As Producers Get Out, You Should Get In: Why I’m Long XLE
Summary WTI crude in the mid-30s is close to the cash operating cost of many high-cost oil producers. As oil trades in the mid-30s, production will be shut in and supply will fall, in theory creating a floor in the price of oil. Continued low oil prices will likely create an underinvestment in oil production, and could create risk to the upside in future oil prices. Investors should consider buying XLE, as it will likely be able to weather the storm, and avoid XOP, as it contains much smaller producers that may not survive. Investors should avoid USO as it is subject to the decay associated with negative roll yield in WTI futures contracts. On December 15th, West Texas Intermediate Crude traded through $35 a barrel. This is close to the variable operating cash cost of many high-cost producers operating out of North America. At these prices, producers potentially stop pumping crude from their wells because it is more expensive to pull it out of the ground than the oil is worth. North American rig counts have already fallen precipitously; at these levels, they are likely set to fall even more. As rig counts fall, supply lessens from this area, and investment in future productive capacity also likely falls. This may set the oil market up for much higher prices in the future, repeating past energy cycles. Investors should consider buying the Energy Select Sector SPDR ETF (NYSEARCA: XLE ), which contains the larger players in the energy sector, to capitalize on this potential for higher oil prices in the future. Investors should avoid buying the SPDR S&P Oil and Gas Exploration and Production ETF (NYSEARCA: XOP ); however, as many of these producers are smaller and may not be able to ride out the storm. Investors should also avoid the United States Oil ETF (NYSEARCA: USO ), as contango will eat away at profits over time. Cash Operating Costs of the Marginal Shale Producer Below is a chart of the estimated cash operating cost of oil production for oil producers globally. “Cash cost” is the variable operating cost of pulling oil out of the ground. These figures are roughly a year old, but are probably still relevant. Note that Canadian oil sands, U.K. producers, and U.S. producers are on the upper end, within a $25-40 barrel cash cost range. As oil prices dip into these levels, independent producers will begin to shut-in production as it stops making economic sense to continue producing. This, in theory, should create a floor on the price of oil, as the price-determining marginal supply from these producers diminishes. Note that as the price dips as low as $30, almost 30% of producers are operating at levels that don’t make sense to continue. (click to enlarge) Source: Morgan Stanley and Business Insider Falling North American Rig Count Rig counts have fallen dramatically since last year as oil has collapsed and oil producers have cut back CAPEX in the face of a deteriorating credit market in the oil and gas sector. New rigs that would be too expensive to operate at low oil prices are not coming online, and old rigs being phased out are not getting replaced. Per Baker Hughes, North American rig counts have collapsed from a high of 2,300 rigs to 883 today, or a decline of 61% in one year. North American Rig Count through Time (click to enlarge) Source: Baker Hughes and Bloomberg Given that many producers have cash costs of oil in the $30-40 range, rig count is likely to decline further with oil breaching $35 a barrel, in my opinion. As rig count falls, the industry as a whole sets itself up for stronger oil in the future. The effect is twofold; supply of oil falls initially, stabilizing prices, but then the ensuing underinvestment in oil infrastructure creates a situation where oil prices could increase dramatically as underinvested producers are less able to quickly increase production in response to higher oil. We could see a repeat of the underinvestment of the late 1990s that led to the boom in oil prices in the mid-2000s. Buy XLE, Avoid XOP and USO Investors should consider XLE, as it contains very large producers such as Exxon Mobil (NYSE: XOM ), Chevron (NYSE: CVX ), and Schlumberger (NYSE: SLB ) that have the ability to weather the storm of lower oil prices for a long time. Investors should avoid XOP, as it contains a higher concentration of smaller capitalization companies that may not be able to survive mid-30s oil for a long time. I could imagine a situation where oil remains in the mid-30s, and XOP continues to tank, as smaller producers come under increasing financial pressure. See below for the breakdown of top holdings of XLE and XOP; note that some of the largest concentrations in XOP are in stocks with market caps of less than 4BN: Source: Bloomberg Investors should also avoid USO, as it is long oil futures contracts, and is therefore subject to the negative roll yields associated with contango. Oil contracts trade for future delivery at specified points in time. Currently, the market is in contango, meaning that contracts further into the future are more expensive than contracts expiring closer to the present. Contango in WTI Crude (click to enlarge) Source: Bloomberg USO owns short-dated contracts, and as those contracts expire, it sells them and buys contracts further into the future. With today’s prices, for example, USO would sell the Jan. 16 expiries at 37.11 and buy the Feb. 16 expiries at 38.27, creating a 37.11/38.27-1= -3.03% yield in just one month. A rough annualization of that yield means that USO is currently losing 36.4% annually! It is better to own the producers themselves who sell their production forward in the futures market than to own a fund exposed to the cost of maintaining a long position in futures, as the price performance between XLE and USO over the past five years has shown. Shorting $1 of USO and buying $1 of XLE, price performance over past five years, excluding dividends: Source: Bloomberg Conclusion Oil in the mid-30s is approaching the cash operating costs of many North American oil producers. As oil falls, they will shut in production, theoretically creating a floor in the price of oil in this range. Underinvestment in oil production in the future due to low oil prices today may also one day contribute to strong future oil prices. Investors looking to take advantage of this potential floor should look to buy XLE, as it contains some of the largest oil-producing companies in the world, and should be able to weather the supply glut in oil, and avoid XOP, as it has smaller producers that may not be able to survive lower oil. Investors should avoid USO as it is subject to negative roll yields associated with contango in WTI futures markets.