Hello Everybody,

Oil prices continue to be immensely volatile, with prices rising roughly 30% from the lows earlier in the year.  After OPEC decided to keep production steady in November, many market prognosticators wrote about how the shale drillers were likely to go head-to-head and keep producing as much as possible.  This was a very illogical argument, as many shale oil companies have consistently overspent in relation to their cash flow; with the declining cash flow from lower prices, these companies likely wouldn’t even have access to the capital required to maintain similar CAPEX budgets.  My biggest concern was that a large amount of the well-financed E&P’s would try and pick a quick bottom in the oil market and keep production as aggressive as possible, as it is common for commodity-based companies to focus on growth even when it isn’t necessarily economically beneficial.  I’ve really immersed myself in the industry through reading as many conference calls and quarterly filings as possible, and I’ve been pleasantly surprised by how responsible the decision making has been in the industry as a whole.  Most companies have cut CAPEX by 25-50%and many have done even more than that.

Despite these cutbacks, oil supplies are still at record highs.  This is because producing wells are the last things to be cut and hundreds of billions have been spent over the last few years to grow production, so it will take time to see production flatten out and then possibly decline.  Oil demand has begun to pick up incrementally and I believe that this trend will continue to pick up speed.  Slower growth in China and a weak Europe are the primary impediments to this occurring faster than it indeed is.  The most important indicator in my opinion on the future of oil supplies and prices is the Baker Hughes rig count.  The U.S. rig count has now fallen to 1310, from 1771 a year ago. That means there are 461 rigs that have been taken out of the market, with most of that occurring in the last few months.  In reading about future plans from the E&P’s, it is clear that these numbers are going to continue to decline considerably, and honestly I wouldn’t be shocked to see the rig count decline to under 1,000 unless prices rise in response.  If this does occur, we should see flat or possibly declining production in North America by early next year at the latest in my opinion.  If demand picks up or if OPEC changes its stance, it isn’t impossible to see $90-100 oil prices again.  The most bearish impact on prices in my opinion is Iraqi production, which has really been growing at a fast rate despite the social disaster that is occurring in the country, but who knows what will happen there over the next 12 months.

So much about investing is reliant on psychology.  Analysts from Citigroup are forecasting that oil might well decline to $10 a barrel and Goldman Sachs has also forecasted incredibly bearish prices.  Fundamentally, little has changed since when prices were above $100 per barrel.  Supplies were growing, particularly in North America and demand growth had been tepid.  So why is it that it is only now when prices have already dropped that we see these dire projections?  The reason is that most market participants focus on short-term trading using strategies such as technical analysis, which has been about as useful to society as alchemy was to the Middle Ages.  Very little emphasis is placed on fundamentals, which is what creates tremendous opportunity for patient value investors.  This is why it is very important not to overreact to short-term movements in prices as they really have very little relevance.

We have added selectively to well-financed oil services and E&P companies but we have certainly not gone all in like we have in other sectors before.  Warren Buffett and Berkshire Hathaway recently sold a nearly $4 billion stake in Exxon Mobile.  His record in energy has been mixed at best, but I don’t really believe he made a strong bet on future prices by selling that stake.  Oil prices are down over 50% from the highs but Exxon is only down about 14% thanks to its strong financial condition and refining business, which benefits from lower oil prices.  Now knowing where prices are going, it seems logical for him to exit a low conviction investment in Exxon and I wouldn’t be surprised to see him look for better opportunities in the services sector where there might be better value.  These are just my opinions that I thought I’d share.  If you have any questions or if I can assist with anything, please don’t hesitate to contact me!