Mention oil to a middle-aged value investor and his eyes are likely to turn glassy in awe. This generation remembers walking to school seeing cars lined up around the block for gasoline during the 1973 Arab oil embargo. These guys are always bullish on the stocks of oil companies because they fear the next crisis sending oil prices through the roof is always right around the corner. Incredible free-cash flow generation of 10-15% on many of these oil producers seals the deal in the eyes of these investors.
Oil, however, is an undifferentiated commodity like any other. And like any other commodity, an extended period of high prices and gushing cash flows is likely to lead to over-investment and over-production worldwide. Watch out below.
After falling precipitously during the pandemic, oil prices have averaged $80 per barrel for almost three years now, since January 2021. That’s more than 2X the cost of production. These companies are minting money. The last time prices remained this elevated for this long, from 2011 to 2014, the subsequent fracking craze drove prices down to $26 per barrel two years later.
Why $26? Because the estimated marginal cost of production per barrel of oil for high-cost American producers was $30. This is a hard number to derive. At the very least, however, $30 represented the floor at which new rigs ceased coming online.
The funny thing about history is that it repeats itself.
Look at production increases that have taken place in the last few years while the oil price has been elevated. In a global market of 100m BPD (barrels per day), Iran has gone from producing only 500K BPD to 3m BPD today. US production has increased from 9.7m BPD in May 2020 to 13.2m BPD today. On the demand side, electric-vehicle production now accounts for 5% of global car sales, eating into roughly 2m BPD of oil demand compared with three years ago.
Without OPEC cutbacks last year, the oil price today would be much lower amidst the production increases that have taken place elsewhere. The Saudi cuts are a symptom of rising global supply. But they are not a solution to it. The problem stems from inequities within OPEC itself.
Despite commitments from all OPEC members to reduce production, only Saudi Arabia has done so, from 11m BPD to 9m BPD. They are carrying the weight for the rest of OPEC. Everyone else in OPEC pretty much ignores the OPEC mandates with the exception of Kuwait, which is holding back 500K BPD of production (and they are not happy about it). There is growing discontent amongst the Saudis over being the only ones cutting back. How much more will the Saudis reduce production before crying uncle?
Elevated prices continue to draw in new marginal production assets. Look no further than Exxon’s prospective production plans for the huge oil find off the coast of Guyana, not to mention Petrobras’ planned production increases. These could force the Saudis to contemplate yet another rate cut, to 8m BPD. But will they be willing to sit back and watch themselves outcompeted into oblivion.
The Saudis are a coiled rattlesnake waiting to strike. At some point, they revert back to full production of 11m to 12m BPD to restore market share. They have done this before. They can do it because they are the world’s lowest cost producer at roughly $10 per barrel. Adding 2m to 3m BPD to today’s fragile market could very quickly tank the oil price to a level only they can make money from.
How low does the oil price go if the Saudis come back on board?
The last time the market was flooded with oil, $30 per barrel was the trip wire that froze American output at 9m BPD. This time around, the Americans are more efficient. 2023 was a year of efficiency gains. Investment spending rose “only” 20%--down from 40% growth the year before—to appease shareholders who wanted cash profits paid out in dividends. But a 20% increase in investment on top of a 40% increase the prior year still buys a lot of technology. How much? Despite the rig count in the US falling 20% in 2023, to 494 by December, output rose from 12.1m BPD to 13.2m BPD. That is a 31% increase in productivity. If the average cost of an American barrel of oil had been $30 in 2022, it is today only $20.
If the Saudis flood the market to regain share, in other words, they will have to drive the price below $20 per barrel this time to slow the Americans down but not below $10 per barrel where the Saudis go negative. Look for oil to bottom, therefore, at $15 per barrel in two years.
The time to own commodity stocks is when there is blood on the streets. The time to sell them is when investors think the good times will go on forever. We are much closer today to a peak of pricing and optimism in the oil industry than we are to a trough. The risk vs reward tradeoff for investments in this industry today is about as bad as it gets. This is not a sector for fiduciaries to be risking their clients' hard-earned money in.
Look at oil investments like any investment in a cyclical industry. There is nothing unique about oil. Do not own these shares. Short them. Revisit the industry when the oil price falls below $20 per barrel.