Many income investors are sweating over their oil investments, and rightly so.
Across the spectrum, values have fallen and payouts have been reduced. No one should be surprised. West Texas Intermediate crude prices are down nearly 60% since last July. Lower oil prices are the scourge of the oil sector.
First, allow me to clear the table of a misunderstanding.
Lower oil prices are unequivocally positive when aggregate benefits are measured against aggregate costs. The less money allocated to oil and oil derivatives (namely gasoline), the more money allocated to spending and investing in other segments in the economy. Lower oil prices lead to more value creation elsewhere.
The cynical investor might riposte, “Great, but my income stream and portfolio have taken a hit. I’ll take higher oil prices.”
To be sure, higher oil prices might alleviate current pain for some investors, but they are no panacea. Contrary to popular perception, profits are achieved not by higher prices, but through economies of scale and efficiencies that cut production costs. Great fortunes – those of Andrew Carnegie, Henry Ford, Sam Walton – were achieved by relentlessly driving prices and costs down, not up.
Indeed, the greatest fortune ever was derived from driving oil prices down.
Through the duel efficiencies of economies of scale and vertical integration, John D. Rockefeller helped reduce the price of refined petroleum to $0.059 a gallon by 1897 from $0.30 in 1869. The average refining cost of his beloved Standard Oil dropped to $0.0029 (less than a penny) from $0.03 per gallon. Falling prices and relentless efficiency gains made Rockefeller the richest man ever (in real dollars).
The problem today is that many investors bought into price and ignored efficiency. Everyone makes money when oil changes hands at $100 a barrel. The same can’t be said when oil trades below $45 a barrel. Last October, IHS, a research group, estimated the median break-even price among U.S. shale producers at $57 per barrel.
Many popular price-driven income exploration partnerships appear to be operating below the median break-even price. I’ve received numerous inquires on former high-flyers and high-yielders Breitburn Energy Partners (NASDAQ: BBEP), Linn Energy (NASDAQ: LINE) and Mid-Con Energy Partners (NASDAQ: MCEP). All have slashed payouts; all have seen their unit price slashed.
The problem for many U.S. oil producers is that today’s lower prices aren’t a byproduct of falling production costs, as in Rockefeller’s day. A stronger dollar is the source of much of today’s pain.
Oil transactions are settled in dollars. Over the past six months, the dollar has appreciated 30% against the euro and 20% against the yen. The dollar has appreciated against most of the world’s currencies. Foreign producers may not have achieved any efficiency gains, but they’ve picked up an advantage when exporting oil and receiving dollars for their efforts.
When the dollar was weak, oil commanded a higher dollar price. The higher dollar price spurred a surge in U.S. oil production. Today, U.S. crude inventories – at 458.5 million barrels – is the highest it has been in the past 80 years.
The supply glut is winnowing out the less efficient. The number of oil-drilling rigs in the United States has dropped 46% from its peak last October. Output will surely fall.
Concurrently, world oil demand increased by 1.1 million barrels per day in February. Falling output coupled with rising demand suggests a crude oil price recovery occurring sooner than later.
Paradoxically, lower prices lead to a safer investing environment. You can more easily separate the efficient from the inefficient. The key to successful long-term oil investing is finding the value-priced efficient producers. I’m finding more of them today, and more of them are finding their way in the High Yield Wealth and Personal Wealth Advisor recommendation list.
Saudi Arabia’s Plot Backfires!
When the Saudis announced they would not cut production to bolster oil prices, the intent was obvious. The move was meant to drive down crude prices, and punish the U.S. oil industry. The US had already over taken both Saudi Arabia and Russia in crude production – and the Arabs thought they could stop it with this move. WRONG! And we’ve found a great way for the average guy to cash in.