On Friday, OPEC’s meeting ended with no reduction in their targets for oil production. This was the expected result, as the unknowns as to how quickly Iran could increase production makes it difficult to project an actual target. While most members of OPEC wanted a reduction in production, Saudi Arabia wouldn’t comply given the reluctance of Russia (non-OPEC) to reduce its production. It is important to note that it is much more difficult for Russia to cut production without damaging its oil production system, where Saudi Arabia has much more flexibility. Geopolitical issues have really complicated the situation much further. While the ongoing revolution in Libya has caused production to drop, the war in Iraq has the Iraqi government producing at extremely high levels to maintain itself with so much of the spending going to fight ISIS. All of the real production growth has been coming from the Middle East, which has prevented supplies to drop globally.
The North American oil market has played out like we expected. The rig count has dropped by a staggering amount in the last year. 1 year ago, there were 2,342 rigs drilling in North America and today there are 914! That is one of the biggest drops in history and in a more normal environment would have resulted in a major supply drop. Oil companies have responded by focusing on their highest quality wells and leveraging the service companies to cut costs. This has greatly improved efficiency, lowering the breakeven price levels. To be clear, most oil companies are absolutely still bleeding money but the improved efficiency has allowed production to maintain higher levels than would have been achieved otherwise of course. Global demand increased this year, but not by enough to counteract supply growth. Also the strengthening U.S. dollar is also very negative for oil.
There can be no doubt that just about every investment in the energy industry has been a disaster outside of refineries. Whether it was MLP’s, offshore drillers, service companies, etc., the results have all been terrible. I’m definitely not pleased that we have been hit by this downturn, which has certainly caused losses for us, that have offset our gains in financials. Some of the stocks that we have gotten hit hard on such as Chesapeake Energy and Transocean Rig, have also greatly hurt investors such as Carl Icahn who is among the largest shareholders’ in both. I’m happy to say that we haven’t compounded the problem by aggressively adding during the downturn, because we saw better risk/adjusted returns in the financial space. While many of the losses are only temporary in our estimation, some have been permanent in stocks such as Sandridge Energy. To put it in perspective, Sandridge was actually blessed with excess liquidity prior to oil plummeting and had just announced a stock buyback. Now its leverage has caught up to it and the company has had to do debt for equity exchanges to stay afloat. This is a very common theme in the industry and there have been a great deal of bankruptcies, with many more to come.
The thing about investing is that it is not about the past but it is about the future. These prices for oil and natural gas are ultimately unsustainable. Even countries as flush as Saudi Arabia are having to issue to debt and are eating into their cash reserves. Countries like Venezuela and Libya are in dire straits. Russia’s economy is hurting badly with the combination of sanctions and low oil prices, but has definitely benefited from the decline in the Russian Ruble. The biggest fortunes are made in buying into downturns that ultimately recover. Unfortunately, there are some industries which don’t recover. Coal is an example of an industry where even the best financed companies have gone or are likely to go bankrupt due to sustained low prices and massive regulatory changes. I don’t see the same dismal future with oil. Eventually, it will be an incredible buy but the key will be focusing on well financed companies.
As far as our current positions in the sector, we’ve already taken the hits. The reward/risk is quite attractive and many of these companies have the potential to double or triple over a 5 year period. The amount of capital tied up in energy for us is very low at this juncture, so while energy has hurt us this year, it doesn’t offer much risk and should offer a nice tailwind over the next 2-4 years. We have also benefited from other companies that perform well with low energy prices such as airlines and automobiles. This has been an important hedge and we believe that many of the stocks in these industries are still quite attractive relatively. I’ll keep you posted as new developments emerge but I thought it would be helpful to put Friday’s OPEC meeting into context. Thank you very much and please let me know if you have any questions whatsoever!