“Buy when there’s blood in the streets, even if the blood is your own.” – Nathan Mayer Rothschild, 1815
As we are writing this, WTI crude oil is trading at $69 a barrel, a fresh 4-year low, after OPEC refused to cut production as a response to the recent decline in oil prices. Prior to today’s OPEC meeting, Brent option time spreads indicated a 250,000 barrel/day cut by OPEC, while as much as 42% of analysts polled by Bloomberg expected a cut; therefore, today’s 6% decline in the WTI oil price as a response to a no-cut decision is not surprising. The following chart puts into perspective the ferocious decline of oil prices over the last five months (spot WTI traded as high as $107 a barrel in June).
The green line represents the WTI spot price (left axis); while the blue line shows the percentage deviation of the daily WTI spot price from its 200-day moving average (right axis). With today’s decline to $69 a barrel, the WTI spot price is now trading at 29% below its 200-day moving average. A further drop to $65 a barrel would put the WTI spot price at 2 standard deviations below its 200-day moving average. Should it hit that level, crude oil would be trading at its most oversold level since April 2009, and prior to that, November 2001 (when the U.S. entered a recession in the aftermath of the September 11th attacks on the World Trade Center).
We reiterate our conclusion from our November 19, 2014 commentary (“The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015“). Quoting our conclusion:
“With U.S. shale oil drilling activity still near record highs, we believe WTI crude oil prices are still biased towards the downside in the short run. But we believe the recent decline in WTI crude oil prices is overblown. Beginning next year, we expect U.S. shale oil drilling activity to slow down as capex budgets are cut and financing for drilling budgets becomes less readily available. Combined with the strength in our latest CBGDI readings, as well as imminent easing by the ECB, we believe WTI crude oil prices will recover in 2015, averaging around $80 a barrel.”
At the time of our November 19, 2014 commentary–while certain E&P companies were already cutting their 2015 capex budgets–we realize panic has not set in yet in the E&P industry. We believe this will now change as WTI crude oil prices definitively decline to below $70 a barrel. Our analysis suggests that around 18% of all global oil production will not be profitable with WTI/Brent below $70 a barrel. Even pricing in a 10% cost deflation (e.g. day rates for rigs have already declined substantially), many shale oil and Canadian heavy oil producers will still not realize a profit with WTI oil at $69 a barrel. While prices would continue to be volatile over the next several months, we believe crude oil prices are now close to a bottom. More importantly, we believe many U.S. E&P firms will not only cut capital spending in 2015 (debt financing costs for new shale oil projects have already risen by 200-300 bps across the board)–but will divest assets in order to stem cash flow issues. Clients who have cash on the sidelines will be presented with an excellent, once-in-a-decade buying opportunity as distressed assets come onto the market over the next 6 months.
Here’s why–with WTI at $69 a barrel–we are now long-term bullish on oil & gas assets:
1) E&P firms will be desperate for cash and will slash production at the same time
This is the primary reason why we are bullish with WTI crude oil at $69 a barrel; and more importantly, why we believe the 1st half of next year will present a once-in-a-decade buying opportunity for distressed assets, even if we factor in a 10% cut in the cost of production of U.S. independent E&P firms. Our analysis of 29 independent E&P firms suggests a funding gap of over $13 billion with WTI crude oil at $69 a barrel based on current capex budgets. Secondly, none of the key U.S. shale oil fields are profitable with WTI crude oil at $69 a barrel and Brent at $72 a barrel, even assuming a 10% across-the-board reduction in costs of production (see below exhibit).
Exhibit: Breakeven Brent Oil Prices at Key U.S. Shale Fields Assuming Base Case Well Costs
and a 10% Reduction in Costs of Production
With WTI crude oil at $69 a barrel, U.S. oil producers will be cutting capex and putting distressed assets on sale at the same time. Clients will thus be able to: 1) purchase oil & gas assets at distressed prices, 2) purchase oil & gas assets going into a declining production/rising oil price scenario. Clients who are more risk-averse can also purchase equity or debt at existing E&P firms at discounted prices. We would not be surprised if U.S. oil production actually decline next year (right now, U.S. oil production is expected to increase from 9 million barrels/day today to 9.5 million barrels/day by the end of 2015).
2) U.S. oil demand will surprise on the upside
The EIA currently estimates U.S. oil consumption to rise by only 160,000 barrels/day next year, based on a scenario of relatively slow economic growth, higher vehicle fuel efficiencies, and simply less driving as more baby boomers retire. But with WTI crude oil at $69 a barrel–and with U.S. employment growth still recovering–Americans will likely spend more time on the road next year than currently expected. The argument for an upside surprise is even more compelling since Americans are still driving less miles than at the peak in 2007–which is unprecedented in the history of the automobile–as seen in the below chart.
3) The ECB’s one-trillion euro quantitative easing policy will buoy demand and support commodity prices
The European Central Bank’s Vice President and second-in-command, Vitor Constancio, is now on record for advocating a one-trillion euro quantitative easing policy to begin as early as the 1st quarter of 2015. The purchase would involve all of the Euro Zone’s sovereign bonds (including those of Greece), with the allocation to be determined by the relative size of each euro member’s economy. If implemented, this will not only lower the cost of sovereign borrowing across the Euro Zone, but would also act as a transmission mechanism for other forms of borrowing by improving the health of banks’ balance sheets, while increasing the region’s inflation outlook. All else equal, this should also provide a boost to commodity, and of course, oil prices as well.
Bottom line: WTI crude oil prices at $69 a barrel will provide once-in-a-decade, distressed buying opportunities for clients over the next 6 months, as well as excellent opportunities to purchase equity or debt of independent E&P companies.