2008, Redux

Who says there’s no such thing as time travel? It’s starting to feel like the fall of 2008 all over again. Indeed, the demons of 2008 are like those characters you see in the Halloween horror movies. You can kill and bury the monsters, but a few scenes later, they reappear.

So what’s happening? Is it 2008 redux? Or are things now worse than 2008 and we just don’t know it yet? Oh, for a copy of a tomorrow’s newspaper! Still, let’s do the best we can with what we’ve got.

Let’s start with oil. In an eerie similarity to 2008, oil prices ran up for much of 2011. Posted US oil prices were well over $100 per barrel for a while. Then prices faded a bit, and traded in a $90-100 range. In August, oil prices suddenly dropped nearly 17% within a couple of days, into the high $70s. US oil prices are now in the mid $80s per barrel.

To state the obvious, there’s a lot of money in play. Here’s the raw math. The US consumes over 20 million barrels of oil per day, while world consumption is over 90 million barrels per day. So roughly, a $10 price decrease per barrel pulls $200 million per day out of the cash flow of the domestic oil industry. That same $10 price decrease pulls about $900 million per day from the cash flow of the global energy industry, from everything from independent oil companies to large state-owned actors.

Thus, if oil prices just stay where they are for any length of time, we’ll see lower top-line numbers across the energy industry, and likely lower bottom-line numbers, as well. Oil producers tend not to make large capital decisions based on temporary price swings, and most of the current cap ex will likely remain programmed. But at least some companies will scale back expenditures where and when possible. So the large, quick oil price swing we’re experiencing could make a major difference to energy sector investors over time.

What’s driving this gyrating action in the oil trading pits? Start with the run-up. Earlier in 2011, events in the Middle East — unrest in Tunisia, Egypt, Yemen, etc., as well as civil war in Libya — contributed to supply fears and higher oil prices. Oil prices climbed a wall of worry, with a particular focus on the perennially worrisome Middle East.

Rising oil prices aren’t all bad, of course. High oil prices support capital investment in energy projects, from shale gas to oil sands to offshore projects and more. So along the way, with rising oil prices, we had nice run-ups in the oil and oil service sectors. But recently, market retreats have taken almost everything down across the board.

Now we’re witness to share price massacres, even for the normally long-term oil business. A broad-based stock market calamity is accomplishing what nothing else has been able to do this year — take down oil prices and pull the support from related share prices in the energy sector. Heck, even the Obama administration’s ill-advised sale of oil from the US Strategic Petroleum Reserve in midsummer didn’t have a fraction of the oil price effect we see in the current market crash.

The precipitous decline in oil prices has given crew cuts to some of the best names in the energy sector — Schlumberger (NYSE:SLB), Baker Hughes (NYSE:BHI), FMC Technologies (NYSE:FTI) and more. The nominal losses in share value seem bad now, but when the dust settles, you’ll have bargains galore in this sector. You’ll have a chance to pad your portfolio with the best of the best names.

It’s hard to say this during a market meltdown, but don’t fear investing in the energy sector. Things will get better because energy sector fundamentals are solid. That is, keep in mind that the oil price crash isn’t due to a sudden increase in global supply, let alone a sudden drop in global demand. It’s much more due to speculators despeculating, which I’ll address below.

First, let’s look at the supply side. Most of the world’s daily oil output comes from legacy fields — some of which are decades old, and “not getting younger,” if you get my drift. For all the new technology that’s bringing “new” oil upward, the global industry still faces the same old issues of inexorable depletion.

On the demand side, there’s also no significant negative change. The general economy may stink, and people may even be rioting in the streets — as in London and other places. Yet one of the last things people do anywhere is cut back on fuel usage. Once people get used to living with the convenience of gasoline, diesel and jet fuel, they won’t give it up easily.

The US Energy Information Agency (EIA) recently confirmed this point about inelastic oil demand. The EIA just released a report stating that worldwide oil consumption will increase in 2011 and 2012, spurred by increasing demand in developing countries. In other words, rising demand is baked into the cake via worldwide growth, no matter what happens in the sclerotic Western economies.

Thus with this in mind, why did we see an oil price crash, and oil share takedown? The bottom line is that oil prices and share prices for oil and service companies are sliding due to massive liquidations of positions by traders and speculators (especially hedge funds) that are caught in a price downdraft. The traders and hedgers have to fire sell positions just to raise cash to cover margin calls.

Looking ahead, the energy sector is destined to recover. I expect oil prices to drift back upward, restoring the otherwise missing cash flows to producers. I believe that oil prices, and share prices within the energy sector, will recover sooner than most other parts of the economy and stock market.

Regards,

Byron King,
for The Daily Reckoning