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Why You Should Short Public Oil Companies

Carl Pope is a former chairman of the Sierra Club and an adviser to Michael R. Bloomberg.
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U.S. coal companies have lost about 75 percent of their market value during the bull market that began in 2009. Oil and gas companies, which account for 60 percent of U.S. carbon emissions, and about 84 percent of fossil fuel market cap, have fared much better. But risks abound.

Publicly traded oil and gas companies have access to only 10 percent of the world’s oil reserves. As it happens, their reserves are often located in deep water far from shore or in the complex geology of tar sands, making them among the most difficult -- and expensive -- to extract. Readily accessible, inexpensive crude reserves in places like Russia and the Persian Gulf are set aside by governments for their own national oil companies.

That didn't seem to matter when prices were high. From 2004 to 2013 the real price of oil almost tripled. Demand jumped by 13 percent. Customers kept driving and flying even as costs soared. Pumping $25/barrel crude and selling it for $40/barrel is a good business.  Selling it for $120/barrel is a spectacular business.  Saudi Arabia, Russia, Kuwait, Norway, Nigeria and Venezuela reaped bonanzas.  So did the oil majors -- BP, Chevron, Exxon Mobil, Eni, Phillips, Shell and Total profited from  legacy oil costing them only $30 to $60 per barrel.

QuickTake Oil Prices

In 2012 Bernstein analysts produced a sobering look at the industry fundamentals.  With oil above $100/barrel, Bernstein found that the 50 largest, publicly traded, non-OPEC oil and gas companies were under financial stress.  Average net income margins had dropped to 22 percent, 30 percent lower than when oil was priced below $40/barrel. The replacement cost of oil -- the long-term marginal cost of production -- had increased by 44 percent in a single year. Easy oil had already been found.  When replacement costs were factored in, the average marginal cost for non-OPEC producers was $104.50/barrel. “Net income margins in the sector are now at the lowest in a decade. This is not sustainable," the Bernstein report stated. "Either prices must rise or costs must fall."

In effect, publicly traded oil and gas companies had become dependent on ever higher oil prices to match their ever higher costs of discovery. Even the biggest and richest of them, Exxon Mobil, increasingly taps expensive unconventional sources to maintain production. From 2006 to 2013 the percentage of Exxon Mobil’s proven reserves made up of tar sands and heavy oil increased from 15 percent to 32 percent. Relying on a larger share of more expensive oil reduced Exxon Mobil's margins and returns.  Its stock value trailed the S&P 500 by 40 percent during those seven years -- even as the company used the vast majority of its profits to buy back shares to sustain their value. Two years ago the situation was sufficiently dire that the Economist proclaimed that “the day of the huge, integrated international oil company is drawing to a close.”

From 2004 to 2014 oil companies kept investing  more than a half trillion dollars a year in finding and developing new fields for which the break-even point would be $75-to-$125 per barrel.  Development completed, companies started pumping the new crude. Demand didn’t rise as fast as expected; supply outran it. In the summer of 2014 the oil market was suddenly glutted.  A 5 percent shift in the supply-demand ratio cut prices by more than 50 percent, from $110/barrel to below $50, then back into the $50-to-$60 range.

Chevron cancelled its stock buy-back program, but even so is in a negative cash flow position.  Goldman Sachs calculated that more than half of the new oil projects awaiting investment go-ahead would be uneconomic at today’s prices, leaving in limbo $750 billion in investment and 105 million barrels a day of potential production. 

As prices fell, the first Canadian tar sands oil companies began to file for bankruptcy. About 1.4 million barrels a day of tar sands projects were put on hold or cancelled . Oil and gas revenues in Alberta are down almost 50 percent. Independent U.S. oil producers scrambled for cash to service their debts. Bankers worried that oil and gas debt could be the next sub-prime crisis.

Many new projects are losing money. Due to sunk development costs, however, their owners keep pumping to generate cash flow -- keeping the market soft. North American exploration dropped by 35 percent; the U.S. rig count is down more than 50 percent. Oil majors slashed their exploration budgets by up to one third. Productivity and output kept rising. (Meanwhile, BP  just agreed to an 18.7 billion settlement of claims stemming from the Macondo oil spill in 2010.)

The market initially didn’t seem particularly worried by all this.  Exxon Mobil stock, for example, is down only 10 percent from its peak. But if public oil companies couldn’t make robust profits when oil was priced at more than $100 per barrel, how will they fare long-term if a barrel of oil is priced in the $50-to-$80 range? Capital and operating efficiencies may be leading to greater productivity, creating the potential for the break-even point to drift down the price range.  But how low can they afford to go?

Worse, the world is not especially eager to remain hooked on oil. California has committed to cutting oil consumption by 50 percent.  Electric vehicles have tiny market share, but sales have more than doubled every year for three years. Natural gas as a U.S. trucking fuel is growing 15 percent a year. Along with radical increases in vehicle efficiency, these trends will all combine to undermine growth in demand for oil for years to come.

A looser oil market wouldn’t end global use of oil. But demand growth could easily slow enough that legacy production, along with new OPEC and Russian fields and the most efficient U.S. shale deposits, could satisfy the market. Prices would fall even if demand held steady. In that situation, any public oil company that continued to invest heavily in expensive new projects would be burning up shareholder value.  

It could get grimmer still. The Saudis just suggested  -- before retracting the statement -- that the era of fossil fuels might end in the middle of this century. Suppose they actually believe it -- and even hedge against it? Suppose the Kingdom tries to sell off its oil before the price collapses.  What would that do to the market for Shell’s costly Arctic drilling? For the complex, dirty extraction of Canadian tar sands? Ultra-deep Brazilian pre-salt wells in the South Atlantic? Even some of the more expensive U.S. shale wells? 

It wouldn't take much to send such a market spiraling down. By contrast, the reverse path back up to profitable $100+ prices seems very steep.

For some time to come, oil as a commodity will still enjoy powerful incumbency advantages. But as market pressures intensify, publicly traded oil companieswill be increasingly squeezed by OPEC, Russia, electric vehicles and other competing energy sources.  Barring another revolution in shale technology, the majors would have access only to the highest-cost segments of a potentially oversupplied market. That market is inherently volatile, and the industry is vulnerable. Divestment from oil may be a moral cause for some investors. Others -- those seeking profit over the long term especially -- might want to follow suit simply to save their shirts. 

Previously: Why You Should Short Coal

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Carl Pope at Carldpope@gmail.com

To contact the editor on this story:
Francis Wilkinson at fwilkinson1@bloomberg.net