Shorting Oil, Hedging Tesla

[jhm]

Why Saudi Arabia Continues To Pump Crude At Record Levels | OilPrice.com

Ok, here's some fun financial economics to explain why the Saudis are pumping like there's no tomorrow. The economic model is correct, but I think another rationale a decrease in the present value of reserve is critical. Specifically, the threat of EVs decreases the present value of reserves, not simply by increasing discount, but by actually reducing the expected future value of crude. Also the risk of response to global climate change increases the discount and possibly decreases the expected future value.

The fact that oil exploration is down sharply also suggests that the present value of reserves is declining for the whole industry. It only makes sense to search for oil when the present value of the reserve minus the present value of the cost to extract exceeds the cost to discover.

 

[jhm]

Oil Industry About To Be Burned Again By Fall In Oil Prices | OilPrice.com

Wow, the is pretty sharp criticism of the capital that perpetuates the glut. Berman seems pretty disgusted with an industry that lack the discipline to actually get out of a glut.

Specifically, he explains that rig count is largely a measure of the flow of capital into the industry. There is a 5 week lag for price movement to change in rig count. So rigs are continuing to be added even as price of oil collapses.

 

[jhm]

Oil is continuing to have a meltdown. Currently at $40.76. Could drop below $40 today, though oversold at a support price.

Does Tesla continue to move with oil? Seems it is less the case.

 

[ggr]

The thing I find most interesting about that is the volume! I have no idea what it means that the volume has picked up so much.

 

[jhm]

The thing I find most interesting about that is the volume! I have no idea what it means that the volume has picked up so much.

This is for futures contracts. Volume increases as it approaches expiration.

 

[jhm]

Exxon Has Worst Profit Since ’99 as Chevron Posts Loss

Earning season is pretty bad for the oil majors. Chevron posts a loss and impairs $2.8B in production assets that will not recover costs at current oil prices. Exxon earnings at 11 year low.

With refinery margins compressing, inventory high, and crude price declining, we could see production slowing. So crude demand could fall off for a while.

 

[neroden]

Exxon, Chevron, and Shell are all paying dividends which are higher than their actual quarterly earnings, if I'm not mistaken They are not funding this by asset sales or cutting back on expansion enough, however; they're *borrowing money* to pay the dividends.

This is an industry in its death throes. Remember I commited to my prediction of ExxonMobil bankruptcy by 2030.

I've been trying to analyze the fate of the refineries. ("Downstream"). They're mostly optimized to produce gasoline -- oh dear, that'll be worthless. Some are optimized to produce diesel -- oh dear, demand for that is going to drop massively too. The logical result is to optimize to produce jet fuel, which has high margins and will have rising demand for quite a while.

Even doing this, however, many many refineries will have to close. Somewhere between b60% and 70% of oil in the US is used for gasoline or diesel; with this demand mostly eliminated, this is massive overcapacity of refineries. So first step: lots of refineries close. Second step: the survivors try to maximize jet fuel production. Jet fuel prices go up because it has to cover refinery overhead which gasoline used ot cover.

But here it gets interesting. The oil fractionation can be adjusted to produce a slightly larger percentage of diesel and jet fuel (maybe 10%). Converting a lot of the "naphtha" to longer-chain jet fuel kerosene instead of gasoline, however, seems to be impossible with current technology!

They're going to have a lot of waste product which used to be made into gasoline. They can shorten the chains by cracking and generate more 1-4 carbon chains, however, and that's probably what they'll have to do with the unwanted gasoline. This should generate a downward pressure on the prices of natgas and propane. (As should the higher percentage of gas in all new oil wells; it keeps rising. However, the death of the fracking industry should put natgas prices up.)

 

[jhm]

Lately I've been wondering if it would be better to short oil companies than oil itself. Suppose oil stays range bound between $40 and $60 for several years. Tesla does fine, so my oil hedge is not really needed. But persistent low prices like this will kill oil companies. It seems producers who are drilling at $50 are basically betting that oil will go back to $80, and they get to cash in. But if oil stays in range of $50, they go bankrupt. So shorting companies that go bankrupt is a much better return than shorting oil.

 

[neroden]

Lately I've been wondering if it would be better to short oil companies than oil itself.

Well, I think oil itself has a much brighter future than oil companies. Oil prices could drop by 50% (but probably not much more than that), and oil companies would drop by 100%. Oil could stay flat, and many oil companies would drop by 100%. In a sense, oil companies are a *leveraged* play on the oil prices, if you see what I mean.

Suppose oil stays range bound between $40 and $60 for several years. Tesla does fine, so my oil hedge is not really needed. But persistent low prices like this will kill oil companies. It seems producers who are drilling at $50 are basically betting that oil will go back to $80, and they get to cash in.

Yep. I actually think a cleverly managed oil company which retrenched to its most profitable wells and fields could survive persistent $40 oil, but these guys are *still exploring for more*.

But if oil stays in range of $50, they go bankrupt. So shorting companies that go bankrupt is a much better return than shorting oil.

Yep.

I don't do shorting myself, due to the risk that the oil companies will *temporarily* skyrocket in price requiring huge margin requirements ("the market can remain irrrational longer than you can remain solvent"). (After all, we could also see short term excursions into high oil prices for a few months at a time. The long-term demand drop doesn't mean that this is going to go *smoothly*. After the first big wave of wells being shut in, there probably will be a temporary price spike. Liquid markets always overshoot.)

I have been considering buying some LEAP puts on the oil companies (as a bear bet which removes the unlimited downside / insolvency risk which shorting has), but the trouble is that the expirations don't go far enough out and I'm not at all sure their stock prices will crash by Jan 2018. If I were a Big Short type, I'd go to one of the big finance firms and ask them to get me a quote for a custom put which expires 5 years out... but I'm not.

 

[Bangor Bob]

The chemical divisions will probably be all that's left in the end. Lubricants, plastics, specialty polymers (solid-state battery electrolytes?)

There will be a long tail. As an example, commercial whaling crashed to essentially nothing (compared to where it was) by 1870, and yet GM was filling transmissions with spermacetti-derived oils into the 1970's.

 

[neroden]

The chemical divisions will probably be all that's left in the end. Lubricants, plastics, specialty polymers (solid-state battery electrolytes?)

Yeah. There's also asphalt, but if it goes up in price enough (which it will as less and less oil is refined), people will switch to concrete.

I'm guessing on a fairly long period of jet fuel usage, though, since there isn't a working replacement for it yet. Once, kerosene was the "primary" product of refineries; now gasoline is the "primary" product of most refineries, with diesel the "primary" product of others. Soon enough (within 20 years certainly) jet fuel will be the "primary" product (and jet fuel is basically kerosene).

When jet fuel goes away, sometime further down the road, t'll cause *another* wave of bankruptcies in the oil business, smaller but even more fatal than the first wave. I'm not sure whether chemical feedstock or asphalt will become the "primary" product, but either way, the market will be miniscule. The trouble is, for chemicals, lubricants, and plastics you get better (more chemically consistent) product by starting with natgas, which is cheaper; and for asphalt, it's mainly used because it's cheap and if the price goes up enough, concrete (or preferably one of the new carbon-negative concretes) will take over.

 

[Bangor Bob]

Come to think of it, even jet fuel is subject to displacement by gas. Shell has a big GTL plant making jet fuel in Qatar.

The world's largest gas-to-liquids plant

 

[jhm]

In a sense, oil companies are a *leveraged* play on the oil prices, if you see what I mean.

This is exactly right. Quotation marks not needed. They are highly leveraged. So their equity is essentially a call option on oil, while their debt is a put option on oil. (That is they can put the low cost of oil on their lenders in the form of a default on loans.)

So once you see that oil company is a call option on oil, you see why they are willing to drill for more when volatility is up even if oil price expectations are low. This is also why if oil remains range bound oil companies lose value, even if they don't go bankrupt. For example, an ITM call option loses value as implied volatility declines.

The scary thing about this industry is that this option theoretic behavior can perpetuate a glut just as long as lenders are willing to enable it. Another issue is that there is a rational choice to drill for oil whenever that price of oil net of production cost is greater than the present value of oil reserves. So as oil reserves lose value (due to both increases in discount rates and declining price expectations), the industry becomes willing to drill at lower price levels. Both of these serve to perpetuate a glut and low prices.

 

[neroden]

OK, jhm, that's actually incredibly informative and I'm going to have to go and think about it for a while to figure it out. Thanks.

 

[jhm]

Saudis lower oil price to Asia most in 10 months in sign of glut

So this is also informative. Saudis are lowering their oil price for China by $1.10/b. Keep in mind that the Saudis have been intentionally expanding their supply through this whole glut with no signs of slowing. So lowering prices is just part of this strategy of taking market share. The problem is that Chinese refiners just can't keep up with all the cheap oil coming their way. So this is the more immediate cause of discount.

Players like Saudi Arabia, Iran and Russia are not going to back off. US and Canada oil producers will back off or go belly up trying. Other producers with national security will get shot up by thugs. But this glut is not simply a miscalculation of supply waiting for demand to catch up; it is a war.

Oil is down to $40.24/b.

 

[Erleichda]

With oil below $40 a barrel, I don't think war or other supply disruptions need to be engineered. Economic disruption and fear will affect decision making. Assuming US oil producers were aggressive hedgers at $50, the US should stay stable at current production for the next 12-18 months. That will put more pressure on high price dependent producers. Nigeria and Venezuela seem like the highest short term risks. Eventually some of these producers will go through political and financial restructuring and likely re-enter the market as smaller producers. Looking at geopolitical and financial risk by country, you can probably develop pretty good estimations of which producers will exit the market first.
I see general macro studies on the impact of lower oil prices, but didn't see any studies on a country by country risk matrix analysis. Long term price declines are likely going to have events that will drive prices backup in the short and medium term. Major producers or supplies will go offline and cause a short term bump up, like we had this spring. Having some predictive analysis of this process would help understand pricing floors and ceiling.

I guess we may be talking about different things, but I can't see big money oil players not trying for one last bump in prices for a few years. Drops in demand will finish them off as EVs takeover but not for 5 or 10 years (as have been debated here). So this next Presidential term offers the only hope to reduce the supply, and it can't be reduced by anything except major disruptions to production, right? So WHERE would you start that war? Russia, Syria, Iraq and Iran are about to be aligned. However they have 2 belligerent neighbors as the Saudi's will be cutoff geographically and from this union. Turkey is also somewhat stuck, wanting to protect their border but with a despot at the helm. Despite being duped into Iraq, the American people have shown they have very short term memory about these things. Easy to dupe them into another war I think, if the fears of terrorism are stoked. I just can't imagine these countries as a whole want peaceful production when the revenue is dying.

A cornered dying animal is not a pretty thing; I don't see anyone "exiting" the market quietly.

 

[neroden]

This is exactly right. Quotation marks not needed. They are highly leveraged. So their equity is essentially a call option on oil, while their debt is a put option on oil. (That is they can put the low cost of oil on their lenders in the form of a default on loans.)

OK, so it doesn't work quite like options. Chevron management is always in a bullish position on oil. Specifically, when Chevron issues debt they are doing something with economic similarity to *buying* an put option on oil (they're the ones who can default if they go bankrupt, so they have the option value) and the bondholders are *selling* a put option (they have potential downside and no upside). The interest is the equivalent of the premium. Chevron gets to hang onto the principal in the meantime, *and* can default on the interest, which is quite unlike the situation for a put seller; this makes it a worse deal in many ways for the bond buyer. Normally the bonds are like out-of-the-money (below-the-money) puts because they're issued when oil prices are high enough that the company is profitable; right now they're more like in-the-money (above-the-money) puts because oil is at a level where Chevron is unprofitable. Arguably unsecured corporate bonds on questionable companies are a very very risky thing to buy, with limited upside and large downside compared to stock -- especially since the bondholders are not reliably getting the liquidation value in bankruptcies these days. When Chevron issues stock, they are doing something economically similar to selling an out-of-the-money (above-the-money) call option on oil and the stockholders are buying one. I'm not sure looking at it like options actually makes things clearer...

Anyway, the point is, at current prices, Chevron can't service its debt. So the baseline is endless losses and liquidation. Management doesn't want to be out of a job, and wants to keep collecting bonuses. So the management takes risky gambles on a rising oil price, hoping to "win it big". Thus, they increase their payback *if* oil prices go up; they don't increase the probability of oil prices going up, but they think of themselves as increasing their expected return since the result if oil prices stay flat or go down is the same -- it's bankruptcy, and it can't get worse. That's the option-like structure of the incentives.

So once you see that oil company is a call option on oil, you see why they are willing to drill for more when volatility is up even if oil price expectations are low. This is also why if oil remains range bound oil companies lose value, even if they don't go bankrupt. For example, an ITM call option loses value as implied volatility declines.

The scary thing about this industry is that this option theoretic behavior can perpetuate a glut just as long as lenders are willing to enable it. Another issue is that there is a rational choice to drill for oil whenever that price of oil net of production cost is greater than the present value of oil reserves. So as oil reserves lose value (due to both increases in discount rates and declining price expectations), the industry becomes willing to drill at lower price levels.

OK, I'm still trying to figure this out, because this doesn't make sense to me. The thing is, there are multiple classes of reserves. Let's say we have
Good field reserves, production cost at $20/bbl
Bad field reserves, production cost at $70/bbl
As the oil price goes down below $70, the bad reserves are simply deleted from the list of reserves; they aren't considered reserves any more. I don't see how this increases willingness to drill. The rule should be that they drill when projected price of oil is greater than estimated production cost of a given field. I don't see what the present value of oil reserves has to do with it.

Both of these serve to perpetuate a glut and low prices.

 

[doggusfluffy]

Jamaica is paying its oil debts to Venezuela with food | VICE News

"Jamaica has been accumulating a debt with Venezuela since 2006, and it is perfectly legitimate to pay that debt with products" said Rolín Iguarán, an oil expert from the University of Zulia in Venezuela. "In this period of economic recession, Venezuela is returning to practices that were used in the 1940s."

 

[jhm]

Battery technology charges ahead | McKinsey & Company

Sometimes it's fun to look back a prospective studies from the past. McKinsey issued this in July 2012, well before the oil glut was in sight.

The chart above is particularly interesting. Likely McKinsey would draw this boundary lines a little differently today. Things like the cost and environmental impact of electricity, cycle life of batteries, energy and power density, and availability of charging infrastructure can all tilt these lines in favor of BEVs. Also removing non-battery costs of manufacturing EVs is critical too, as noted by McKinsey.

Nevertheless, this chart tells an important qualitative story. Specifically note that hybrids, both plug-in and traditional, gasoline prices to be above $3.50 to compete with both ICEVs and BEVs. BEVs can go the distance with ICEVs as both gasoline (consumer) and battery (producer) prices fall, but not hybrids. In 2011, HEVs were just starting to become competitive with oil, but as battery prices would fall from $500/kWh to under $200/kWh today, the tide would turn decisively against ICEVs. Tesla, I believe is within a year of going sub-$150/kWh (producer price), if not there already.

This chart has key strategy implications for automakers and oil producers. Firstly, the move of automakers into hybrids has exposed them to the risk of low oil prices. Surely there sales of ICEVs can benefit, but in a world of peaking oil demand there really is not much of a future for hybrids.

Second, oil producers with large reserves cannot afford to lose market share to hybrids. $3.50/gal becomes an upper bound on the competitive price of gasoline. Automakers are in position to scale up hybrids rapidly, but not EVs. Thus, lowering the price of gasoline is a near term effective strategy to maintain oil consumption.

Let's keep in mind that this study was done by McKinsey. The Kingdom of Saudi Arabia is also a client of McKinsey. The whole Vision 2030 was essentially constructed by McKinsey as a strategy to diversify the Kingdom's economy moving into a post-oil age. No doubt McKinsey and other advisor had the analysis in 2012 to craft a strategy shift for the Saudis. The move to defend market share even if it drives gasoline prices below $3.50 across the globe is a rational response to falling battery prices. Knocking hybrids out of the new car market would have preserved oil consumption for about 10 years to 2023 or so.

The Saudis have accelerated their drilling for the last four years, consistent with this strategy formulation in 2012. Perhaps this oil glut was no accident, but a well calibrated strategy from the likes of McKinsey and Co. Fortunately, Tesla has a well calibrated strategy too.

 

[tander]

My understanding was that Saudi Arabia's plan was to drive prices down to a point not tolerable by others, thereby driving them out of business. Presumably all those without staying power are gone now. So what's their plan now? Keeping prices low doesn't seem like a good one.