OPEC Poised for Oil Production Cut on Wednesday

The 171st Meeting of the OPEC Conference is scheduled to meet this Wednesday, 30 November, in Vienna, Austria.  It's widely anticipated that OPEC (Organization of Petroleum Exporting Countries) will agree to cut oil production by at least 2.5% in their 10:00 AM EST announcement.  OPEC last cut oil production in August, 2008.

Until this afternoon, the largest wild-card in the equation was Iraq, however they announced today that the fourth largest oil exporter in the world will cooperate with OPEC and called for a 4.546 million barrels per day reduction in production.  Iran is similarly considering a cap on production, although they have yet to announce any projected levels.

Oil spiked on the news from Iraq, however it settled down before the close, today as the news was digested by commodity traders.  As of this writing, WTI Crude is trading at 46.92 and Brent Crude is trading at 48.02.

It's important to note that four of the top ten oil producers in the world - Russia, the US, China, and Canada - are not members of the OPEC cartel.  None have signaled either support or opposition to the OPEC plan, although all would benefit from a production cut accompanied by higher oil prices in 2017.

Ironically, the initial call for a cut in production came from Saudi Arabia, the world's largest producer.  Starting in 2014, Saudi Arabia increased production dramatically, driving oil prices from their $100 per bbl range down to as low as $26 per bbl.  Their intent at the time was to cripple the US shale market by driving price below a profitable level for the hydraulic fracturing wells used in the shale fields.  While the price cuts did initially cripple the shale industry, price eventually stabilized in the mid-40s, thus mitigating the impact.  Saudi wells could absorb the short-term impact on profitability, however as we head into the fourth year of abnormally low prices, the impact is now being felt across the Saudi Arabian economy.

Analyst expect at least a 2.5% production cut on Wednesday.  This will likely cause significant volatility in the oil market for the short term, and we can expect to see an overreaction to the upside until the actual impact of the cut is determined.  With refining currently at or near capacity, it's likely that the cuts will have little end-user impact over the long term, and we can expect oil to stabilize in the low to mid 50s in 2017.  That's still lower than it should be, however it's far better for the economy as a whole than the excessively low range we saw in 2015 and parts of 2016.

Schlumberger Warns of Impending Severe Oil Supply Deficit

Schlumberger (NYSE:SLB) announced earnings after the bell yesterday, beating EPS estimates by $0.02 and revenue by $70 million.  That's the good news.  Everything else about the release points to a serious energy crisis looming in the not-too-distant future. 

Demand in the oil industry continues to grow at a steady and aggressive pace.  As the economies in the US, Europe, and China recover, that demand will increase.  The supply side, however, has taken a horrendous hit over the past two years.  CEO Paal Kibsgaard summed it up, "We are heading towards a significant global supply deficit as the E&P [exploration and production] spend rate now is down by more than 50%."

There has been a significant cost efficiency problem within the industry for some time, and that inefficiency in cash flow has been exacerbated by the dramatic plunge in oil prices worldwide over the past seven quarters.  Rig operators have reacted to this price crisis with a massive reduction in oil field activity.  Active rigs are now down to 25% of their original level, and the appetite to start new wells has reached a critical low.  This has caused a ripple effect through the entire oil supply-chain industry, and it's about to reach critical mass.

Non-OPEC production is set to drop an additional 900,000 barrels per day.  Similar weakness is being forecast in the non-Gulf OPEC nations, and as short-term high production activities run their course, the expectation is for an accelerated decline in overall oil production worldwide.

Kibsgaard went on to say, "The market is also underestimating the potential reaction from the supplier industry, which has temporarily accepted financially unviable contracts to support the operators and to keep their options open as the downturn has deepened and extended into uncharted territory."

Cash flow from the rig operators is becoming strained, and they are delaying payments to creditors in an attempt to improve that flow.  This, too, has a ripple effect through the supply-chain industry.  What the entire environment demonstrates, though, is that as the service industry pricing inevitably improves - supply and demand will naturally force it - much of the capital that would normally be spent on exploration and production will instead be spent on debt reduction.  That will put added pressure on the oil supply deficit, extending the duration of the pending crisis.

What all this means is that there will be continued negative pressure on the various industries that support all aspects of the oil business.  Expect the metals industries to take a hit as both repairs to existing rigs and the development of new rigs are put on hold or canceled outright.  Expect shipping to take a hit as the flow of supplies, raw materials, and energy resources to and from suppliers and operators continues to decline.  Expect the chemicals industries to take a hit as there is less demand for the materials that are used in drilling and refining.

This is not good news for the consumer, either.  We currently still have an oil glut, which, coupled with an uncharacteristically strong US dollar,  is holding prices down for the moment.  As that glut transitions to a supply shortfall over the coming year, however, we can anticipate a rapid rise in oil prices world-wide.  That will dramatically impact the price at the pump, likely forcing gas prices to record highs around the world. 

It will take some time for all of this to play out, but it does appear that the piper that played the tune of ridiculously low oil prices is poised to deliver the bill.  Paying that bill will be painful at best. 

Happy Trading.

Caterpillar Is a Pure Energy Play in 2015

Following last Tuesday's earnings announcement, Caterpillar (NYSE: CAT) was crushed, falling $7 per share from $86 down to $79 overnight.  It's stayed in that $79 range for the rest of the week, based entirely on it's gloomy outlook for 2015. 

The exposure CAT has in the energy sectors is significant, and with no foreseeable end to low oil prices, it's no wonder that the stock of this well-run company has been pummeled.  The good news for traders and investors alike, however, is that we now have oil as a leading indicator for this company's eventual rebound.  Take a look at a chart of CAT (red line) compared with the Energy iShares ETF (blue line.)

CAT (red) vs IYE (blue)

The correlation between the two makes sense when you consider the company's outlook for 2015.  CAT is forecasting a 9% decline in revenue compared to 2014, primarily as a result of depressed oil and gas prices.  Consider what CAT sells relative to that industry:

• Engines for drilling;
• Engines, transmissions, and pressure pumps for well servicing; 
• Engines for compression sets for gas gathering;
• Engines and turbines for pipelines;
• Turbines for offshore production pipelines.

In 2014, $22 Billion in sales came from this industry alone.  With depressed oil prices, however, there is an anticipated significant reduction in CapEx expenditures on the part of oil exploration and production companies in 2015.  Lower CapEx in that industry translates directly into lower revenue for Caterpillar.

If the price remains low for the better part of 2015 - and at present, there's not much to suggest it won't - then the turbine business is expected to decline well into 2016.  Without a dramatic price move in oil in the short term, it's reasonable to expect CAT's stock price to remain depressed at least through their next earning period.  It's for that reason that I'm using oil prices as the leading indicator CAT's future growth.

In their January 27th conference call, CAT offered some insight into several other industries of note. 

• Agriculture is expected to be weak in 2015.  This will lead to lower sales of industrial engines, and you can translate that into lower sales of other farm equipment.  It may, however, be good news for the parts industries, since there will be a greater desire for maintenance as opposed to new purchases.
• The rail business is expected to be down, at least according to CAT.  Now, this runs contrary to what we're hearing from others that have exposure to that industry, so it remains to be seen if CAT is being overly pessimistic or if this is a reflection of their more global position as opposed to a pure domestic play.
• Construction is expected to be up in the US.  This coincides with the view from others in that industry, and given the pessimistic outlook portrayed by CAT as a whole, this adds a measure of weight to the strength of the construction industry domestically.
• Construction everywhere else is expected to be down.  That's a recurring theme, with Europe leading the charge into recession.  China's growth is slowing, and construction is forecast to decline there as well.
• Mining is very weak, with commodity prices - especially for copper, iron ore, and coal - trading well below normal.  Interestingly, CAT does not foresee this improving in 2015.  If they're right, the various mining industries will face serious headwinds throughout the coming year.

As is typical in earnings calls this week, the strength of the US dollar was raised as a major headwind to global profits.  Now, this makes sense from two aspects.  First, any company that relies heavily on US exports is going to face headwind since foreign currency now buys less in terms of US goods and services.  Second, sales overseas in foreign currency faces unfavorable US dollar terms, so those sales now result in less revenue expressed in the dollar.

The good news for the strong dollar, however, is in terms of overseas manufacturing.  Companies based in the US, like CAT, that have extensive overseas manufacturing facilities are expected to see much lower costs thanks to the favorable exchange rates.  In fact, CAT anticipates this artificial cost reduction as offsetting the impact to revenue in the overseas markets.  It's a factor to consider when looking at opportunities in other companies with a strong overseas manufacturing presence.

So there you have 2015 in a nutshell, at least as it pertains to companies with heavy exposure in the oil and gas industries.  As to CAT, watch the oil ETFs for signs of strength once the price of oil stabilizes and begins to recover.  I'm expecting the oil ETFs to be a leading indicator that will signal a great entry point for CAT, and one that may provide an excellent cross-earnings announcement play in the quarter in which we see oil rebound.

Union Pacific Sees US Economic Growth; Cites Several Uncertainties

The overall theme of strong US economic growth in 2015 continues with Union Pacific (NYSE: UNP) forecasting strength in several key domestic arenas.  With 31,838 route miles providing rail access to and from both the Pacific Coast and the Gulf Coast shipping ports, this 150 year old railroad corporation has the inside track on a wide range of industrial and consumer goods being transported around the nation.  What they are forecasting for 2015 is very promising on the domestic front.

Agricultural demand looks strong in the US, although there's oversupply internationally so demand for US agricultural products overseas looks weak.  There is also some short-term weakness evident in demand for ethanol - which will impact demand for corn - however with plunging gas prices in the US, demand for ethanol is forecast to increase as we head towards higher demand for gasoline through the first half of this year.

For those interested in the automotive sector, the news on that front continues to be positive.  UNP saw continued strength in consumer demand for both finished products (i.e. new cars) as well as increased demand for automotive parts.  They see this trend as continuing into the 2015.  Seasonally adjusted, shipments of new cars in the 4th quarter increased by over one million vehicles.  Shipments of parts also saw a 2% increase in the 4th quarter. 

On the energy front, strong demand for coal continues to be forecast.  Inventories are currently low, and UNP expects strong demand to replenish those supplies.  The price of natural gas, however, could put pressure on demand for coal since a lower natural gas price will decrease the demand for coal across the nation.  While UNP has yet to see this impact in their shipment orders, they have called this out as a concern for their coal segment in 2015.

The price of crude oil is already having an impact on shipments, and that's expected to continue into 2015.  Volumes in the Bakken fields are down significantly already, and as long as crude prices stay below $75 to $80 per barrel, declines there will escalate.  The Uinta Basin and Niobrara Basin have increased shipment volumes, however I'd be concerned about Niobrara maintaining that trend.  The Uinta Basin produces traditional natural gas and oil, and is increasing overall production while decreasing the number of rigs, primarily through horizontal drilling.  The increased volume per rig is currently able to offset the impact of decreased margins, although if prices remain low, that will not be enough to sustain profitability.  The Niobrara Basin, however, has a very high exposure to margin risks associated with shale extraction - the most expensive of the oil production methods in use today.  Low oil prices will cripple production in this basin.  This will also have an impact on UNP's shipment of frac sand which accounted for 35% of their 28% increase in non-metallic minerals volume in 2014.

Switching to the construction industry, UNP is seeing sustained growth in the shipment of construction materials and they expect that to continue into 2015.  This growth is in both residential and non-residential building materials, and it's also being seen in lumber shipments. 

Intermodal shipments continue to grow domestically as well.  This is of interest since intermodal shipments transcend the various transport providers including trucking, rail, and shipping.  There's weakness being felt in imports, however, due to the long-running labor dispute in the west coast ports.  A much-hoped-for deal in mid-2014 didn't manifest, and the impact is being felt along the coast.

UNP reported strong demand for imported beer in 2014, and they forecast increased demand in 2015.  I'm not sure if there's a trading opportunity here, but in the interest of full disclosure, I will state that I'm doing my part to ensure demand remains high.


UNP did cite several uncertainties in their 2015 forecast, but by now they are uncertainties of which we are all aware:

• Crude oil prices will impact multiple industries, especially if they remain this low for any length of time.
• Global economies are softening, primarily in Europe, Japan, and Russia.  China's growth has slowed, (although it's projected to be close to 7% in 2015, so that's still a significant amount of demand.)
• The west coast labor dispute will continue to add import pressures.

Based on UNP's assessment of shipment volume projections in 2015, keeping an eye on the automotive industry and the construction industry should provide some interesting trading opportunities.  On the speculative side, it's worth keeping an eye on the interaction between coal and natural gas demand as the energy price dynamic plays out through the first half of the year.

Schlumberger Hints at Global Growth, Oil Pressures in 2015

Schlumberger Limited's (NYSE: SLB) earnings conference call yesterday provided some interesting insight into the global growth potential for 2015 as well as a detailed view of the changing dynamics we are witnessing within the oil industry.  For those not familiar with this global company, Schlumberger provides technology, project management, and information solutions to global oil and gas exploration and production (E&P) corporations.  Their clients operate in over 80 countries, giving them a unique view into the health of the economy both domestic and global.

Despite currency weakening both in Russia and Europe, Schlumberger foresees healthy growth in the global economy, surpassing the growth seen in 2014.  They see demand for oil increasing by about one million barrels per day by 2016.  This is matched by the one million barrels per day increase being supplied by the global oil market.

The dramatic drop in prices that we've seen is primarily being driven by a significant increase in supply coming out of North America and Saudi Arabia.  Globally, Saudi Arabia has shifted their strategy from one in which they sought to protect the price of oil via a manipulation of the supply to one in which they seek to protect their market share via an increase in supply regardless of the impact on price.  It's a fundamental shift in philosophy, and it's one to which the rest of the world has yet to fully react.

The impact of this strategy shift and resulting price drop is already being felt.  Exploration and Production (E&P) are down significantly, and are projected to drop by 25% to 30% in the US next year, coupled with a 10% to 15% drop globally.  Already, some 400 oil rigs have been taken offline, due to profitability issues relative to the new oil price point.

Hydraulic Fracturing technologies in the US and Canada have made a significant contribution to the oversupply of oil coming out of North America.  In the realm of cost, however, this technology is one of the highest - much higher than the cost of traditional oil wells that have both a lower start-up cost and a longer life span per site.  (Production from fraked sites declines 45% per year as compared to 5% per year from traditional wells.)  The Arabian oil companies have the lowest production costs and can therefore ride out this wave of low prices to the detriment of all competitors. The break-even point on some Arabian wells is a mere $10 per barrel.  Average break-even in the Gulf-States is $27 per barrel.  US Shale, on the other hand, has a break-even point optimistically at $50 per barrel, and some of the newer sites are even in the $80 per barrel range.  Clearly, the Saudis have the price advantage and can win the market share game simply by holding prices below $50 per barrel indefinitely. 

The impact is being felt beyond North America.  In the North Sea, both UK and Norwegian oil-rig counts are lower today and are projected to be even lower in 2015.  Those wells are simply not profitable at the current price point.  Not only are rigs being taken offline worldwide, but applications for new wells are down over 50%, and Cap-Ex spend projections for next year are being lowered tremendously.  Financing for new exploration and drilling is expected to be difficult to obtain, again due to profitability.  That will be exacerbated by rising interest rates should that happen.

What this means in the medium to long term is two-fold.  At the moment, Saudi Arabia is antagonizing one of the largest industries in their largest global political ally.  Expect the petroleum lobby to begin to apply political pressure in the White House and in Congress, if that hasn't already started.  This will change the politics between US and Saudi relations, and anytime you have a changing political dynamic in the Middle East, events can become very volatile very fast.

The second outcome will be tightening of supply, which will result in a rise in oil prices.  Nobody is willing to predict when that will occur, but it's definitely on the horizon for sometime in 2015.  Even if it's not an overt action taken by the industry, it will be a de facto result as the more expensive drilling operations either go offline until prices rise, or they go bankrupt in the face of insurmountable losses.  A look at the overall break-even points for the various producers will provide an excellent investment opportunity since they are the ones most able to survive this downturn in price, and they are the companies that will reap the harvest when prices inevitably resume their climb.