Yes most investors won’t believe it until the dust settles but we are basically there. The doom-and-gloomers are saying we are going to $10 to $20 per barrel and the V shape recovery theorists suggest that $60 to $70 is around the corner. However, what about the realists? Those actually working in the space who see and feel the day to day activity of what is happening on the ground. These people we will call the realists because they actually see, feel, and hear what is happening and what is about to happen. Basically, they are living this oil decline. We could almost call them first movers. We had a fair amount of communication last week with those on the street and have some short term insights as to what is happening now that is giving us a moment of pause.
First we will start with U.S. Rig Count
This is the cleanest data we can get with regard to what is actually happening. If the drills are working, it likely means production is ramping up or getting better. We know this is not happening from the data release last week. Below we looked at the long term historical rig activity (50 years) in both the U.S. and Canada. The raw number below is 877 oil rigs at work in the U.S. Graphically, we can see this number is at about a 13 year low. Can it go lower? Absolutely, it could go as low as the 1999 low of 502 rigs or even lower. Probabilities however, tend to favour something different.
Source: VIP Wealth Solutions and Bloomberg
What is happening in Canada’s oil patch? First, the streets of Calgary are quiet on a Friday afternoon. Many companies have taken furlough actions where workers are working 4 day work weeks. This means that fewer people are at work on Fridays, thus fewer people are downtown. The chart of rig activity is only suggestive of the big difference between Canada and the U.S. The U.S. seems to have a longer cycle of rig activity and Canada seems to be quicker to react. However, the data suggests that Canada may have already seen the worst of the past 50 years or close to it. The last low on the Canadian rig count was in May of this year when it reached 72 rigs. When we go back to our long term data, we can see a low print in 1992 of 54 rigs. Things are so bad that Canada almost put in a 50 year low and then turned the corner. Now this turn is not a straight line higher.
Source: VIP Wealth Solutions and Bloomberg
In talking with our friends on the street in Calgary, they are looking out to a 2016 time frame. Not in the spring, or the summer, but in the fall. Suggesting that there remains lots of time left in this trade and likely some volatility to go with it.
One Last Shoe to Fall
One of the points that came out of discussions was energy hedging. It was suggested that hedges are starting to come off this quarter. First, what does this mean? Many energy companies hedge their production. A year ago when a company was producing 10,000 per day, an energy company could hedge part of their future production through the derivatives market. Meaning they could sell a contract of oil into the future at $80 to $100 per barrel and realize that price one year forward. Those contracts are starting to come due. The result of this is that current and future production will be priced closer to the spot rates we are seeing today. This means that the quarterly numbers going forward can surprise to the downside, all things remaining equal.
SO why are we there?
Consider the simplicity of this assessment. When oil was $100 per barrel, companies could raise money with little or no problem to find more oil. Today, few can raise the funds as easily as they did when it was $100. This means there is a smaller portion of easy money for capital expenditures – basically finding more oil. It also means that they need to rely on their own free cash flow or debt. We know cash flow is lower because prices are lower. We know debt is the lever that can put companies out of business; so in low cash flow periods, companies are less likely to use this precious resource. This is where the so called supply response happens. When there are less drill rigs working as we have now, supply goes down. It is difficult to tell how long it takes for the supply response to gain its teeth, but time and time again it has been shown that the world works in cycles. Clearly we are at or near the bottom of this cycle. Why are we at the or near the bottom? The top was at $100 plus oil so we are not at the top. The middle could be defined at $60 or $70 to $100 and the bottom needs to be defined at something below $50 or $60. The absolute bottom is anyone’s guess.
Are we getting drunk on $100 any time soon?
Likely not. There are new technologies in place that bring on supply faster and cheaper than ever. This is likely the new reality that the energy space needs to get used to. Could we see $60 oil in 2016? Sure.
One interesting chart that we came across was from the Vanguard Resources investor presentation. It showed the real lack or any credible prediction coming out of the futures market as it relates to the future price of oil. The chart suggests that oil is more of a random walk based on supply and demand and world events. The futures curves say little about the future price of oil with any predictability. Given this, we need to temper our own resolve and remind ourselves that the world is not in our control and we need to continue to monitor and pay attention to the facts in front of us.
It has been suggested in conversations that the only thing that can save the short term nature of this oil issue would be a world geopolitical event. You only need to Google “world headlines” to gain a sense of what might or could happen. Below are a few posts from CNN:
How the West has strengthened extremists
The Real Danger with North Korea
Did the U.S. betray the Curds in the ISIS fight?
We have seen war premiums reflected in the price of energy before and know that this world is far from being at total peace. There always remains an outside reality that bad things can happen. We will hope for peaceful outcomes as the world unfolds in front of us.
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