Don't Fear "Market Death" – Learn to Profit from It

“Signs of increasing demand give oil futures a lift,” declares an upbeat headline in the Houston Chronicle.

Meanwhile, U.S. oil inventories may be as high as they were the first year of the Great Depression, way back in 1930!

Lots of oil… gently rising demand… rising futures. What’s happening here? Can we play this?

To find out more, I came down to Houston this week…

I’m attending the Platts North American Crude Oil Conference. It’s two solid days of non-stop, detailed, well-informed, high-level discussion about U.S., Canadian and Mexican energy development; we’re certainly dissecting the price crash of the past year.

Key issues include: where are prices headed, and what’s happening to the investment landscape?

Here’s one key takeaway for you, which explains much about where things are going and how to invest at this point: the idea of “Market Death.”

“Market Death.” Ominous as it may sound, it’s the key to profiting in hard times.

The Price Crash of 2014

Looking back, many things contributed to the oil price crash of 2014. Indeed, negative signals were abundant… at least in hindsight. Still, nobody forecasted what was going to happen last year. What do I mean?

Well, in 2014 U.S. “tight oil” output climbed; we all know that. On the other side of the world, Russian oil exports increased as well, via the newly-opened ESPO Pipeline – Eastern Siberia-Pacific Ocean; which put significant downward price pressure on Saudi exports to Asia.

Within OPEC, cheating on quotas abounded. Pretty much all OPEC members put too much oil into the markets, considering basic global demand. Also, oil output climbed from Libya and Iraq.

Meanwhile, worldwide oil demand growth slowed appreciably, courtesy of China’s slowdown, plus lingering weakness in Europe and Japan, and even slow growth in the U.S.

In November 2014, Saudi finally made its move at the OPEC conference in Vienna. Saudi declared that it would not throttle-back oil output, and instead would simply “let markets sort it out.” I’ve discussed this before.

Price War

The long and short is that we’re now in a classic oil price war. That is, across the world, “too much” oil supply is moving about – bought, sold and traded – at a price below marginal cost of production, let alone the cost to replace the barrels.

Every year, for the past decade or so, the global oil industry has invested about $750 billion (inflation-adjusted) in overall capital expenditure. Yet at current prices, annual world oil industry cash flow is dropping like a stone; down by nearly $1.5 trillion, if current trends hold. In other words, we’re living through historic market tumult. Energy economics are simply upside down.

Looking ahead, and based on decades’ of economic research into price wars, we can expect that in months to come many producers will actually increase output; they’ll produce and sell more and more oil at low prices, simply to maintain cash flow. The idea, for the oil producer, is to offset declining price per barrel with more volume.

At the level of global markets, however, and absent demand growth, more oil volume will drive prices down even further; or on the best of days the “extra” oil will moderate any quick price rebound. Prices will stay “sticky” to the down side. Bad things in the oil industry will get better slowly; and still might get worse.

Market Death

How does this resolve? Over time, financially weak players will give out. They’ll close their doors, if not go bankrupt or be bought out. One angle on this, however, is that weak players tend not to be large producers; they’re likely small fry. Thus, losing these guys from the market won’t make much difference to supply.

To illustrate the point, I learned that 70% of “new” oil from the Eagle Ford development in Texas comes from 30% of the wells. In other words, we could see 70% of wells go away, and only reduce output by 30%. Just in one play. And the world is filled with similar plays, from Brazil to Alaska to the Far East.

One way or another, the culling process will have to continue – globally – until more and more players cut back output and/or go belly-up. It could be in North American tight oil. It could be in the North Sea. It could be in West Africa; Brazil; even the Middle East.

It’s called “market death,” and it means what it sounds like.

That is, when “too many” players put product into a market – in context of a price war – some entities simply have to go away. They can go out of business. Change business. Stop producing. This is over and above the fact that, in a cash-starved environment, innovation lags and new ideas don’t see the light of day.

In a time of over-supply, Market Death is the only thing that works to cut back supply and firm up prices. It’s the only way to clear the output overhang, and allow prices to recover.

First Rule of Survival

The way through this thicket is NOT to sit around, moaning and complaining that prices are too low.

No, the way for oil companies to deal with the situation is to be ruthless in cutting costs. Management teams need to do whatever is necessary to husband cash, avoid expense, get efficient; save the business until there’s a recovery, and then get back into the game. This kind of aggressive effort is the sign of an investable play, at this stage.

Time Frame

How long will the current situation last? Again, it’s hard to say… In recent days, we’ve seen oil prices bounce off of lows, per the Houston Chronicle headline above. This development might translate into a “V-shaped” price recovery; or it may simply be a market head-fake, before another price dip to the downside. The V could be a W. Nobody knows. We have to live through it.

One point to keep in mind is how many nations across the globe require relatively solid oil prices to maintain national budgets – meaning social peace.

For example, Venezuela requires oil near $130 per barrel to balance the national books; we already see near-riots in that nation, due to lack of basic goods. Across the Atlantic, Nigeria needs at least $120 oil to keep the national lights on; and even then it’s a problematic national unity on the best of days.

I could list more nations in dire financial straits; but you get the idea. Social breakdown in some nations can happen fast. We could see a collapse of governments and entire industries – oil, specifically – overnight.

This is what makes it so difficult to forecast too far out. Sure, oil price doldrums could last for months, and even years until “market death” hits in a big way. Then again, we could open a morning newspaper and see where one entire nation or another is collapsing, nearly right out of the blue.

For now, the investment takeaway is to build a list of the very best oil and oil service prospects (familiar names like Schlumberger, Baker Hughes or Oceaneering International) and be ready to buy-in on down days, market dips and the like.

Don’t “back up the truck” with massive share-buying; just nibble away and accumulate a position. Keep some cash handy. If we have another oil price dip, you’ll be able to acquire more shares at even better pricing.

Best wishes,

Byron King
for The Daily Reckoning

P.S. Ever wonder how you can make a lot of money from oil without owning a well? Or whether or not you should buy gold and silver? Or is fracking just a flash in the pan? Get insight, insider scoops and actionable investment tips twice a week with Daily Resource Hunter? Just click here for a FREE subscription!

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