Uncertainty ratchets up, DJIA moves higher. Plus Notes about Oil and Gas - Updates and Thoughts by H
- isaacsonhoward
- Nov 29, 2014
- 7 min read
This week’s leading headline with greatest impact – OPEC lets oil prices tumble. OPEC chose to let the markets resolve the current global oversupply of oil. With OPEC agreeing not to cut production, WTI Crude fell from $73.69 per barrel on 11/26 to $66.15 on the 28th. http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=7d (WTI Crude = West Texas Intermediate Crude, which is the “standard” US oil. Brent is the “standard” European oil, and is priced a bit higher, though they both trade on global commodity exchanges. I am using only WTI for discussion to keep things reasonably simple.)
A few thoughts on oil production:
As noted in earlier notes, break-even for US producers on average was estimated at $72.50 per barrel. Thus, with market prices now less than $72.50, we will very likely see cut backs in new exploration and drilling. Keep in mind that much cost of getting oil out of the ground is “upfront”, in acquiring rights to drill on the land, and then mobilizing the personnel and equipment to drill and frack. Then the pumping begins. Additional costs are incurred to maintain higher flows of oil from existing wells, but these costs are significantly less than drilling new wells.
The difference between the “break-even cost” and the selling price of oil provides money for (1) transportation of the product to markets, (2) additional well stimulation and new well development, (3) funding for development of new processes and some “experimentation”, and (4) profits. In the “olden days”, the classic rocker pumps were used to maintain production at a very low cost over time. Through the tactical addition of sand, chemicals, water, gases, etc., under very high pressure, production can be significantly enhanced and maintained at higher levels for longer times. The costs to do this though are tremendously higher, and thus well output volumes can decline rather steeply if the wells are not regularly stimulated.
Because oil exploration and production profitability per barrel is significantly down, companies will need to be much more careful in evaluating and pursuing projects. Cost of transporting oil to market will absorb a greater percentage of the margins, and this can have an impact on the building of additional pipelines, as well as the investment into rail cars and the use of rail, esp. as it pertains to the Bakken in N. Dakota and the Niobrara of NE Colorado. Of course, once pipelines are constructed, their operating costs are significantly less than those of rail transport.
Thoughts on hedging and profits:
Many producers hedge 50-80% of their selling price for the upcoming 12-18 months, to provide a greater ability to project revenues and to protect against market price moves. Often market price moves are short term in nature, so the hedging minimizes the volatility of revenues and profits due to pricing. Hedging will protect some earnings for the next few quarters, but with oil off approximately 36% from its summer 2014 highs, and one year forecasts for oil are now sitting on average at $76 per barrel, the return to high prices and higher margins are not imminent. http://oilshalegas.com/index.html
Keep in mind, though we may think that oil and natural gas are similar and correlated price-wise, a look at the oil and gas pricing charts below over the same period demonstrates that their pricing moves to very different rhythms. (The number in the black box on the right of each chart is the current pricing as of Friday’s close.
Sources: http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=1y and http://www.nasdaq.com/markets/natural-gas.aspx?timeframe=1y
While talking here about the oil and natural gas markets, it is important to touch on the key uses of each of the fossil fuels:
Commercial uses and residential uses of natural gas include primarily heating, lighting, cooling, cooking, water heating and drying. As noted by NaturalGas.org: “Natural gas has a multitude of industrial uses, including providing the base ingredients for such varied products as plastic, fertilizer, anti-freeze, and fabrics”. “Natural gas is consumed primarily in the chemicals, petroleum refining, pulp and paper, metals, fertilizer, stone, clay and glass, plastic, recycling and food processing industries.” Its components and by-products are used in manufacturing process for heating, dehydrating, co-firing, and oxidizing. http://naturalgas.org/overview/uses-industrial/
As passenger travel and freight are the two largest uses of oil and its derivatives, transportation costs and shipping costs are likely to be the greatest beneficiaries of lower oil prices. UPS’ energy surcharge is directly tied to the price of jet fuel, and it should be coming down by a bit. https://www.ups.com/content/bb/en/shipping/cost/zones/fuel_surcharge.html
Other fuel surcharges applied by airlines, hotels, utilities, etc. may come down over time, though analysis needs to be done on a case by case basis.
Political risks arise from the falling price of oil. Iraq, Venezuela, and Russia will be very challenged to support their governments with declining incomes. Certainly, the leadership of these countries could become more desperate and dangerous; they could also become more trade focused to replace oil incomes.
On to the markets:
The markets were closed on Thursday and open for a half day Fri. We hit new highs during the week and ended the week a bit higher than last Friday. S&P 500 and Dow 30 indices, to 2068 from 2064 last Friday and to 17828 from 17810, respectively. Oil held steady until OPEC’s decision (discussed above), falling to $65.99 from $76.69 last week . The ten year T yield fell to 2.17% from 2.32%, as European and Japan’s rates continued lower. http://www.marketwatch.com/
There is problem with rates moving lower as the market moves higher! If the US economy is so good and the Fed plans on raising rates in summer 2015, why are we now at 2.17% on the ten year, down from 3% at the start of the year? The stock market movement higher is a positive sign, but yields should be moving higher if the economy is truly improving substantially. The major issue, based upon my opinion, has to do with foreign exchange rates. If the Fed raises rates as the rest of the world’s rates move lower, then our currency, the US Dollar, will further appreciate against global currencies. This will then make US made goods more expensive for foreign countries to import, hindering US economic growth. Thus, IMO, the Fed will tread lightly on raising rates, until they truly need to.
There is also a statistical issue with oil prices moving lower. This will cause inflation to move lower to a certain degree. In the US, this is not a major issue. In Europe, this is a big problem. Southern Europe continues to face deflation, brought on by the forced austerity and wage and job cuts of 2008-2010. Overall, consumer prices for November through Europe rose only 0.3% over last year, down from 0.4% in October. Lower energy prices will not help these figures. (As noted in last week’s “Update” both the European Central Bank and the Japanese Central Bank were expanding their quantitative easing programs, to stem off deflation and to encourage their economic growth. ) There is a hope that lower energy prices will cause consumers and producers to spend more in other areas, bring positive economic results and support for other pricing increases…. As noted, this is a hope.
Here in the US, consumer debt, mortgages and car loans are increasing and supporting consumers.
Student loans will be an issue as the economy and time move forward. Unlike most other debt, student loans can not be resolved in bankruptcy court. Hence, they can ruin a person’s financial life immediately upon completing college, precluding auto and home loans, impacting their hiring, and ultimately their retirement. There is speculation that our current President may look to do something in this area before he is out of office.
Economic news from this past week: (Some very good, some okay….)
3rd Q Real GDP rose by 3.9% and revised 2nd Q GDP rose by 4.6%, after adjusting for inflation. (This was after last winter’s 1st Q contraction.) These were both positive surprises and stronger than expected. http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
US Consumer spending in October was up 0.2%, after a flat September.
Personal income in October rose 0.2%, consistent with September.
Though overall wages and salaries are up 4.4%, this figure has been reasonably consistent since the start of the year and does not indicate a pick up in wage pressures.
Pending home sales fell 1.1% in October from September, though sales of new single family homes rose by 0.7%.
Initial unemployment claims increased by 21,000 to 313,000, though the expectation was for additional declined.
Auto loan delinquencies increased by 13% to 1.16 out of every 100 loans. For borrowers under 30, the rate rose by 17.8% to 1.55 of 100 loans.
Sources: http://news.investors.com/economy/112614-728168-latest-batch-of-economic-data-suggests-growth.htm and http://news.investors.com/economy/112414-727791-economic-news-today-markit-service-sector-gauge-eases-again.htm
Thoughts:
The challenges to the global economy and the upward march of the markets are unlike the volatility of October, which was driven by Ebola fears and global tensions and faded very quickly. Lower oil prices may be with us for 12+ months, and potentially longer, depending on numerous factors. Lower oil prices definitely is an overall positive for the American consumers and for the economy, though it will present new and different challenges for companies in the industry and all who use its products.
As noted above, oil and natural gas markets and pricing is very different. Costs of producing product vary greatly depending on the locations of the wells and the types of drilling being done. Understanding individual companies and their businesses is essential in identifying the opportunities within the marketplace.
The US economy should continue to move forward, though winter can have a significant impact on economic growth if it is anything like last year. Impact would be temporary, depending on how the Fed and global central banks respond. As of now, all appear to be accommodative and simulative.
Based upon our economic and market models, we are projecting total returns in the overall stock markets of approximately 10% through December 2015 and we are managing portfolios to balance risk and reward, based upon the needs and goals of individual clients.
Between now and year end, we are actively evaluating portfolios to assist clients in managing their tax liabilities. We are also working closely with our CPA and Tax Adviser partners in opening and funding 401k plans and Defined Benefit plans, to defer taxes and protect assets. For higher income earners, we are raising the ideas of non-deductible IRA contributions and subsequent Roth conversions.
If our team can assist you in any way, please feel free to reach out.
In the meantime, have a great weekend and a productive week!
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