Rule #1 Finance Blog

With Investor Phil Town

What’s Behind the Drop in Oil Prices? What to Do Next

The oil patch is experiencing an Event, the sudden and totally unexpected meltdown in oil prices from $115 to $27. What we want to know is whether this event is going to affect oil patch companies for another year or two or for much longer.

Mr. Market has already determined that however long the price drop will last, it’s too long and he’s exiting rapidly. Some oil patch service companies are priced at 20% of their highs. If we can determine a range of outcomes, we might find a bargain in this otherwise expensive market.

Oil Price History

The chart below from the World Bank shows the inflation-adjusted price of oil from 1861 to 2014 (and the plunge continued in 2015 to today’s price of $27.

world-bank-oil-prices-chart-1861-2014

Picture Above: Price of Oil chart 1861-2014

Notice that oil, priced in today’s dollars was at or under $40 from 1890 until 1978 when the price shot up to $117, inflation adjusted, as OPEC began its historic squeeze. The only exception to the sub-$40 prices we’re a short period of pre-WWI monopoly control by Standard Oil and the 1920’s inflation explosion post-WWI.

Those pricing problems were brought under control in the late 1920’s by the Texas Railroad Commission; this group controlled the volume of Texas and California oil that could reach the market by controlling the amount they allowed into railroad oil tankers. This strategy effectively set the price for 5 decades. The result of controlling production, however, was that post-WWII American refiners found it cheaper to buy inexpensive middle-eastern oil than home-grown oil. This eventually restricted US production and put the power of pricing into the hands of the Saudis and OPEC.

In the late 1970’s Nixon’s decision to disconnect the dollar from gold meant that the Saudis suddenly started receiving massively devalued dollars in exchange for each barrel of oil. These fiat dollars wouldn’t buy as many Mercedes as gold-backed dollars had done, and the Saudis responded aggressively by forming OPEC, an oil cartel, the sole purpose of which was to jack up the price of oil in order to preserve the buying power of the dollars they received for each barrel. OPEC succeeded beyond the Saudis’ wildest dreams; from that point the price of oil exploded upward. With oil at all-time highs, drilling accelerated all over the world and eventually the over-production drove oil prices, adjusted for inflation, back from $117 to $18.

Peak Oil and Fracking

Then came Peak Oil

As major oil fields began to decline and as it became more difficult to find new sources of oil, many researchers concluded that the world would run out of oil by 2040 or so. Oil prices began to rise as futures traders responded to the Peak Oil theory by raising prices on future oil delivery. OPEC responded to Peak Oil by cutting production. The result was oil prices exploding upward. However, higher prices made for more technological innovation and as oil rose through the $70 range fracking technology was perfected in North Dakota and Texas.

Fracking makes it possible to re-open existing depleted wells by drilling horizontally and then pressurizing the drill holes to 10,000 psi, sufficient pressure to crack open rock and release hidden oil reserves. The result was that between 2008 and 2014 American oil production increased from 4.5 million barrels a day to 9 million barrels a day. This meant that fracking had injected as much new oil into the market as the entire production of Iraq or Libya or Iran. This deluge of oil brought out intense competition in the world markets as buyers began to shift off of Saudi oil in favor of cheaper US production.

In 2014, the Saudis responded.

They announced they would not only not cut production to shore up the price of oil but that they were increasing production to hold on to their customer base. At that point, the Saudis increased production by 20% and flooded the world with oil. Today’s prices are a result with even more production about to hit the market.

If the price of oil stays in the $20’s, Ray Dalio estimated half of American exploration and production companies will go bankrupt by the end of 2016. However, In a deal to restrain their nuclear bomb research, Iran has been given $150 billion and a free pass to sell oil. At full production, Iran can put 3.5 million barrels of oil per day into the world supply, nearly the equivalent of the entire US production from fracking and sufficient to continue to drive down oil prices in spite of a shutdown of US fracking.

Russia and Oil Prices

Russia is major wild card to this lower for longer oil price scenario.

Russia has enormous oil reserves and oil is Russia’s main source of GDP. They are so dependent on oil that a recent WSJ article estimated that Russia needed $90 oil just to balance its budget. With oil down and a crashing ruble, Russia is headed for an economic meltdown that can not be good for Putin. He can benefit from anything that raises the price of oil.

Therefore, his military excursion into Syria may be as much about finding a way to disrupt OPEC production as any desire to save Assad. If Putin can threaten the Saudis with a disruptive war by supporting their Shia enemy, Assad, the Saudis might see the writing on the wall and cut production before Putin’s allies, Iran, Iraq and Syria, cut it for them.

Who Benefits If Oil Prices Go Up?

If the price of oil goes up, Russia will benefit. And so will the United States.

My best guess is that Putin is communicating with the Saudis through back channels about their options: cut production or I’ll do it for you.

I think we’ll see the Saudis step back production quietly and I expect the price to move up above $50 within a couple of years.

Meanwhile, I would think that producers in the US will be looking for a modern version of the Texas Railroad Commission to control production in the US in order to be less vulnerable to foreign oil cartels and intrigues. But that may not occur until after half the US oil patch goes under.

What to Do Now?

So what to do as an investor?

Dig deep into the oil industry, read everything, read the 10Ks, find the 4Ms, and pick a few of the best companies, those with the least debt, the best people, the lowest cost production, the most reserves and get ready to buy them if and when this price bottoms.

Now go play.

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