General ThoughtsIndustry-OilMacro

Lessons Learned from A History of Oil

Since oil prices were in the headlines yesterday after an 8% fall, I thought it might be a good time to comment on something I’ve been working my way through while putting in the miles after a day of looking for bargains.

I’m about halfway through the excellent series of podcast called “A History of Oil”. It’s an outstanding series that starts by introducing George Henry Bissell—the father of the oil industry—who in 1853 began experimenting with “rock oil” that was discovered in northwestern Pennsylvania. Bissell commissioned a $526 study of this strange substance and determined that it could be refined into kerosene—a highly demanded fuel used to light homes at night. Since whale blubber was becoming more costly (you could say the world was witnessing “peak whale”—i.e. whale population was plummeting), this newfound oil could prove to become quite lucrative as a whale blubber substitute.

The History of Oil series then moves to the fascinating beginning of the oil industry at “Oil Creek”, the stretch of the Allegheny River where drilling for oil first started in the small town of Titusville. This tiny hillside town in northwestern Pennsylvania quickly became the 1860’s version of the California gold rush. The population went from a sleepy 250 to a bustling 10,000, real estate prices skyrocketed, and fortunes were made. A lucky man named Jonathan Watson became the first millionaire from oil—Watson owned the land where the first successful well was drilled by Colonel Edwin L. Drake—an employee of Bissell’s Pennsylvania Rock Oil Company.

The guys at Oil Creek didn't care if a rig was in their back yard.
The guys at Oil Creek didn’t care if a rig was in their back yard.

The podcast series recounts the early tales of riches and the many booms and busts. I’ve made my way through the portion of oil history that witnessed a 23-year old grocery store owner named John D. Rockefeller, who began selling kerosene in his store—and eventually transitioned into the refining business that later was built into Standard Oil—one of the world’s most valuable, and most intimidating companies of all time.

Indeed, it was the very first Big Oil—later to be broken up when an ambitious populist from Ohio named John Sherman—whose resume included three terms in the House of Representatives, the US Senate, Secretary of the Treasury, and Secretary of State—introduced a bill called the Sherman Antitrust Act. The bill passed 52-1 in the Senate and unanimously in the House. The law sparked the first of many battles between Big Oil and government regulation.

Standard Oil was broken into pieces, but not before John D. Rockefeller became the richest man in the world—creating a net worth that would approach half a trillion bucks in today’s dollars—far more than Gates, Buffett, or any of today’s titans. Not bad for a guy who, as an ambitious young grocer, set a goal of making $100,000 during his lifetime.

This was no ordinary grocer
This was no ordinary grocer

The Oil Business

I began slowly investigating the oil industry last fall as energy prices plummeted. There is one company I have taken small positions in on a couple occasions, but by and large I have stayed on the sidelines as I continue to watch debt-laden businesses continue to struggle and cash flow dry up. Many of these companies are dead companies walking—almost certain to go bankrupt as their revenues fall, margins evaporate, and fixed costs (i.e. interest payments) persistently eat up a larger share of each barrel produced.

I think the oil business is very interesting, and it is one of the industries (especially the “upstream” exploration/production side) that really lends itself to the classic boom/bust cycle.

Soros once said regarding oil prices in his “real time experiment” in 1985:

“The supply curve is inverted. Most producers need to generate a certain amount of dollars; as the price falls, they will try to increase the amount sold until the price falls below the point at which high cost producers can break even. Many of them will be unable to service their debt.”

The more things change, the more they stay the same. In 1985 Saudi Arabia became frustrated that their production cuts weren’t having the impact they desired (which was oil price increases). This led them to decide to shift its focus from prices to market share. In December of 1985, OPEC shocked everyone by formally announcing its intention to maintain market share (i.e. maintain or increase production levels). The price of oil collapsed 50% over the next 6 months from $30 to $15 per barrel.

1986 Oil price collapse
Does this look familiar?

This 1986 price collapse was quite similar to the chain of events that unfolded starting last November 2014 when OPEC again announced its intention to maintain production in an effort to squash US high cost producers and maintain market share.

In both 1985 and 2014, these decisions by producers (both OPEC and US domestic producers) defied the logic of the “rational economic man”.

Where is the “Rational Economic Man”?

The “rational economic man” theory in economics basically says that this hypothetical figure will always act with perfect knowledge and complete rationality in pursuit of his own economic interests—meaning he will act in such a way that the supply/demand balance will always stay close to equilibrium. For example, as the price of a commodity falls, demand should theoretically increase and/or production should decrease—this balance should always trend toward equilibrium.

This makes a lot of sense. For example, chemical companies add capacity and/or increase utilization when prices are rising in order to satiate demand. Like most commodity businesses, this eventually leads to excess capacity and bloated cost structures. As the cycle surpasses its peak, companies are forced to lay off workers, cut back production, and sometimes take capacity out of the system as prices are falling, which then sets the cycle up for another repeat.

So eventually the economic man shows up and the cycle ends. But in the meantime—before this self-correcting process occurs—a self-reinforcing behavior (as Soros calls it) is prevalent—a behavior that takes prices (and supply/demand) far from “equilibrium”—or where they should be based on economic theory.

So sometimes there is a disconnect between reality and economic theory and the “economic man” is nowhere to be found.

For example, banks influence the value of the collateral as they lend more. In the recent case of the mid-2000’s housing bubble, securitization and newfangled financial products such as synthetic CDO’s reinforced home prices—these new products created an entire new market for CDO’s and the demand from investors for these securities fueled more lending. The more loans that were packaged up and sold in the form of securities, the more lenders were willing to give loans, which meant easier credit and more demand for the actual product—the house. This circular cycle was self-reinforcing for a period of years. Banks were willing to lend up to 100% (or more in some cases) on the ever-rising value of a house, but this value was rising in large part because of the fact the bank was willing to lend on it. It’s the chicken and the egg.

This is the same concept that has occurred in virtually every boom/bust cycle in the past.

The oil industry behaves in a similar way. Interestingly, what has happened over the past 9 months has surprised many economists and industry analysts. When prices started falling, many predicted drastic cuts in production by the high cost shale producers. Eventually, this would have to be true as producers run out of money. But what is interesting is that they continue to produce more as long as they have the cash in the bank to do so—even if they destroy value with every barrel that they pull out of the ground. By April 2015, six months after the price declines began, US production was at multi-decade highs:

US Crude Production Chart

So despite what economic theory says, what has actually happened on numerous occasions is that as energy prices decline, sometimes production increases (or at least remains stable) by producers who desperately try to maintain market share or by countries (such as the OPEC nations) who increase volumes to offset price declines in order to meet budgetary needs.

This was true in the late 1960’s when Soros was formulating his reflexivity theory, it was true in 1986 when Saudi Arabia dropped the hammer on the oil market, and it is true today as OPEC—at least for now—continues to maintain its production level.

Interestingly, this very same behavior was prevalent in the 1880’s at Oil Creek.

Even back then, or maybe especially back then, oil prices swung violently as supply/demand fluctuated and the boom/bust cycles repeated themselves over and over again. This nonsense was much to the dismay of Rockefeller, who specialized in the “downstream” business of refining oil—which means he had to buy his raw material from these irrational producers and was thus at mercy to the wild swings of the market.

One of the episodes of A History of Oil describes the fascinating turn of events as Rockefeller defies the advice of his own board of directors and—in an effort to fight this irrational behavior of the producers who frantically began drilling more and more in a “race to the bottom” as prices plummeted—began buying up “every barrel” of oil that was produced. Rockefeller eventually forced his company into the upstream (production) business in order to try and get more control over the raw material needed for his kerosene, and thus add an element of “economic man” behavior to the industry.

But whether its human nature or the nature of the oil business (or probably both), this defiance of economic logic repeats itself over and over.

Just this past weekend, Iran pledged to double its own production when/if sanctions get lifted—despite oil prices at half of where they were trading at a year ago.

Meanwhile, US oil production has begun to slow down in the past couple months, but as recently as April, crude output was rising and reached a high not seen since 1972—leaving analysts, economists, and Middle East oil producing nations scratching their heads.

It’s very interesting theater.

I’d recommend A History of Oil to anyone who is interested in locating bargains (or short opportunities) among the carnage in oil that is certain to continue if prices stay where they are. The business is a difficult one—like most commodity businesses. But it’s one that probably provides significant opportunity for the skilled bargain hunter who can be greedy when everyone else is fearful.

Caveat Emptor…

Have a great week.

21 thoughts on “Lessons Learned from A History of Oil

  1. Hi John, hope everything is well with you. Another great written piece. There’s a video series I think you would really enjoy called “The men who built America”. It’s very good and talks about Ford, Vanderbilt, Carnegie and Rockefeller. I leave you with the court speech of Rockefeller from the series. It’s about 2 minutes and awesome. Enjoy the rest of your night

    Tony

    https://www.youtube.com/watch?v=_LC9Dh4kR_g

    1. Thanks a lot Tony. I have heard good things about Men who Built America, and it’s next up on my list of things to watch on Netflix. I just got done watching “Hank” (a documentary about Paulson and the financial crisis), which was excellent.

    1. Most of the accounts I manage are cash accounts, where I don’t short. I do operate a private partnership that has the capability of going short, but I am generally not a fan of the risk reward of shorting. I do short on occasion, but I am not generally a big fan of shorting common stock because of the risk reward. Instead, I would look at buying puts, which caps downside and often can create significant upside returns. But generally, the nature of going short is that you can make a 100% return if you’re right and it goes to $0, but your gain is limited and when shorting a basket of things, it has always seemed easier to lose 20-30% than it is to make that amount. Plus, some of these “dead companies walking” can occasionally get bought as the industry consolidates, or in some cases the stock prices can double or more before going to $0, which means you lose 100% of your capital in the investment before you make 100%. So if you do short, you have to take very small positions in order to be able to withstand the moves against you. It’s much better risk/reward to find attractive stocks to buy, and thus much easier to move the needle of the account value that way. So I think shorting is just a very difficult game, and unless I have a catalyst or some event where I think tilts the risk/reward far in my favor, I tend not to get excited about shorting companies even if I think they’ll eventually be worthless. Again, I would look to create interesting risk/rewards using options which is a much better way to manage risk and capitalize on an event, upcoming principal payment, or just go short, but it has to be a real special situation for me to get excited about it.

      Having said all of this, I do think there will be a significant opportunity to find significant mispricings (in both directions) in oil.

      1. To add my two cents: I have only been economically short one issue, and did so by writing a call spread.

        Before shorting, I would suggest one carefully re-read all the sections in one’s brokerage agreement about shorting, margin requirements, etc, before taking a short position, and even then considering the use of options to limit one’s downside risk. The reason is that there are so many risks: government regulations of short-selling (SEC Rule 204), special government regulations put in place during market panics (e.g. the 2008 SEC ban on short selling financials), forced buy-ins, unlimited losses, debt to the brokerage, interest one is charged for being short which can vary arbitrarily, brokerages could change margin requirements to any arbitrary amount, arbitration clauses, you agree to indemnify the brokerage for anything it did even if it did the wrong thing, some brokerages also do market-making and thus have further incentive to fleece the client, and all the other “screw you” legal language that you agreed to when opening an account. Many of these behaviors are not present on the long side — because it wouldn’t be politically tenable for the average person to get screwed so much by financial intermediaries when owning shares of a company.

        Personally, I’d rather just establish an options position with limited risk, and sleep well at night.

  2. Information sharing from icapital Newsletter:’After 2008, US natural gas prices collapsed, and some analysts predicted that shale gas producers would be wiped out. The number of rigs drilling for gas fell from 1606 in the summer of 2008 to just 268 as at Mar 2015. Yet US gas production has continued to rise. Cost savings derived by putting pressure on suppliers and improved techniques such as “walking rigs” which are more flexible and cheaper to move have resulted in a lower breakeven level. Drilling rigs and other equipment such as pumps for fracking tend not to be tied up on long-term contracts, meaning producers can adjust spending quickly in response to oil price movement. As a result, production per rig, the critical performance indicator, has risen by an average of 28% across the main basins such as Eagle Ford, Bakken and Permian. The US shale oil output, which incurs a higher cost, has remained resilient despite a fall in rig count. The industry’s ability to keep growing will depend on how far it can reduce its cost.’

  3. I am no expert on the oil area although I learned a bit about it recently to make a few investments.

    My current opinion is I think many of the service providers (e.g. Halliburton), and the oil majors will likely be fine (e.g. Royal Dutch Shell, Chevron). Other service providers such as the ones that provide sand for fracking will likely be OK but the equation becomes more speculative due to the oil pricing uncertainties. For the service providers, it is a case of selling pickaxes, shovels, and jeans to the “gold speculators,” to make the real money. Or in the case of the oil majors, they just have so many business segments, economies of scale, some minor customer brand recognition, and geopolitical clout, that they can cut any unprofitable sectors and keep chugging along. To continue the analogy with gold, the oil majors are sort of like a giant bank that buys the gold nuggets from all the speculators in the end, and makes a reliable commission by doing so.

    All of the upstream business models that involve exploration, drilling, operating wells, and many of the midstream ones seem highly speculative to me, since oil is a commodity, and there are so many geopolitical risks of oil prices and import/export restrictions; developed countries are unlikely to be the low cost producers; pricing for the commodity could be completely arbitrary (within some very large uncertainty band, say oil should be between $20 and $200 a barrel); everything is dependent on highly uncertain financing; and as you mentioned in your nice post, these companies are often operated irrationally.

    Due to this reasoning, I agree that upstream oil drilling companies and some of the midstream ones are likely bad long investments. Unless there is some corporate event pending, such as merger arb or liquidation. In the latter cases, very high probabilities of knowing the outcome could reduce the speculative or risk component. But I would insist on a quite high probability of an event, since the intrinsic value could be highly uncertain!

  4. Hi John,

    I was hoping to get your thoughts on FAST. You’ve mentioned it several times in previous posts when discussing ‘compounders’ and it would be interesting to see how you think about the stock as a possible investment candidate given its weak price performance over the last few years and the recent CEO change. (It’s also interesting to note the insider selling over the last six months.)

    The operating performance seems to be holding up alright but it doesn’t seem like a clean picture right now.

    It would seem like a fairly attractive entry point for a 3-5yr hold but I would be interested to get your thoughts.

    Thanks!

    1. Kyle,

      I really like Fastenal as a business. I think their corporate culture is excellent, and I think it’s a well-managed, cost efficient business that will probably continue to put up stable growth numbers (although I don’t think it will achieve growth rates it has in the recent past). However, I really think that the stock is quite expensive–probably because everyone else recognizes these same attractive features. It’s been a great stock to own over the past few decades, and it has always supported a 25-30 multiple, but I think there are probably other investments that are more attractively priced. But I do keep FAST on my watchlist in case it ever got cheap to a “no-brainer” type level.

  5. Thanks, John, for another great post. I am wondering, might there be one thing different than before: that it might be foreseeable that the world will finally become less dependent on oil. Less oil will be needed because of energy savings, wind turbines, solar energy, electric cars,… And that it actually makes economic sense for among others the opec countries to produce as much as they can right now, now that the world is still dependent on oil?
    If this is the case, we might not see higher oil prices anymore.

    1. It’s an interesting take. I really have no idea if and when the world demand for oil begins to fall. I will say that there have been multiple times in history that people have predicted “peak oil” only to be proven wrong each time (in fact, all the way back in Rockefeller’s time there was a peak oil argument going around at one point). As for the demand side of things, I would think it would be equally difficult to predict. I think there is a lot of innovation in the energy industry (both relating to oil and other energy sources), but I find it hard to believe that demand for petroleum products will significantly decline anytime in the next couple decades–but I certainly could be wrong on this.

  6. John, if you had to invest this week in only one of the oil majors, which would you choose? Exxon, Chevron, Total, BP, or Royal Dutch Shell?

    1. Hi Giselda,
      I am leaning more short right now than long if I had to do anything. I think the oil majors will be fine long term, but I do think if the oil prices stay around where they are now for a while longer, we will see significantly more carnage to come. Production levels have actually increased, and I just read an article this weekend that touches on the point I made in the post where companies continue pumping (or actually increase production) when prices fall just to keep revenue stable. In the short run, this works out okay and if oil prices recover, they’ll survive and keep market share. But it’s unsustainable. Each barrel pulled out of the ground is destroying value for many of the small producers. Even among the majors, cash flow is declining significantly and the debt ratios are rising. Dividends are being financed with new debt (cash flow isn’t sufficient any longer to cover capital expenditures and dividends). To make matters worse, these companies were buying back enormous amounts of stock with borrowed money when they were flush with cash when oil was at $100. Now they are going to need that cash and they’ll have to likely increase leverage further to continue financing their capital projects and dividends.

      I think it’s a very scary predicament for shareholders–even of the majors–if oil stays low. I think there will be many more bankruptcies in the smaller producers. The majors will be fine long term, but the stock prices could decline significantly between now and then. I think these potential risks could be why Buffett sold Exxon a couple quarters ago.

      This might not come to pass if oil goes back to $80 or $100, but I have no idea where oil is going to go and so for now, I’ll sit this one out. Maybe at some point they’ll reach a level that becomes bargain territory, but given the state of the cash flow and the current valuations, we aren’t there yet in my opinion.

  7. Hi John, I’m a first time visitor here. I just stumbled on your blog. Great stuff! I wrote a number of posts about oil myself. I took a different route educating myself but came to similar conclusions. I knew about the price drop in 1985 by looking at charts but didn’t know the backstory. Looking forward to keeping up with your blog.

  8. First time reader and love your work. What do you think about the drop in rig count from Baker Hughes with the lack of a drop in EIA production data? Makes me wonder what was the size of the rigs were. Thoughts?

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