Vancouver Investment Advisor Ritch Wigham

Thoughts on Oil

Oil

The last twelve months have been nothing less than stunning in the world of “big” oil. Or small oil, for that matter, maybe more for small oil. A driller last year had the prospect of being paid nearly 400% more for his product than he will see currently. This is also true for natural gas. In my life as an investment advisor I have seen oil trade at $12.00 and natural gas below two dollars. That was then and definitely isn’t now. There are a series of truisms about oil I feel I have learned in the past 25 + years I have followed these markets. Not only are fundamental factors of supply and demand of importance but political factors must be taken into account when we look at where we are in the current depressed oil environment. I will, and am willing, to suggest that the best opportunity any of us may ever have again to be involved cheaply in the world of non-sustainable energy is now here. Does that mean I am a “bull”? Yes I guess it does. I strongly believe that we are either at the bottom or close enough that whatever I was to do in the energy markets will be rewarded sooner rather than later.

These are my reasons:

1.The simple cost of production is now so high that the internal rate of return for new projects makes the development of new oil sources un-economic. As a base level an oil project has to be able to pay for its development within seven(7) years, which amounts to about 13% per year. This means that the products, when produced, need to pay down the debt incurred within about seven (7) years. That is a very long time to guess the price you are going to get paid for your production. So, as an example, if last year you were going to be paid $80.00 dollars and your I.R.R. (internal rate of return) was five years, you approved the project. Today that I.R.R. might be more than double that time (multiplier effect) so you shelve that project and keep your oil in the ground as inventory and re-asses that project again later on. So far this year from reports I have seen, already more than 1/3 of projects have been cancelled or deferred. I would bet that number is now shockingly low based on current prices. It takes a very short time to cancel a project and a very long time to approve one. Don’t be fooled and think that these cancellations will fall back into the pipeline any time soon. It just isn’t that easy.

2.In my lifetime this is the first time I have seen either the mining industry or the petroleum industry mothball or outright shelve projects and capital spending as quickly as in the last several months. Companies used to just “produce” through price weakness. THEY DON”T ANYMORE. It used to take a long time for scarcity to affect the market, hence the years it took for natural gas to become a profitable business instead of a by-product business for the major producers.

3.Currencies now more than ever play a larger role in the pricing of crude. At some point in the next “bull” move, our friends in the Gulf will insist on a new base for the pricing of crude besides just quoting in U.S. dollars. I am not sure just how that will work but the reasoning is that it will somehow take the “currency risk” out of selling crude. For example, if a barrel of crude is $40.00 U.S. when the Dinar is 400/dollar when you ship, but goes up to 300/dollar when you get paid, which is like selling crude oil for $30.00 U.S/ barrel. The converse is also true. What that means is that since you pay your employees in Dinar, you have lost ¼ of your pricing power and a much larger amount of your profit.

Currently, the currency relationship of the selling countries has not made up the ground they lost with the fall in the price of crude. What this ultimately means is that they are running deficits from their production. Producers don’t keep producing anymore when they don’t get paid for it. They have finally understood that they have a finite resource.

4.Politically you simply cannot have a price of crude (longer term) that does not support the spending habits of those producing it. Arguably most of the conflicts that we deal with either internationally (Iraq) or internally (Nigeria, Sudan, et al) are fueled by oil. Most of OPEC is run by a series of despots or dictators that maintain their hold on power using Petro-dollars. Iran produces almost no gasoline but subsidizes its use to the tune of $.60/gallon at the pump. Iran produces a significant amount of crude. It is however a lower grade (high sulfur content) than most of the OPEC countries. Therefore Iranian dirty crude carries a discount and is sold cheaper than other crudes. Iran cannot increase the price at the pump easily, therefore right now it is losing huge amounts of money on its crude exports because of the subsidized use of gasoline for its domestic needs. In essence at the current price, Iran loses more on every barrel than it costs to pump. Remember, Iran has almost no refining capacity. Curious for a country trying to develop “domestic nuclear power” This cannot continue for long. The same scenario is happening in Venezuela. Chavez technically is not a dictator, but I bet he would lose his power if he made his countrymen pay fair market for their gasoline. (Caracas is $.12/gallon. Yes that is twelve CENTS ) even Saudi Arabia charges nearly a dollar.

Conclusion:

I could continue on, but I am sure you get the point. When crude hit $147/barrel last year it was said that demand was running about 88 or 89 million barrels /day. Currently demand is said to be about 81 or 82 million barrels/day. That small change created a more than $100.00 dollar price swing. So a less than 10% usage decline created a 70+% drop in price, what happens when the usage goes back up only 5%? I want to be long when that occurs.

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