My TFSA Update July 2015 - Going All-In On Oil

Last update on Aug. 10, 2015.



“We need new production equal to a new Saudi Arabia every 3 to 4 years to maintain and grow supply” - Dr. Richard G. Miller, former BP geologist

In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. In addition, I’ll explain why I believe oil will surge to over $65/barrel by this year’s end.


July Results: Down 6.3%

At the end of July, I had $59,570 in my TFSA account, which is down by $4001 since the end of June. That means my portfolio went down by 6.3%. During the same month, Canadian stocks went down by 0.9% while U.S. stocks went up by 7.6% in terms of Canadian dollars, so I vastly underperformed the market in July.

In my last TFSA update, I explained that falling oil prices would probably hurt the performance of my portfolio in July. However, I was taken aback by the extent to which oil prices fell during the month. From June 30 to July 31, oil prices went from $59/bbl (bbl=barrel) to $47/bbl, the fastest drop on record since October 2008. Consequently, stocks of oil and gas companies also took a big tumble in July, almost regardless of their financial health and the quality of their assets.

While I considered oil prices to be very cheap before, today I consider them stupidly cheap. I am so completely convinced by this that I’ve made the decision to go practically all in on oil.

Although a large percentage of my TFSA portfolio consists of oil and gas stocks, the majority of my stocks are unrelated to oil and gas. Within the next couple of months, however, I plan on replacing most of my non-oil and gas related stocks with oil and gas related ones.

In addition, I’ve already taken the step of borrowing money to invest in oil directly (i.e. as a commodity). The only other time that I borrowed money to invest was in late 2008, in the midst of the financial crisis. Note that I’m using borrowed money outside of my TFSA, so you won’t see the effects of this investment in my monthly TFSA updates.

I don’t recommend anyone else do what I’m about to do. Borrowing money to invest is a dangerous game. Even though I’m convinced my bet will pay off, I’ve still only borrowed a modest amount such that failure won’t bankrupt me. Also, I don’t think most people have the risk tolerance to do what I’m about to do. We should know our emotional limits and stay onside.

As I bet on oil prices to rise in the next few months, I have a specific target in mind. I believe that by December 31 of this year, oil prices will end up above $60/bbl. The $60/bbl mark is important because if oil prices stay below this number for the first half of next year, some of my oil and gas stocks will suffer greatly. However, if oil prices stay above this number, I will reap a big reward. In fact, I can see my TFSA portfolio doubling by this time next year if I’m right.

For the rest of this article, I will explain why I believe oil prices will exceed $60/bbl by year end.


The Big Picture for Oil

First, let’s look at a few of the reasons some investors think the fair price of oil is below $50. If you ask them, most will cite the following three reasons:

  • They believe that that Iranian oil will flood the market.
  • They think North American shale producers will start pumping as soon as oil hits $60 or more, keeping the market well supplied.
  • The Chinese economy is slowing, so demand for oil will go down.

On the surface, these seem like legitimate reasons for the price of oil to stay low. But what’s remarkable to me is that these investors completely miss the big picture.

Let’s start with some basic facts. According to the International Energy Agency(IEA), the world is currently producing some 96 mmbbls/d (million barrels per day). What’s important to realize is that this production number doesn’t stay still. Unless you invest heavily in new wells and/or other production enhancements, oil production declines year after year.

How quickly the production declines depends on the types of wells. For conventional wells, the decline rate is around 5 to 7 percent per year. The vast majority of world production still comes from conventional wells, though its share is declining.

For unconventional wells, such as the ones drilled by shale oil companies in North America, the decline rates are much higher. In the first year, production from these wells declines by roughly 70%, and then moderates to 35% the next year, then to 25% the year after, etc. These wells typically never decline any slower than 8% per year.

If we apply a decline rate of 6% per year globally, that means world oil production currently declines at a rate of 6 mmbbls/d. In other words, in order to keep production flat, the world will need to invest enough so that we bring on an additional 6 mmbbls/d. The question is whether the world can do it.


Production Forecast by Region

To answer this question, let’s examine how the world managed not only to maintain production, but to increase it by another 1 mmbbls/d in the past. The set of oil production charts published in this link helps us see this more clearly.

As the last chart in the link shows, if you had taken the U.S. production out, production from the rest of the world would have increased only slightly, by perhaps 200,000 bbs/d in total from 2008 to 2014. In other words, most of the production increases over the last few years have come from drilling shale oil wells in the U.S.

Although production from U.S. shale oil increased compared to last year, that party is coming to an end. Because most shale oil companies are unprofitable at oil prices below $60/bbl, U.S. companies have cut drilling by more than half. This, combined with the extremely high decline rates, has led experts to believe that shale oil production will decline by as much as 800,000 bbls/d. Since it takes 6 months on average between the change in drilling activity to manifest itself in production changes, we’ve only just begun to see U.S. production decline.

That’s the story for the U.S., but how about the rest of the world? Can we expect production to remain steady as it has for the past few years? The answer appears to be ‘No’. To see this, let’s go through the major regions that produce oil.

Let’s start with Canada, which is one of the few countries that has increased production rapidly over the last few years. Canada’s increase in production came from two sources - shale oil and oil sands. Canadian shale oil is in the same boat as U.S. shale - unless prices improve, production will go down.

The other more important source of production increase is from the oil sands. Unlike shale oil, a typical oil sands operation costs billions of dollars and takes many years before it starts producing. As a result, we can expect those projects that are close to completion to finish, adding more production in the near future.

However, the future is bleaker for more long term projects. Most oil sands projects break even when the price of oil is at $70/bbl. To generate a healthy return, oil sands companies will have to feel confident that oil will fetch substantially above that price. It’s no surprise then that no less than 16 oil sands projects have been cancelled or delayed since the beginning of the oil crash. If Canada does add production, it’ll be at a far lower rate than in the past.

Next, let’s talk about Russia, which is one of the largest producers of oil in the world. Although Russian oil production has increased by over 500,000 bbls/d since 2008, experts believe that trend will be reversed this year. There are two reasons for this: sanctions and bureaucracy.

Because most of Russia’s oil wells are very old, they need sophisticated Western technology to maintain production. However, Russia no longer has access to such technology as a result of sanctions imposed on it in the wake of the Ukraine conflict.

But even with Western technology, experts believe that Russian production would decline anyway. All the major Russian oil and gas corporations are now controlled by their government, which has led to inefficiencies and lack of investments. Russia was able to increase production through privately operated ventures in the past, but such private ventures no longer exist. This is why one Russian oil executive claimed that Russian production could fall by 800,000 bbls/d in two years.

Next, let’s move on to Saudi Arabia. Since the beginning of the crash, Saudis have been able to increase oil production by almost 1 mmbbls/d to 10.6mmbbls/d. However, what many don’t realize is that this is pretty much all they can produce.

Even though Saudis have maintained that they can increase production to as high as 12.5mmbbls/d, most knowledgeable experts don’t believe they can. As Matt Simmons illustrates in his book Twilight in the Desert, Saudi oil production is not constrained by the number of wells they can drill, but rather by their access to water, the capacity of their facilities, pipelines, and so on.

Furthermore, there is much evidence to suggest that after multiple decades of production, their biggest oil fields are in decline. Although they can drive production from these old fields higher for a time, it will come at the cost of damaging their wells and reducing the total amount of oil they can recover through the wells’ lifetimes.

Therefore, I believe the Saudi decision to increase oil production is a short term tactical move to depress oil prices and to discourage investments in other oil projects, such as the oil sands. Already, the Saudis have begun signalling their intent to cut oil production by 300,000 bbls/d, and some such as billionaire T. Boone Pickens believe that the Saudis might even cut production further to boost prices in the fall.

In fact, the Saudis moves are very reminiscent of what happened from 1997 to 2000. In 1997, a lot of Asian countries ran into debt problems, which led to a slowdown in demand for oil. Instead of lowering or even maintaining their quotas, the Saudi-led OPEC decided to increase output quotas. Many investors took this as a sign of a price war against other other producers, and they drove oil prices down by over 50%. A year later, the Saudis cut production and oil prices tripled from 1998 to 2000.

There are striking similarities today to the situation in 1998. Today, another big Asian economy (i.e. China) is experiencing an economic slowdown. Today, as back then, oil production modestly outstripped demand. Today, as back then, most new oil projects don't make economic sense at the prevailing oil price. Will the Saudis pull the rug out from beneath the oil speculators again? We’ll see. But I won’t bet against it, given that Saudis need over $100/bbl oil to balance their budget.

Lastly, let me briefly comment on the state of oil production in the rest of the world, which produces a total of 60 mmbbl/d. At 6% decline rates, these countries would have to invest to produce a combined 3.6 mmbbls/d just to maintain production. However, it doesn’t make economic sense for most of these countries to invest in new production in today’s price environment.

Oil projects in the rest of the world take diverse shapes and sizes, but many of them are simply unprofitable at today’s oil price, and these projects will likely get cancelled or delayed. For example, for Arctic oil to be worth drilling, oil prices have to be at least $80/bbl. Offshore projects in Nigeria are said to require at least $70/bbl to break even.

The major exception to these rules are Iran and Iraq. Of these two countries, I believe Iraq is already producing as much as it can, given that it needs all the money it can get to fight ISIS, so increasing production would be tough. That leaves Iran, which many experts estimate can produce an additional 200,000 to 600,000 bbls/d next year. Even if Iran produces the upper range of this estimate, that leaves 3 mmbbls/d in new production that the rest of the world has to come up with.



To summarize, let’s do a rough estimate. If production from the U.S. declines by 500,000 bbls/d over the next year, and if Russian production declines by 400,000, Saudis stick to a decline of 300,000 bbls/d, Canada adds 100,000 bbls/d, and Iran adds 500,000bbls/d, that leads to a decline of 600,000 bbls/d in total. If the rest of the world declines by just 1%, that’s another 500,000 bbls/d of decline for a total decline of 1.1 mmbbls/d. I think that estimate is conservative.

In the meantime, because of low prices, some knowledgeable people estimate that the world demand for oil has gone up by 2 mmbbls/d this year (despite the slowdown in China), and they expect demand to keep going up next year. If it goes up by the same amount next year, the world will move towards a shortage to the amount of 3.1 mmbbls/d.

Oil storage in the U.S. has gone down every month from May until July, and I believe we’ll continue to see storage come down in August. This means that the world is close to a balance between oil supply and demand, if it hasn’t already entered into an era of shortage.

Even if we still have a mild overproduction in our hands today, I believe the world will have a shortage of some 1 mmbbls/d by the end of this year, and it will get worse. By comparison, at its peak, the world experienced a glut of some 2 mmbbls/d. I believe that a shortage of 1 mmbbls/d won’t go unnoticed by the speculators, who will drive prices up.

I also believe that when oil speculators finally realize there’s a shortage, they will also wake up to the rude fact the world can’t produce oil fast enough to keep up with the declines and increasing demand. Increasing oil production is like running uphill, whereas decreasing production is like running downhill. It’s much harder to do the former.

T. Boone Pickens, a self-made billionaire who made the bulk of his fortune trading oil and gas, recently stuck to his prediction that oil will reach $70/bbl by the end of this year. To show how confident he was about his prediction, he also added that if he’s wrong, it’ll be because the price of oil will be substantially higher, not lower. I believe he’s right, and I believe we’ll come back to this period and wonder - How in the world did we ever think that $50 a barrel for oil was sustainable?

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