It is unclear when it happens, but for all adults there is a certain point in time where the feeling of exhilaration morphs into something that years prior would have been considered mundane or even . . . boring. (Yikes) Apparently this feeling is a sign for adults that their vintage is steadily increasing.
Tax season is a stressful time for employees at our office in general, so the sudden excitement surrounding an inner-office bet made in late February was a welcomed distraction. The bet was to see who could get closest to the price where oil futures would bottom.
However, the bet did not end until the oil futures price moved above $55 per barrel. For inquiring minds, I am referring to West Texas Intermediate crude oil futures, not Brent crude oil futures. To learn the difference, click HERE.
The winner of the bet would receive a “free lunch” from each person who made a wager. While I did not win the bet, I was not pleased that I came in 2nd . . . from last. Leave it to Otto, our resident “IT Guy” to win, and for the nerdy research guy to almost get last place. As they say, humble pie is a dish served cold.
I am not a sore loser and will pay up on the bet, but I have learned the hard way recently that wagering with Otto will result in purchasing a lot of lunches. It seems when it comes to wagering, betting against Otto is a foolhardy endeavor.
What makes this situation worse, is that I have to write the final blog about oil before I can move on to a different topic. So as much as it pains me (I can hear Otto’s evil laugh in my head), I will be discussing a major concern for oil bulls in the short-term, the reduction of oil storage capacity.
According to Citigroup, “U.S. storage capacity may be tested in 2Q as production shows no signs of slowing yet”. The following charts from Citigroup demonstrate the shortage of available oil storage.
Cushing, Oklahoma is a major trading hub for crude oil and according to Wikipedia, “a famous price settlement point for West Texas Intermediate on the New York Mercantile Exchange.” The EIA (Energy Information Administration) updates the U.S. energy marketplace along with the public regarding oil storage on a weekly basis.
The chart in the upper right hand corner above shows the working storage capacity and the current level of oil being stored at Cushing. The chart is a visual representation that if oil production declines do not start soon, storing oil may become a difficult prospect.
This is crucially important because if the oil storage is used up, producers will be forced to sell their oil on the open market and will not be able to store oil to wait for potentially higher prices at some point in the future. Citi goes on to state “any price recovery will likely be short lived as higher prices should re-start shale drilling, once again increasing supply and sending prices back down . . .”
Additionally, Citi also believes that by the autumn of 2015, the U.S. Gulf Coast could also begin to see storage constraints when the oil refineries go into what is expected to be a deeper and longer maintenance, given the shallow maintenance this winter and spring.
The possibility of storage constraints could potentially place pressure on oil prices in the future, but it is unclear at this point whether available storage capacity for oil will run out in Cushing or the Gulf Coast region. In due time the answer will be revealed, but it is clear that storage capacity is declining. Pairing this potential headwind for higher oil prices in the intermediate term with the recent orgy of borrowing and stock issuance by the oil and gas sector, places some concern on the stability of higher oil prices into the future.
According to the Wall Street Journal, when adding in syndicated loans and total borrowing, the oil-and-gas sector’s borrowings rose to $2.5 trillion by the end of 2014. To put this debt increase in perspective, the total outstanding debt in the oil and gas sector at the end of 2006 was $1 trillion. The chart below courtesy of Dealogic and the Wall Street Journal demonstrates just how much debt the energy sector has piled up:
Nowhere has the debt pile up been seen to be occurring more rapidly than in the high yield space of the debt markets. The energy sector has seen a massive increase in the use of high yield bonds as shown in the chart below courtesy of Citi Research & LCDComps:
Readers might be asking why the increased debt levels matter. The answer is simple, debt expense coverage. According to the Wall Street Journal, “The Switzerland-based Bank for International Settlements has warned that the “oil-debt nexus” could create a vicious circle whereby over indebted companies pump more oil to ensure they can pay interest on their loans, adding to the current global oil glut, and further depressing oil prices.”
The easiest way to explain why the large increase in debt outstanding in the oil and gas sector matters regarding oil’s price is the debt service required to fulfill the payment obligations. Ultimately, as energy companies have increased debt levels they have also increased their bottom line expenses.
As oil prices declined rapidly in late 2014, energy companies became capital strained and shortly thereafter, layoffs and corporate restructuring began in earnest. Fast forward to today, and these same energy producers still have to cover their debt expense and that could prevent production from declining further to support oil prices.
The energy companies have to cover their debt, otherwise they could jeopardize the vitality of their individual companies. Consequently, they have to produce enough oil and other distillates to cover their debt expenses. Essentially this creates a floor under oil production whereby energy companies cannot afford to reduce production because they have to cover debt related expenses.
As can be seen below, West Texas Intermediate crude oil prices have rebounded since their lows near $42 per barrel back in March.
The real question, is whether oil prices have bottomed or if they will reverse course. As explained previously, storage capacity is already dwindling to near record levels and the exponential increase in debt in the energy sector is undeniable.
What remains to be seen is whether big sellers begin to emerge as prices rebound and potentially move higher. Trying to predict the price action in the future for oil is a fool’s errand, but price volatility in either direction is very possible, if not likely.
While there is a case to be made for both oil bulls and oil bears, at this point the bears have been in control in the longer term while the bulls have staged a comeback in the short-term time frame. The real question is which side will ultimately win regarding price action in oil in the intermediate time frame. However, based on my recent wagering track record, it is probably best that I do not make a prediction. Although interestingly enough, I am immediately reminded that past performance is not indicative of future results.
I am doing everything I can to not allow my pride to get the better of me and turn me into a sore loser, but losing that bet has been a burden I have struggled to bear. On a seemingly regular basis, Otto has been rubbing in his victory. It is frustrating to think of all of the time I have spent researching the oil industry and oil price fundamentals only to almost come in dead last when predicting oil’s price.
Unfortunately I have to get going, it appears I am taking Otto to lunch . . . until next time, Happy Investing!