Tuesday, October 6, 2015

The Death of OPEC: Shale Fracking

The turn of the quarter seems to have breathed some life into the equities and commodities market as Tuesday's session continues to cap off gains from the recent rallying. To begin with, the S&P Volatility index (VIX) has dropped for the fifth session in a row, ranging from a high of 25.88 on September 30 to a low of 18.82 earlier today. Stocks and commodity securities seem to be cooling down after an economic atmosphere riddled with slower growth prospects was illustrated during the summer and emboldened by Fed rate delays. The Dow Jones struggles to maintain its bullish surge from the past couple days as it shifts around the break-even point with losses of -0.16%. Up until now, around $700 billion worth of stock has been restore. These gains, of course, lead by surges in the energy sector. Notably, the Dow Jones Industrial Average finally jumps up to its 50-day moving average once again.The S&P 500 trades pretty neutrally midway through Tuesday with a pared loss of 0.48%. It seems that the wind has left the proverbial sails of the investor's pockets, and it can't help but feel like bulls have been put out to the fray. The Russell 2000 index, a ticker related to the performance of small-cap stocks, is down the most on this rickety Tuesday with losses measuring -0.95%. This can probably be attributed to the increased pressure in a weak economic environment on small-cap stocks. Tightened emerging markets have increased the U.S. trade deficit as well as German factoris. In response, the International Monetary Fund downgraded their global economic outlook to 3.1% at their latest conference. Goldman Sachs moved their outlook for rate hikes to the Federal Reserve's December meeting with higher probabilities assigned to moves in 2016. Advancing stocks edge out declines by about 400 according to NYTimes with a less saturated trading day. Supply and demand forces seem lodged at current price levels with fundamental and technical indications struggling to topple each other. The healthcare sector, the only losing sector on the day, are one again squeezed by the mirage of falling drug prices. On the other hand, energy's rebound continues as volatility in the sector transforms into a real bullish move. The entire sector is up about 3.91% on Tuesday, lifting a 5-day change to 10.80%. Industrywise, oil and gas drilling and integrated services sections rise the most at 6.33% and 3.28% respectively. Chevron and Exxon-Mobil were among the biggest gainers in the Dow today with steady positive movement of 3.52% and 1.48%. Much of the oil and gas industry acted in that way continueing the potential behind bullish reversals. Why did these reversals appeared sustained? WTI crude oil futures rose dramatically today with gains up to 6.01%. The new price level sits just under the $50 mark as new confidence is found in production declines. Brent crude, today, topped that mark as it shot up $2.86 more to land at $52.73. A 5-day performance of WTI has chopped year-to-date losses to -16.58%. 

2014 IEA World Energy Investment Outlook Shale Investment
2014 IEA World Energy Investment Outlook


Amidst the major gains in the oil and gas industry (and perhaps even contributing to them), OPEC released a report describing a global cut of $130 billion worth of petroleum investment spending. Multinational companies are not the only ones cutting capital expenditures as even OPEC governments now running trade deficits are experiencing this run on capital. Even with all this, everyone keeps pumping in a global dash for market share that has isolated many of the consumers looking for an industry with high profit margins. Instead, even the largest firms are racing to grind down costs of operations as the market appears less and less monopolized by OPEC oil wells. Saudi Arabia just recently was forced to cut their oil price because of the U.S. overproduction. In a miraculous year, the crude oil market has seemed to stumble into a semi-competitive system dominated by large firms that can apply economies of scale to succeed. But with the shifts, a brand new batch of success stories takes competitors by storm. The shale frackers, through innovation and technological breakthoughs (like most new success stories), developed a way to get that oil which was originally out of reach. In the figure above, the IEA researched fracking projects and forecasted what costs and cash flow in those projects would look like over time. With such high initial costs and long-term gratifications, bleeding governments can't afford to take on negative cash flow for almost ten years. It hurts economic conditions, weakens currency against the dollar (which prices most crude benchmarks), and makes borrowing costly. So what about American producers, why are they managing so much success with a project that returns almost -$300 million worth of cash flow in the first five years? The key is a capital system that provides many routes to the necessary credit to fuel long-term investments. Firms can use the assurance of future production and liquidity as collatoral as well as their current traditional assets. On top of that, smaller producers that wish to get in the mix have the ability to begin a capital intensive program and receive assistance from a larger firm with more experience and cash flow. Take for example a recent move by Suncor to work with Canadien Sands Ltd. Low crude oil and natural gas prices have caused these projects to become extremely unprofitable (as most are still in the appraisal or facilities and growth phase), but in the next couple of years the cash crops will pay outl, especially as prices stabilize once more. Global demand for these ligrter, sweeter products will increase after price drops increase consumption and economies of scale keep pricing competitive. That is why OPEC is scared, Because a technological breakthrough and a superior product will flood the market (as export bans are lifted), member economies based on the commodity will be strapped for cash. Asian demand is most likely slowing down and has already caused major cuts in the Saudi oil benchmark. OPEC Secretary-General Abdalla Salem el-Badri, according to Wall Street Jounal, has plead for U.S. production to negotiate for a higher price! What does this mean for the future in oil and gas? Production declines should be evident in the first couple of years. This may not be so evident as capital expenditures increase which would rightly prompt the expectations of productions of increasing. Not with initial large-scale shale production. As prices get higher, fracking innovation will only stand to get better. Appraisal and development costs will drop inevitably leading to more efficient production, and the price will react.The real question is how long the world is going to allow itself to remain petroleum dependent. There will be a push to electric cars, and there will be a tapering off of demand in the long-run even though shale fracking will get cheaper and cheaper. For now, oil and gas companies should come out on top due to these capital expenditure programs supporting new fracking projects. On Q4 reports, I would look at capital expenditures, operating costs, and lon-term debt to see where a company might be in its long-term agenda concerning shale interest.

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