Stop the Presses — Oil Isn’t Crashing

Over the past three weeks, there have been numerous headlines insinuating that a freefall in oil prices is underway. Last week I read that a slowdown in China, OPEC’s decision not to cut production, and America’s growing oil production were all contributing to the downslide. Based on the headlines, one might suspect that we were right in the middle of a major bear market for oil.

Just how far had the price of West Texas Intermediate (WTI) fallen? All the way to $91.78 a barrel. Keep in mind that WTI opened 2013 at $93.14 a barrel. Since then it has traded at high as $98/bbl at the end of January and down to $86.65 in mid-April.

According to the US Energy Information Administration (EIA), the weekly average price of WTI this year traded below $90 only once. The week ending April 19th the average price was $88/bbl. Over the past 12 months, the weekly average has traded in a range of $17/bbl. The low took place during the week ending June 29, 2012 at $80.33 and the high occurred the week of Sept. 24, 2012 at $97.56. The weekly average price of WTI over the past 12 months has been $90.95. So despite the bearish headlines, WTI is still trading above the average over the past 12 months.

Over the past 2½  years, the average weekly price of WTI traded below $80/bbl only once. During the week ending Oct. 7, 2011 the weekly price averaged $79.43, but then climbed back above $100/bbl within two months. To get consecutive closes below $80/bbl, we have to go back nearly three years to the end of September 2010.

Following the oil price crash in 2008, there was some weakness in early 2009 that for a short time saw weekly averages in the $30’s and $40’s, but by October 2009 the price had once again reached $80 despite a severe economic slowdown.

Typically the cycle of oil prices goes like this. High oil prices result in increased spending on new projects by oil companies. But high prices also slow the economy, reducing demand for oil in the process. This combination causes a supply surplus that leads to plunging oil prices and lower investment in new oil projects.

This is a cycle that has been repeated many times, but this is a cycle that I believe will ultimately come to an end because I don’t believe the oil companies will always be able to build out spare capacity to stay in front of growing demand.

Over time the lower prices brought on by the supply surplus act as a stimulus to the economy, and demand — and in turn oil prices — pick back up. Because of the underinvestment by oil companies during the period of low prices, we often see an increase in demand at a time when the oil industry isn’t increasing supply. Thus we return to the oil price spikes that slowed the economy in the first place.

But the 2008-2009 bust was unusually abbreviated. True, prices did plummet, but they didn’t stay down long. Here is why:

global oil consumption chart

Historically global demand was dominated by the US, and while the US and EU both saw decreased demand as a result of the higher prices, demand in every developing region in the world continued to grow. Thus, unlike previous oil spikes, global demand continued to climb and the oil industry was unable to build out the kind of spare capacity that had taken place in the face of previous price spikes.

Between 2000 and 2011, global oil consumption increased by more than 11 million barrels per day, but the development of additional production capacity did not keep pace. This eroded spare capacity in the global oil market, which led to much higher prices and greater volatility.

global oil production chart

A number of agencies are predicting much lower oil prices in the coming years. I have been hearing these predictions regularly since 2005. Daniel Yergin, author of the Pulitzer Prize-winning book on the oil industry called “The Prize” and one of the most highly-respected analysts in the industry, consistently underestimated the price of oil during the past decade before recently reversing direction.

But I do agree with the sentiment that supply is likely to expand for several more years. It’s just that demand is going to expand as well, and existing fields will continue to deplete. In an interview I conducted last year with former Shell president John Hofmeister, he corroborated my thesis:

“In 2005 China needed about 5 million barrels per day (bpd) of oil; in 2011 China needed 10 million bpd of oil; by 2015 China will probably need 15 million bpd of oil. And that kind of tripling of demand in China, augmented by significant additional increases in daily demand from the rest of the developing world, including India and the fact that OPEC has been largely flat in its production and its inability to create spare capacity for most of the last decade is behind surging prices.”

Mr. Hofmeister and I know that oil depletion reduces production in existing fields by 4 million to 5 million bpd each year, which means it takes that much new oil development just to maintain global production rates. Mr. Hofmeister summarized the problem as “We have not been able to keep up with demand growth and the decline rate simultaneously.”

However, over the past few years tremendous investments have been made in finding and developing new sources of oil, and growing demand will not as easily erode spare capacity as in recent years. This is why I have predicted that oil is likely to trade in a range — perhaps as low as $70 up to maybe $120 for the next few years. Some may feel that it is unlikely that oil could fall to $70. After all, it’s been three years since the price of WTI was at that level. But if Iran capitulates on its nuclear program, escaping the related trade sanctions, a lot of oil could hit the market, and certainly the expectations of oil traders could drive prices down in a hurry in that situation.

Implications for Investors

I continue to believe, as I have for the past two years, that WTI is going to trade in a range that could go as low at $70 and perhaps up to $120. Most of the time it will likely bounce around between $80 and $100. The opportunities for investors are to pick up select companies — based on individual risk tolerance — during the dips. If WTI drops down in the mid $80’s those who are more risk tolerant should start to buy companies with a heavy presence in the Eagle Ford, Permian Basin and Bakken formations. More conservative investors may pick up some of the major integrated oil companies at discount prices during such dips.

When WTI approaches $100, traders might lighten up on their positions, but long-term investors would be well-advised to sit tight. Just as oil broke out of the $10-$25 price range a decade ago and moved sharply to the upside, I believe it is likely to do so again, even if this doesn’t happen for two to five years.

In the short term there are certainly some risk factors that could cause oil to drop to the bottom of the range. But growing global demand and depletion in existing fields will once more erode that spare global capacity, and the share prices of producers with strong balance sheets and good management teams will reward investors richly.

In closing, I would like to wish my wife a happy 24th wedding anniversary today.

Around the Portfolios

Joy Global (NYSE: JOY)

Another quarterly report, another incremental disappointment for the slumping mining equipment supplier and heavily dented Aggressive portfolio holding.

Revenue and earnings for the most recent three-month stretch actually beat analysts’ modest expectations, but that was about it for the good news. Bookings were down 8 percent, sales dropped 12 percent, and operating profit shrank some 20 percent year-over-year, as the mining industry cut its capital spending by some 40 percent in response to persistently weak commodity prices. The sales and profit forecast for the balance of this year was cut as well, and management indicated on the conference call that while the demand for its equipment has hit bottom, a lasting upturn remains over the horizon and probably not in the cards even next year.

The stock continued to drift toward last year’s lows near $50 a share, which also represents solid chart support going back to 2010.

The silver lining is that the sellers appear to be close to exhaustion, pushing relative strength to levels so lo that a countrend rally might be in the cards.

Fundamentally. Joy is modestly priced at roughly 9 times what would appear to be its trough earnings, and expects to pile up some $300 million in free cash flow this year, which is likely to be spent on share buybacks sometime in early 2014.

The CEO is also encouraged by the notion that the defensive and relatively new management teams running Joy’s mining customers have swept out uneconomical old development projects in favor of new ones promising higher returns and slowly moving ahead despite the current downturn.

One likely source of increased demand next year will be the US coal sector, as higher natural gas prices encourage some utilities to switch back to coal for power generation.

Joy remains one of the real dogs in the portfolio, and was one long before our arrival. But it did have a spectacular run in the first few months after purchase in late 2010, before the commodity boom turned tail. Inaction and inertia did the rest, so that by the time we overhauled the portfolio a few months back it looked too beaten up and too cheap to sell.

As often happens with slumping stocks, cheap has since become cheaper, but we’re not ready to jump ship just yet. At this point, the bad news appears to be fully baked into the share price. But there’s no longer any sense keeping the buy under limit at $99 or calling the stock a Best Buy — at best it’s a speculative flyer for bottom-fishers at the moment. So buy JOY below $60 for now, and we’ll reassess once it gets to that limit.

— Igor Greenwald

Stock Talk

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