Production Cuts Can’t Keep Oil from Dropping Below $20
Demand for oil has dropped off so much from the current slowdown that the recent agreement to cut production by 10 million barrels a day hasn’t come close to fixing this.
We invest in stocks presumably to make money, although when we look at how oil stocks have done over the last 6 years, there’s been a lot of money made from them, although it’s been on the short side.
A lot of money has been made on the short side of energy stocks in fact, and this has been the case over more than just the last couple of months, a time when virtually all stocks have taken a big hit. Oil stocks have been infected with a virus for considerably longer than that.
The Energy Select SPDR Fund, the industry benchmark, lost about half of its value from the 2008 crash, which wasn’t remarkable at all and was no worse than your average stock during that time, with the S&P 500 dropping even more during this time.
From its bottom of $37.40 back in February 2009, the energy sector set out to recoup everything it lost and then some, breaking through $100 a little over 5 years later in June of 2014. Then the wheels started coming off, and it’s been all downhill ever since, and downhill with stocks is not the direction you want if you are on the long side.
Both West Texas Intermediate, or WTI, the U.S. benchmark for oil prices, and the XLE, the oil SPDR ETF, were both trading a little over $100 in the summer of 2014, but that’s the last time either saw the sunny side of $100 or anything even close. By the time 2020 rolled around, both were in the $60 area, which means that owning the XLE over this time would have meant that you lost 40% of your money less dividends.
The dividends haven’t added up to anywhere near the amount of this losses, only shaving off 10% from this 40% loss, leaving investors on the long side with losing about 30% over these 5 ½ years leading up to this one. The dividend payments actually barely kept up with inflation over this time, even though inflation has been historically low, leaving investors with the full 40% loss net of inflation.
This should strike us as a pretty vile net return from any investment, and this is similar to being in a market where the bears simply move in and take over, and beat things down more and more over time. If people are worried about bear markets and do all sorts of things to look to cushion the blow, you would think that living in a bear’s den for over 5 years might put them off, but oil stock investors are a lot like Grizzly Adams, they seem comfortable and happy enough living this life.
Many of us have been very bearish towards energy stocks for several years now, for a number of reasons. With us, just seeing these stocks underperform by so much is more than enough, as we like stocks that go up, not down, and especially not down lower and lower like a game of limbo where everyone is playing to lose.
When you see the price of oil, their stock in trade, go down this way as well, when you see the world struggle and even be cajoled to reduce their consumption of it, when you see funds avoid this and ones that don’t get chastised for it, and especially when you see the future outlook represented by the ratio of price to future earnings continue to decline, showing us that the market is seeing these stocks worth less and not more in the future, that should be enough to turn anyone off.
It is not that people haven’t been moving away from oil stocks over this time, as that’s the reason why their stock prices have been going down. However, even the most beat up stocks have their stalwarts, their Grizzly Adams, prospectors lost so deep in the wilderness that the only companions that they have are each other and the bears of course. These prospectors have lost their way so much that they have forgotten why we invest, which is supposed to be to make money presumably.
That was then. Today’s reality has taken a big turn for the worse, with demand for oil slaughtered by the current economic shutdowns and oil producing countries playing a game of chicken with each other, like we saw in our most recent price war between Saudi Arabia and at least Russia but directed to other countries as well, such as the U.S., who have moved into the dominant oil producer neighborhood alongside themselves and their Arab friends.
The war is over, sort of anyway, as the Saudis got the production cuts they wanted, but it hasn’t helped the price. Even cutting 10 million barrels a day doesn’t even cut into half of the present glut, which we saw rear its ugly face in the price of WTI closing below $20 for the first time in almost 20 years.
Given the crucial importance of oil prices to oil companies, seeing the price of WTI cut by more than two thirds in less than a third of a year spells big trouble for oil stocks, and they ended up going down that much as well for a time, even though they have rebounded a bit off their lows. Losing almost half of your investment instead of more than that is little consolation though, and the battle is far from over as oil companies continue to pump a lot more than they can sell and just continue to store it.
This storage capacity will be quickly used up at this rate according to industry estimates, and then there will be nowhere to put it. This will involve not just cutting production but stopping it, a grim prospect for an industry whose future has gotten a lot grimmer already this year.
Oil is an Odd Asset, But Not in a Good Way if You Want to be a Bull These Days
Oil is a curious commodity, as it isn’t subject to market constraints the same way as just about everything else is. Usually, profitability will guide these ships, as producing something at a loss just doesn’t make sense, at least normally. Selling at a loss doesn’t scare oil companies so much, and while we may think of organizations like OPEC as restraining trade, and normally arrangements like this would be harmful, but in the face of such a glut, even more restraint than this is required.
While oil is similar enough to be considered a commodity, where one barrel of oil is substantially similar to another to be replaceable, oil does differ in quality and this is why there are several markets for different grades, from light sweet to the thick and sour oil that is extracted from Canadian oil sands.
We do price these differently, but the biggest difference with oil is the varying costs of production. In theory, oil that is produced more cheaply, including refining and shipping costs, should dominate the market, and for many years it did. OPEC used to be the king of the hill, by a good margin, but they limited production enough to see the price rise enough that more expensive methods of production were brought into the mix, particularly from shale and the oil sands.
These new sources did pretty well when the price of oil was higher, but adding all of this supply did serve to see prices drop, taking us from a market of constrained supply to one of oversupply.
Now that the landscape has literally been flooded with oil, and demand has dropped off so much, this will represent some big challenges for many oil companies to merely survive. These companies can’t just take a vacation from pumping oil because they have significant fixed costs, so they may be put into a position of choosing between a true rock and a hard place, continuing to pump oil at a loss and going out of business that way, or just sit tight and wait for their cash to dry up instead and die that way.
Along the way, big oil companies have insisted on not cutting their dividends and have even been willing to borrow to avoid this, putting their necks on the line even more as far as the magnitude of the risk that they take on should oil prices not rebound.
The most recent events have been so terrible that this has gone from doing everything to keep investors happy even if this means the company suffers a lot, to trying to reduce this suffering enough to even survive. This is by no means bullish for these stocks, to say the least.
The “New Normal” Is A Change for the Worse for Oil
There is another risk that has recently surfaced from the effects of COVID-19, which is the acceleration of technology changing how we live and work. Prior to our most recent technological innovations, having our employees travel to a common location to work has really been the only game in town. It sure isn’t now, and in many cases, allowing people to work from remote locations is just a more efficient way to do things.
The stay-at-home orders that most of us have been under will likely serve to open our eyes to this more, and this is especially the case given that the fixed costs of implementing these things have already been spent. Having no choice has a way to encourage that.
This is not to say that even most people will continue to work from home after they are given their freedom, which is not far away, but there will likely be many that will continue this practice at least partially. Given that this makes a lot of sense in many cases, and reduces both the costs to employees and employers, our staying at home now should accelerate the transition between working at an office and working more remotely.
A lot of oil is burned from people traveling to work, as well as traveling for business meetings, and this could in itself cause a hole in the oil market, at a time where their hole is already big enough to be alarming. This is not a reason to be bullish about oil stocks, to say the least.
Such a thing actually has economic benefits overall, especially when you consider that economic benefits aren’t just monetary. Economic efficiency is actually ultimately measured by efficiency of the pursuit of utility, of happiness essentially, and if we can cut down on the extra we and the companies that we work for need to spend on things like transportation costs and offices, things that actually make us unhappy, and we can achieve the same revenue, the extra can and will be spent on things that make us happier instead.
Governments will benefit from this transition as well, as with less cars on the road, their capital costs will be reduced accordingly. This is something we can really use given that they don’t have enough money to spend on infrastructure anymore and we are already experiencing real neglect and decay.
While this may be rosy for most of us, it sure isn’t for the oil companies, who are the real losers. The climate and our health are among the clear winners though, and whether or not you believe that the future will be as grim as many believe from our burning so much carbon, our lungs will certainly thank us, and air pollution is a bigger crisis than most believe. People understand that smoking is harmful, but when all you have to do is go outside to become a smoker, and when the toxins involved are even more detrimental to our health, that should alarm us more than it does.
Oil is far from on the way out though, as we still need to make things and move them around, and many still do need to be at a physical workplace, more people working from home can and eventually will provide significant benefits for all of us, except for those who work in the oil industry or insist on holding their stocks which are rotting more each day with our without this effect.
Often times, if not always, there is a silver lining within undesirable or even nasty events if you look hard enough. COVID-19 has been plenty nasty by any measure, both in terms of lives lost and jobs lost, but should this cause an acceleration of working remotely, or even just open our eyes to it more, that lining could end up pretty silvery looking indeed, unless you own oil stocks that is.
Long after the virus war ends, which has already started to wane, the oil war will wage on. Wars are expensive, and this one is no exception. With many other stocks, the damage has at least mostly been done and the future often looks at least decently bright, unlike the slow and steady ascent into a pit of fire that owning oil stocks has caused over the last 5 years.
We’ve gotten a lot closer to the bottom of this pit fast, where the molten rock lays, where nothing survives when it hits it. These aren’t stocks we even want to think of being in right now, as they are at the very least too risky, and way too bearish. Maybe at some point there will be some value here, a real rebound that will take us out of the doldrums and see oil quadruple in price or more from here, that day is not today, and far from it, with all the fire and brimstone that is now in the air, being this close to the bottom.
When your house is burning and the air is so thick, and you can hear the fire trucks coming down the street, it should not be as difficult as it seems to be to figure out the right thing to do. This is not a good value play here for investors even as beaten down as prices are, even though we have come off the bottom now, even though this crisis may be coming to an end soon.
Good traders, on the other hand, can play this and other bounces, and even make a lot of money using leverage, but to do this requires a much keener eye and quicker mouse finger than investors possess. The energy sector is an even bigger wasteland now for investors, and this is not a game where we can afford to stick around for too long, as the opportunities are much more hit and run than investors can either hit or run very well. They are well advised to practice physical distancing from these stocks now, as there are much better places to have your money now.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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