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The Real Breakeven Price of Oil is Not What You Think

You can read a lot on the breakeven price for oil right now.  I think a lot of what you read now is missing the point–because I think the breakeven price for oil isn’t all about economics.  There’s a human element to this (and every) trade.

I think the breakeven price for oil is whatever price the Wall Street debt marketers can find a home for a $250 million debt instrument (or whatever amount) for energy producers.

If they can find a buyer for that debt at US$55/barrel WTI (or whatever price), that’s the real breakeven price for oil.  Production will continue to flow in the US at whatever oil price they can sell that debt.

In a ZIRP (Zero Interest Rate Policy) environment, Wall Street debt syndicates will set the oil price, not the Saudis or the US producers.

Ed Crooks is the New York Editor of London’s Financial Times—one of my favourite journalists and I read all his stuff, follow him on Twitter etc.   He wrote a story late last week saying the collapse in oil prices might scare away the investment bankers and debt teams in the US energy patch from issuing more debt—in case the Saudis ever do this again.

Personally I think I have a better chance of being hit by lightning than that happening but anything is possible. (Lightning happens in temperate rainy Vancouver about every 7 years.)

I can’t be too negative here however–the increase in US production these same debt syndicates funded has saved the world from either $150/barrel oil or a big recession in the last 2-3 years.  If you’re an oil consumer, you love the Wall Street debt guys–don’t you?

The point is, true oil economics only really count to set the oil price if both the CEOs of the producers and their financiers were robots.   But they’re human and…hey, we’re a fallen species.   I think adding in the human element means I have time to accumulate a larger position, because oil is not going back to $90 right away.

I think it still means oil is going higher, but not as quick or in as straight a line as the last few days of trading would suggest.

In case I’m wrong, I own some of great low cost producers.  That’s the exposure I think everyone should have–but in small doses right now.  And of course I have my legacy positions from before the crash–the very few companies IO chose to hold through the cycle (again–leaders; they have BIG moves when oil rallies–that’s when you know you own the right stocks).

There’s a lot of stuff to read out there to read on oil right now.  It can consume you. But we’re all getting paid to say something ;-).  Remember that as you read all that stuff—they get paid to talk.

Another interesting point I’m seeing in the junior oil markets–especially in Canada–is that The Good Names are getting a bigger premium than I think they deserve—for scarcity reasons.  Multiples for the junior and intermediate leaders in Canada before the 2014 oil crash were trading at 9x cash flow.  Now brokerage firm analysts are calling for higher than that in the face of lower cash flow.

One brokerage firm was calling for the leading liquid rich gas producers in the Alberta-B.C. Montney play to trade between 13-22x cash flow!

From an economics point of view, that obviously makes no sense.  Why should (greatly) reduced cash flow mean a higher multiple?  In fact, I doubt there is ANY positive cash flow for these companies–the only way that could happen is if they decided to STOP growing–i.e. stop spending expansion capital.  And what multiple would the Market pay for NO growth?

But it does make sense–in Canada–where even in good markets a lot of money is chasing few names.  At these energy prices, there are only 5-7 companies I would own at all—and everyone else agrees.  And the institutional funds pretty much MUST own them regardless, so the Good Stocks actually end up getting a BIGGER cash flow multiple at much lower cash flows.  Strange but true. And not a Game I’m willing to play with my money.

So what am I doing with my money?

I see Big Moves off the bottom in the more highly levered junior oil stocks like Legacy Oil and Gas–LEG-TSX (love it or hate it, it has great leverage to oil) and Lightstream, LTS-TSX.  But I’m not good at picking bottoms.  That’s not the kind of investor I am.  So my strategy continues to be—small positions in the leaders and wait for a more definitive trend to hold up.

The recent rally in oil has been a bit stronger than I would have expected (looks like it peaked Friday?), but of course the drop in the rig count has been stronger than most expected.  (The North American energy complex, as big as it is, moves FAST to any new reality—it’s stunning really.)

There’s so much chatter out there—Analyst Ed Morse at Citi and Stephen Schork of the Schork Report and Rusty Braziel of RBN Energy are all relatively bearish, others like boutique brokerage firm Sanford C. Bernstein is quite bullish.  They’re all well respected names–and no consensus.

I will say the charts do look constructive on the leading intermediate oil stocks though—several have not only cracked through the 50 dma but now also the 100.  That’s impressive.

I’m torn here.  The charts look good but I’m scared to buy more of my favourites right now.  My head says I have more time, and I explain that a bit more below.  I think as natgas heads lower in the spring, that will drag oil stocks down (most “oil” stocks have surprisingly high gas weightings. ) But the charts of leading oil (real oily) stocks make it look like oil is going higher.

And my stocks are going up so I’m benefitting from this.  But I don’t know if it’s real–despite the charts.

So for investors like me who are a little cautious about this rally, I prepared a quick report on Three Very Defensive Oil Producers—all listed in the US. It is now in the Subscribers’ Members Centre.

These three have three characteristics I look for:

  1. Good balance sheets
  2. Oily
  3. Size Matters Now—Critical Mass is Important

This report also provides a very high level synopsis/summary of the Unit Economics report from December 2014 on 33 US E&Ps.  They studied the Q3 financials of the large and intermediate independent producers and found negative cash flow–at $97 oil equivalent.  For new subscribers, the lack of free cash flow even at $97/b WTI is an eye-opener.

I have only written 1 page tear sheets on each, along with the Quick Facts.  But they are the stocks to own if oil stays under US$60/barrel.

For the more aggressive investor, my 3 Junior Oils on the Rebound are still the best stocks to own, IMHO.  That report also in the Subscribers’ Members Centre.

-Keith

EDITORS NOTE–Get my two latest reports–one on the Top 3 Defensive Stocks, and one on the 3 Top Junior Oils on the Rebound–RISK FREE.  I’ve made $1.8 million in energy stocks in the five-and-a-half years since I started investing with $50,000 in 2009.  Click here to get these reports.

 



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