Why I'm Staying Away From Chevron, A View From An Oil Newbie

Summary

• Oil prices have fallen since late 2014 and many investors have purchased E&P dividend aristocrats.
• Following conventional wisdom without understanding the underlying reasons can lose a lot of money.
• Did further research to understand why oil prices might stay low for a while.

Like many people, I subscribed to conventional wisdom that oil is a finite resource so prices are bound to go up in the long run. Many investors use this reasoning to buy "dividend aristocrats" in the oil sector with the belief that those companies are bulletproof. However, I've been in the stock market long enough to know that following the herd and relying on conventional wisdom can lose a lot of money. This past experience plus the volatility of oil prices motivated me to research the oil industry more in depth. This post is scoped to the exploration and production (E&P) area and is far from comprehensive. It is intended to help newbies understand the oil industry better and it would also be for my benefit if experienced oil experts would chime in on the soundness of my reasoning / assumptions.

Here are my research steps:

1. Watched online Coursera lectures on the Energy Sector
2. Read research paper, "Oil: The Next Revolution" by Harvard Professor, Leonardo Maugeri
3. Did a lot of Googling on acronyms and other questions
4. Reviewed benchmarks like EIA.GOV and the Baker Hughes Rig Count

Background. This section is for newbies. Experienced oil subject matter experts might want to jump ahead to the "Oil: The Next Revolution" section.

• The Coursera videos were extremely helpful in introducing the basics of oil formation and putting supply and demand volume into perspective.
• The diagram above shows the different layers of rock and where conventional oil, shale oil, conventional gas, and shale gas appear.
• I didn't do a deep dive into the physical properties of carbon, hydrogen, etc.
• My simple mental framework is oil and gas are trapped in the sandstone layer of rock. Over millions of years, the earth's heat and pressure cause the shale oil and gas to seep up through tiny pores until they form reservoirs in a much more dense layer of rock.
• These reservoirs are what we know as conventional oil and gas (see diagram above)
• On the other hand, shale oil and gas are extracted from much lower depths.
• Below is a YouTube video that is extremely helpful in understanding the fracking process. It's by a company that's interested in projecting a favorable environmental message. I have no idea how environmentally safe fracking is so everyone can make up their own minds.

• Note to newbies. Oil has many different flavors determined by the amount of impurities present i.e. sulfur. This is why there are different names like West Texas Intermediate (NYSE:WTI), Brent, Light Louisiana Sweet, etc.
• This has huge economic implications for refineries as it takes different types of equipment to refine the different grades of oil.

Oil: The Next Revolution" by Harvard Professor, Leonardo Maugeri

• I was lucky to have stumbled upon this paper. It was written in 2012, is 74 pages, is very information dense, and the glossary alone saved me so much time. There are 2 full pages of acronyms related to the oil industry.
• The paper's credibility is also boosted because it accurately predicted the drop and timing of oil prices 3 years ago. The author developed a proprietary database of oil projects around the world and draws a number of conclusions.
  • Oil is NOT in short supply.
  • Shale oil is a game changer and it is not temporary. He describes it as "the most important revolution in the oil sector in decades"
  • Conventional oil production also grows throughout the world
  • He believes that long term demand forecasts tend to be overestimated because people underestimate technological advancement i.e. more fuel efficient cars
  • Technological advancement also helps on the supply side too. Producers become more efficient and lower their E&P costs.

• Here are some numbers:

• According to U.S. Energy Information Administration, "As of early 2015, the IEA forecast average demand for the year of more than 93 million barrels of oil and liquid fuels per day worldwide...with January 2015 production totalling just over 94 million barrels per day."
• Maugeri projects that by 2020, the net additional production capacity by 2020 could be 17.6 mbd, yielding a world oil production capacity of 110.6 mbd by that date"

Understanding Maugeri's Arguments

• Recovery Rates. A common misconception is that conventional oil is fully recovered from oil reservoirs. According to Maugeri's paper, worldwide recovery rates are less than 35% with countries like Russia, Iran, Venezuela, Kuwait at less than 20% and most major oil producing nations at less than 25%. There is a lot of room for improvement in conventional oil production.
• Recovery rates are impacted by factors like technology, geology, management's efficiency, investment, etc. There are major oil companies in countries that aren't incentivized to run efficiently so the companies remain underinvested and poorly operated. Corruption is another issue that impacts investment and management.
• Reserve growth. Technology for surveying techniques improve as well.
• The paper uses Kern River Field, CA, as an example of the potential magnitude of both recovery rate improvement and reserve growth.
  • It was discovered in 1899 with a 10% recovery estimate
  • In 1942, it was estimated to have 54 million barrels of oil reserves
  • By 2007, 2 billion barrels of oil had been recovered with 627 million barrels of estimated reserves remaining

• U.S. Shale Oil is not temporary. According to Wikipedia, two large oil reserves in North America, the Bakken formation and Eagle Ford formation have 3 to 4 billion barrels of oil reserves each. Like Kern River Field, it's possible estimates will go up much higher.
• As a frame of reference the U.S. consumes ~19 million barrels of oil per day.
• Factors that might undermine his oil production projections include geopolitical, regulatory, logistical, and environmental risks. Once you get the oil out of the ground, then you have to transport it, refine it, deal with all of the regulatory hassles, etc.
• On the other hand, he doesn't talk much about shale oil potential in other parts of the world other than to say they are behind the U.S.

Fast Forward to Today

• For me, the most rational floor for oil prices is the marginal cost of production. Marginal cost per project varies all over the place depending on geology, managerial competence, technology used, etc., but I haven't seen a better method for guessing a floor.
• The most recent article I could find about marginal cost was in Forbes.We can see that Professor Maugeri has the lowest estimate in February 2015, "Overall, 80% of Bakken oil now has a break-even point below $42."
• A November 2014 study by IHS "shows that most of the potential U.S. tight oil capacity additions in 2015 (about 80 percent) have a break-even price in the range of $50 to $69 per barrel." This is for WTI.
• From the EIA July 2015 Energy Outlook, EIA forecasts that Brent crude oil prices will average $60/b in 2015 and $67/b in 2016. Forecast West Texas Intermediate crude oil prices in both 2015 and 2016 average $5/b less than the Brent price."

Conclusions

• I realize I took a mental shortcut by basing a lot of my opinion on one person. However, I found his reasoning to be sound.
• Critics of Professor Maugeri say that his forecasts are extremely subjective and he admits it himself. Even though he has a comprehensive database of oil projects around the world, he still needs to guess the production of each project.
• No one knows where oil prices are going, but what you can see is when there are huge imbalances between barrels produced and barrels consumed like late 2014 and early 2015.
• I believe if there was another spike in oil prices it's most likely going to come from a supply side event.
• I'm guessing the demand side isn't going to have a huge move as I'm not optimistic about the U.S., Chinese, or European economies.
• I don't find stocks like Chevron (NYSE:CVX) or Exxon (NYSE:XOM) attractive because it feels like there's more risk than reward at current prices. Large percentages of their revenue come from the E&P space.
• On the flip side, my research has made me more open to studying the airline industry.
• My question to oil experts is "How do you get an edge on the market when buying oil stocks?"
• Let me know your thoughts in the comments below. Cheers.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.