One investor’s perspective
Editor’s note: This list was taken from an interview with Bill Munn, director of investments with Mack Energy.
1. It doesn’t comply withthe principles of supply and demand.
Oil doesn’t follow the basic rules of supply and demand, says Bill Munn, investor for Mack Energy. As most things go, the less the supply and greater the demand, the higher the price.
However, for oil, consumers want and use more of it the greater the supply and lower the price. So when oil hits a surplus like we’re seeing now and the price drops at the pump, consumers drive more. If oil hits $70 a barrel and the price at the pump climbs, then drivers find ways to cut back and drive less.
“Gas consumption is not demand,” Munn said, talking about the current state of oil in the world market. “Demand at $30 a barrel is higher than at $70 and at $100 we know what happens — drivers start changing behavior because that is too expensive.”
2. The market price changes on just 100,000 barrels.
Just 100,000 barrels a day plus or minus in production can change the price on oil on the global market by $1 a barrel.
“That has been true for 50 years,” Munn said.
Using that math, the $50 fall in oil last year means there was 2.5 million barrels a day too much oil on the market.
The recent wildfires in Canada that have shut down large swaths of Canada’s Alberta oil sands fields cut some 1.5 million barrel a day of production from the global market, and conversely saw the price of a barrel climb nearly $10 — evidence of the rule.
3. The price is heavily controlled by speculators.
“It is nothing to bet $100 billion on oil right now,” Munn said of speculators who move the needle on oil more than supply and demand ever could thanks to huge sums of money used to manipulate the market. “Speculators can move it $10 pretty easy.”
As such, Munn said no one should get too excited about oil prices recovering anytime soon as the global surplus continues and speculators can drive the price down to cut any resurgence in production with ease.
“If you start getting enthused and talk about rigs running — and the number of rigs goes up — the price will drop,” he said.
4. Speculators now control vast amounts of stored oil.
“What happened is Wall Street was financing storage,” Munn said. “We bought up millions of barrels of oil and store it. Why? Because they are greedy.”
Munn points to the Glass-Steagall Act of 1933 that prohibited commercial banks from engaging in the investment business.
In 1999 Gramm-Leach-Bilely Act repealed the Glass-Steagall Act’s restrictions on bank and securities-firm affiliations. The result is banks and speculators now invest heavily in oil and gas storage, giving them immense control of the commodities’ prices.
“Nothing good has happened since we got rid of (Glass-Steagall),” Munn said.
5. The current downturn is unprecedented.
The current state of oil and gas and the corresponding downturn being seen is unprecedented in the industry, Munn said.
The price of oil began falling in 2015 because for the first time in history the world had too much oil and it came at the worst time, when global economies began to fail.
“Too much oil accounted for two-thirds of the fall and then demand changed,” Munn said “The world doesn’t need a bunch more oil. Not right now. No global economy is growing. China borrowed their way to prosperity. They are not going to fold tomorrow, but all this crazy buying they were doing, that is over. They are going to buy at the margin now, buy cheap and store it.”
Even if oil were to correct to the often-quoted magic number of $70 a barrel (the price drilling companies say they need to make a profit) there still wouldn’t be a demand to warrant that price, Munn said.
“Even if you correct back to $70, we don’t see any demand growth anywhere,” he said.
On top of that, China has a surplus of diesel fuel it is now beginning to drop onto the world market, another factor in driving prices down.
6. Saudi Arabia is still a major player.
The thought that the United States could change the global oil game thanks to fracturing and horizontal drilling technologies doesn’t float, Munn said.
The reason? Saudi Arabia still has huge reserves of oil it can produce at much lower costs than the U.S.
“They have 40 years of production at 8 million barrels a day,” he said. “They are really well versed at what they do over there.”
“The problem is they also know the world just can’t operate at $100 (a barrel oil),” he added, saying the Saudi’s can help drive prices down by ramping production much easier than the U.S.
7. Oil bankruptcies are unwanted, but more could happen.
“There should be a lot more of them in bankruptcy,” Munn said, talking of the number of oil companies that have already filed for bankruptcy.
Oil companies are just not worth much in a bankruptcy setting, Munn said. Equipment purchased for millions of dollars is worth a 10th that price at auction and oil leases bought up at premiums when the boom was in full swing won’t leverage half the price in a sale.
“Let’s say you owe a billion dollars, your equipment isn’t worth $100 million and I bet you can’t get $50 million for it,” he said. “The banks are in a quandary. They don’t want all that crap back. Banks have been very lenient and will continue to be and hope for higher prices.”
The reason so many could still go bankrupt is they over-leveraged — buying more equipment and leases than they could operate and went heavily into debt, Munn said.
“We probably have 50-60 percent too much horsepower out there,” he added, pointing to the number of stacked rigs and trucks sitting in yards around the Permian.
Many companies are turning to “core properties” (those considered to be the best producing) to keep afloat in the downturn, selling “non-core assets.” However, Munn said that won’t work for long.
“Core properties are not limitless,” he said. “Pretty soon they will be drilled up and what do they have?”
He said some companies will have to go bankrupt, however, as it will be the only way they can survive.
8. You can’t make money in the Permian at $50 a barrel.
“You keep hearing people say, ‘You can make money in the Permian.’ That is BS start to finish,” Munn said. “The reason you can’t make money here is it doesn’t work at $40 or $50 a barrel.”
Making money in the Permian is a no-go because of the costs, royalties, taxes and other fees associated with producing oil that eat up any profits at $40 a barrel, he said.
“Let’s just say it is $50,” he said, “you don’t get $50, you get a discount of that and then you have to pay for transportation and royalties so then you’re down to $35 a barrel.”
Munn said the point where producers in the Permian could make money would have to be in the low 60s for price per barrel.
9. Keystone would have killed the Permian.
“You should be glad President Obama stopped Keystone. If he hadn’t oil might be $10 a barrel,” Munn said.
It might sound counter-intuitive, but the only reason Permian oil is near $50 a barrel is because gulf coast refineries can’t get all the Canadian Oil Sands oil they need to keep busy, Munn said.
Many in the industry will tell you the U.S.’s gulf coast refineries can’t process the light sweet crude produced in Texas and New Mexico. However, Munn said they can, they just don’t like it.
“They want the heavy sour, because it generates more product and is better,” he said. “This deep shale carries a lot of water, you’ll take it, but gravity is in the 50s, refineries don’t like because it evaporates. The gravity for the oil out of Canada is in the 20s.”
In essence, refiners don’t like Texas oil, because it contains so much water that can evaporate — They may pay for 100 million barrels, but get only 92 million in actual oil when its all said and done, Munn said.
10. Don’t expect it to get better anytime soon.
Munn sees the industry remaining choppy for the next two years at least.
“I’m asking people to be more cautious,” he said. “We are going to get through it, but it will take time.”
Munn said he hasn’t seen the metrics yet on any wells in the Permian that could actually turn a profit.
“If you can show me that you can drill a horizontal on the Bone Springs (formation) and spend $7-$8 million and pay the GNA you owe and the taxes, and the well will pay a profit ever — not in a few years, but ever — then I will get excited,” he said. “Once you show me it will pay out, then I know recovery is coming.”