-enriching centrifuges Iran can keep is not what matters most in a final agreement with the so-called P5+1  (China, France, Germany, Russia, the U.K. and the U.S.). If Iran is not allowed at least 8,000 of the 10,000 centrifuges it now has in operation, which itreportedly wants, this will not mean defeat for his nation. (…)

The next deadline to agree on the framework for a deal falls in March — not a lot of time, given that these talks have dragged on for more than a year (or a decade, depending on how you calculate). (…)

Rouhani is, of course, the Iranian regime’s moderate face. Any final decision on a deal would be made by Supreme Leader Ali Khamenei, and any deal would be fought every step of the way by the Revolutionary Guard and others determined to protect their commercial monopolies and turn Iran into a nuclear power. (…)

In his address, Rouhani threatened to call a referendum, presumably on any draft nuclear agreement. Even if Rouhani would struggle to make good on this threat, it suggests that he is confident he has public support for prioritizing the economy, and that he’s using that support to overcome conservative opposition in parliament. (…) (Bloomberg)

It will be interesting to watch how American politicians deal with possible Iranian overtures if it means higher Iranian oil exports and lower prices for American oil producers…Unless the Saudis are part of the deal…

Finally, there is Iraq which is a true supply threat for both the short and the longer-terms as RBC Capital explains:

Iraq is where we could potentially see an increase in OPEC supply in 2015, thereby further adding to the supply overhang. Earlier this month [December], the central government in Baghdad signed an agreement with the Kurdistan Regional Government (KRG) that could add several hundred thousand barrels of exports to the market. Under this agreement, the KRG will hand over 250Kb/d of crude that is being transported to Turkey through its independently controlled pipeline to the Iraqi state oil marketer SOMO. In addition, proceeds from the sale of 300Kb/d of crude from the Kirkuk field, which fell under KRG control following the ISIS summer assault, will be deposited in an Iraqi Federal Government account. (…)

While this agreement could prove to be something of a watershed moment in the historically fraught Erbil-Baghdad relations, there are several risks to this deal in our view. First, it must be approved by the Iraqi parliament, and it could face opposition from Shiite leaders who oppose the deal’s de facto recognition of the KRG’s independent energy policy. In addition, because the deal was done in part to help offset the financial duress caused by lower prices and a reduction in overall exports due to ISIS attacks on the Baghdad-controlled North oil pipeline, there is a risk that the deal could fall apart if prices begin to rebound. (…) Finally, while the KRG-controlled pipeline has not been damaged to date by ISIS, it is probably not beyond its territorial reach and those exports could be curtailed in 2015 because of broader security problems.

Here’s the Saudis’ real target:

Outside North America, no other country has the ability to bring millions of new barrels of supply onto the market. According to the International Energy Agency’s (IEA) base case, Iraqi production is expected to climb from around 3.5Mb/d today to 6.1Mb/d in 2020 and to 8.3Mb/d in 2035, thereby accounting for around 45% of the anticipated growth in global output over the next decade.

Such a surge in output requires an enormous amount of new investment. The IEA estimates that Iraq will need a cumulative energy investment of over US$530 billion to achieve its central case production targets. In the absence of such investment, the organization projects that Iraqi production will plateau at around 4Mb/d in
2020 and 5.1Mb/d in 2035.

Given the enormous financial resources, that Baghdad will have to deploy to counter the ISIS threat over the next couple of years and the immediate economic pain posed by the decline in oil prices, the Iraqi government will likely be hard pressed to devote billions of dollars to the energy sector. At the same time, with Iraq remaining a very difficult place for the international oil companies to operate, and with firms facing new pressures to cut costs, they will probably balk at footing the entire bill for the critical infrastructure improvements. Hence, the real damage caused by the combination of ISIS and the collapse of prices is the flat lining of Iraqi production growth because of a lack of investment. Such an under-performance could lead to a much tighter oil market over the medium term despite continued growth in North American output.

Saudi Arabia’s gambit is thus multifaceted and, in the end, pretty clever:

• By adding a new (forgotten) volatility factor in the oil market, it forces oil company managements to budget more carefully and lower their long-term price expectations. Some projects will be shelved or delayed while some marginal producers will be forced out of the market.
• The real coup would be to severely curtail Iraq’s production growth.
• Politically, it weakens Iran, Iraq, ISIS and Russia (Syria’s ally), all under the guise of protecting its economic interest.

For investors, within the current chaos, the pertinent facts and trends are the following ones:

• The price of oil has dropped 50% to levels below the production cost of some 25mmb/d or nearly 30% of world output. By itself, this is an unsustainable situation. Time is thus on the bullish side.
• For its own economic and political reasons, Saudi Arabia itself (and many other sovereign producers) cannot accept such low prices for very long.
• The game of chickens will therefore end sooner than later, potentially before June 2015.
• Importantly, oil demand keeps growing and could accelerate given the significant economic stimulus provided to the largest consuming countries such as the U.S., China and Europe. Time is thus on the bullish side.
• Geopolitical risks remain. Libya and Nigeria carry significant potential supply risks early in 2015 while Iran and Venezuela may be problems later on. Shorter term risk is thus that supply will be lower than expected.
• In the end, the longer-term (3-5 years) price of oil should thus be higher than it would have been without Saudi Arabia’s actions. Time is thus on the bullish side.

Shorter term, however, volatility will weigh downward on oil prices as over-weighted funds sell down, producers hedge and small investors panic and as the Saudis keep playing the game of chickens by talking the price lower as quickly as possible.

While nobody can confidently plot and time the future course of events, the current chaos in the oil market has restored investors’ risk/reward equation to very favourable levels. This relatively rare situation provides great investment opportunities for patient value investors. Personally, I rarely invest in commodity-related securities (high volatility, low predictability) but I always get interested after significant unusual swings in a commodity, especially a globally important one like oil.

The following charts, like the one above, are from CPMS/Morningstar (prices as of Jan. 5, 2015). Note the historically attractive valuations for Exxon and Schlumberger, two energy blue chips. Most energy stocks are currently similarly cheaply valued. This is “Buy Low” time for high quality companies with solid balance sheets! (Please, read the disclaimer here). (Click on charts to enlarge)

Both XOM and SLB are selling at Price/Book values at the low end of their 20-year range. While their earnings and book values are eventually hit by lower prices, the stocks tend to bottom out well before, being well synchronized with oil prices.

XOM’s and SLB’s ROEs have not deteriorated in the past 20 years, both displaying a slight upward trend line justifying support for P/B valuations at current levels. Note that neither company has incurred operating losses since 1994.

Both stocks are selling at Price/Cashflow multiples at the low end of their historical range…

…while their respective cashflow margins are also displaying a slight upward trend.

Some smart, long-term value investors are already in action:

A decade after expanding its grain business during a slump in prices, the Richardson family of Winnipeg, one of the richest in Canada, is making a similar bet on oil.

With crude futures collapsing to the lowest in more than five years, the Richardson’s Tundra Oil & Gas unit last month agreed to buy 550 wells in Manitoba, part of a $410-million divestiture of Canadian assets by EOG Resources Inc. Tundra’s biggest purchase ever will boost its output this year by one-third to 32,000 barrels a day, and Chief Executive Officer Ken Neufeld says he remains on the lookout for more deals. (…)

To zig when others zag isn’t new for privately-held James Richardson & Sons Ltd., a company founded as a crop merchant more than 157 years ago, before Canada became a nation. Over the past decade, the family invested in grain facilities during a drought and expanded in financial services amid the worst economic crisis since the Great Depression. (…) (Winnipeg’s Richardsons betting on oil rebound)