Hell no, I do not want to relive 1986!

Yesterday a client said, “It feels like 1986.”  We haven’t heard that since 1986, and that year was a pivotal one.

The United Kingdom and France announced plans to construct the Channel Tunnel

  • The Space Shuttle Challenger disintegrated shortly after launch
  • Halley’s Comet made its second visit to our solar system in the 20th Century
  • The Soviet Union’s General Secretary Mikhail Gorbachev announced his Glasnost and Perestroika policies
  • Ferdinand Marcos went to exile, which ended 20 years of authoritarian rule in the Philippines
  • Microsoft completed its IPO
  • The Chernobyl nuclear disaster claimed 4,056 people and 350,000 had to be forcibly resettled
  • In the World Series the New York Mets beat the Boston Red Sox in seven games
  • Oliver North and Fawn Hall began shredding documents after the Iran-Contra Affair was divulged
  • In the World Cup Diego Maradona scored one handball goal nicknamed the “Hand of God” and then followed on with a second goal nicknamed “The Goal of The Century” to give Argentina the win over England (2-1) in an historic match.
  • The No. One hit song of 1986: “That’s What Friends Are For”

Clearly, 1986 was an eventful year filled with many events that echo to today. However, it was not a particularly good year for the oil and gas business, and if indeed we are witnessing a repeat, then it means:

  • The rig count will soften, and that will mean there is not as much need for steel tubular goods.  S. Steel (ticker: USX) yesterday announced it is idling two pipe factories, impacting more than 700 workers.
  • Expect a sell-off in high yield debt, and this has already happened to an extent. Since January 2014, a face value of $9 billion of high-yield debt was placed in the oil and gas industry.  On December 23, 2014 that debt had a market value of approximately $41.7 billion, as investors sold riskier debt, driving yields higher. In fact, the weighted average yield to maturity on high-yield oil and gas bonds issued in 2014 was approximately 7.74% at December 23, 2014, or 181 bps higher than the weighted average coupon rate of 5.93%.

2015 vs. 1986

Is there anything different today than back in 1986?  Yes.  The economy is larger, as is the general population.  There is more currency sloshing around in the world.  Global GDP for 2014 is estimated to be $74.7 trillion, up 422% from $14.3 trillion in 1986.  And the world’s people are more connected now than then, meaning that thanks to social media and online news what happens in one part of the world is felt within minutes in other regions, increasing the power of the individual to levels unknown in the mid-80s.

The Bank of Japan initiated a form of quantitative easing back in March 2001 to fight inflation.  The BOJ increased the commercial bank current account balance from ¥5 trillion to ¥35 trillion (approximately US$300 billion) over a four-year period starting in March 2001. The BOJ also tripled the quantity of long-term Japan government bonds it could purchase on a monthly basis.  In response to the credit crisis and ensuing Great Recession, the U.S. initiated QE in 2008, and when it ended in on October 29, 2014, about $4.5 trillion in new currency was pumped into the economy.  The theory was simple — the Fed would “prime the pump” of the financial sector with nearly free money, which they would put to work in the market to help businesses expand and create jobs, giving people the ability to buy the GI Joe with the Kung Fu grip. It worked, or at least sort of worked, as America’s economy is still standing taller than most in the world.

We have to ask, is the U.S. government now in collusion with Saudi Arabia?  With oil prices at 2008 levels, the 12 members of OPEC are realizing US$1.43 billion less in daily revenues.  The Saudi Arabian government announced it will have a 2015 budget deficit, its first budget deficit since 2011 and the largest in its history.

Russia’s economy is being flushed down the tubes by out-of-touch politicians as the country’s currency becomes less valuable than the paper it’s printed on. During a lecture at Columbia University, Vladimir Milov, the former Russian Deputy Minister of Energy, said President Putin did not understand the real ramifications of the ruble losing its value. “He is being told that devaluation is a good thing, but he hasn’t been in a store lately to buy milk.” Russia hasn’t cast itself over the edge yet, but that’s the direction they’re headed. This will be the first year we see significant decline in the Russian economy, and the inertia from an administration that “makes one systemic mistake after another” may well sink the ship, according to Russia’s former energy czar.

Oil drives world

Is the current U.S. president choosing to use crude oil as a weapon against Russia, while simultaneously putting Americans into war (which is a business plan) with ISIS in Syria and Iraq to fight Saudi Arabia’s battles for it? Since the U.S. is largely impotent in Ukraine, Saudi Arabia with its $750 billion in sovereign wealth can weather a protracted decline in oil in exchange for America fighting ISIS. The kingdom’s royal family is reluctant to go to war with other Muslims at a time when Islamic extremists are gaining “street cred” on the Arab Street as the true protectors of Islam, which threatens the Saudi royal family’s status in the Muslim world. Such a deal is not outside the realm of possibility, since low oil prices also help American consumers and reduce the ability for other bad actors, such as Venezuela and Iran, to fund terrorism both in the Middle East and abroad.

With these low prices, you can expect that Norway will suffer, as will the Canadian oil sand projects.  In the meantime, the U.S. Gulf of Mexico’s deepwater oil projects are starting to come on line, which will add more U.S. crude oil.  The U.S. Gulf Coast is flooded with light sweet crude to refine and the heavier crudes, like the Middle East and Canada, need access to our refineries if they are going to keep pumping—thus the need for the Keystone XL pipeline.

Perhaps U.S. Steel is seeing the layoff as a way to take on a union (Really?  We’re still doing that these days?).  But if oil and natural gas prices are going to stay at this low level for an extended period of time, then the oil and gas industry will experience bankruptcies in 2015 and the rigs will come down. As OilService firms ratchet back service prices, technology investments and people, a new malicious cycle of increasing the inflow of foreign oil will begin, which will undo all the good work the U.S. oil and gas industry has done for the nation since 2003 to increase reserves and production in the U.S. and strengthen our domestic energy security.

Is that really what America wants?  To keep paying a country that couldn’t defend itself in a pillow fight against Hello Kitty, a country that won’t let its women subjects drive, while shedding American blood and spending our hard earned taxable dollars in the Middle East to defend Saudi Arabia? If it means energy security, then that is the uncomfortable bargain this administration has made.

Byron Wien, formerly Morgan Stanley’s chief strategist, as reported by Bloomberg, forecasts “crude oil prices will drop to the $40s before recovering to above $70, driven by demand from emerging markets. The slump in oil will force Iran to agree to roll back its weapons program and in the credit market, the selloff in high yield debt as a result of energy slump creates a ‘huge buying opportunity’.”

Lawmakers: Let’s Raise Taxes

In Utah, legislators are proposing to increase gasoline and transportation taxes by as much as 10 cents a gallon, because they reason that with the low prices drivers can take on more tax! Gasoline sells for less than $3/gallon in every state except Hawaii.  In addition, the Utah legislators want to install an annual tax-rate hike to keep pace with inflation.

The trial balloon floated in Utah has been seen in other states, and even in the U.S. Capitol. The guardians of our pocketbooks, aka politicians, couldn’t let the Beehive State beat them to the money trough, so they are proposing their own tax hike.

John Thune, a Republican from South Dakota, who is the incoming chairman of the Senate Commerce, Science and Transportation Committee, told Chris Wallace of Fox News on January 4 that “everything has to be considered” to fund the Highway Trust Fund.  Republican Bob Corker from Tennessee proposed a $0.12 hike back in June 2014.

Global war, a diminished American energy industry, higher taxes and a potential generational investment opportunity. What does it all mean, and what should we do?  Learn to play four-dimensional chess?  Sure.  Turn off the television and go have a good game of catch?  Another excellent idea.  Acquire the taste of a good single malt scotch?  Yes, you betcha.  Put cash to work in management teams that have and are going to weather the storm?  Always a good idea, regardless of the cycle.  Balanced production and strong balance sheets are always in style.  Cycles in the industry are more volatile than ever and they seem to be more frequent. If past is prologue, prices will rebound, acreage will be purchased, rigs will be contracted and production will increase. It’s what we do.

A quick reference point:  for the period 2008 to 2013, OPEC production is down 1.47%.  In the U.S., for the same period, crude oil production is up 45.2%.  Global consumption of crude oil in 2013 was 90.4 million barrels per day, up 5.03% for the same period.

2008 – 2013 OPEC Daily Production

Oil drives world

2008 – 2013 OPEC Daily Production

From Roger Read, Senior Analyst from Wells Fargo, “For those hoping for OPEC action, the IEA’s projections and oil prices heading south of $60 per barrel add to the pressure on core OPEC members to call an emergency meeting in H1 2015 and implement production cuts.”

As far as the U.S./Saudi collusion question, it’s pretty hard to be in collusion with someone that is kicking the other side in the shins because they are getting beat.

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360 Commentary

A Royal Pain

If OPEC, and Saudi Arabia in particular, is waging a price war against independent shale oil producers in the U.S., there may be a practical limit to the kingdom’s desire to squeeze American operators. As reported in Oil & Gas 360® Meghan O’Sullivan, a professor of international affairs at Harvard’s Kennedy School said this to BloombergView about Saudi Arabia’s willingness to let prices free fall, “Even if the nation can weather the economic fallout, falling prices could translate into a perception among the Saudi people that the monarchy has lost control of the oil market, and inject greater instability into an already uncertain domestic political environment.”

O’Sullivan emphasized the painful lesson the Saudis learned from the oil embargoes and shocks of the 1970s. High prices encouraged a wave of international exploration, which resulted in large oil finds in the North Sea, Gulf of Mexico and other regions. The short term gain in cash flow and international prestige was offset by the loss of long-term market share. The fact that America is now a larger oil producer than Saudi Arabia may be viewed somewhat as an embarrassment, but the kingdom can ill afford more loss of market share and a domestic budget stressed by low prices.

Saudi Oil Minister Ali al-Naimi added to the rhetorical war of words during an interview with CNBC on December 10, 2014 at a climate change conference in Lima, Peru. When asked if he thought it would be necessary for Saudi Arabia to cut oil production to support prices, al-Naimi told the network, “Why should we cut production? Why?"

At the same conference and as reported by Bloomberg, Venezuelan foreign minister and top OPEC emissary Rafael Ramirez, emphasized OPEC should act because, "that is our job. We want stability in the market and predictability." Ramirez continued, “The drop in oil prices is not good for anyone,” and conveyed that his country sees $100 per barrel as “fair.”

The differences in what constitutes a “good” or “fair” oil price depends on large part on the breakeven price to fund government expenditures. Venezuela, as noted earlier, requires an oil price of $121 per barrel to pay for its domestic budget, far higher than the $93 target for the Saudis. The longer the price slump continues, the divisions in OPEC are likely to grow deeper and wider.  

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