In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. In addition, I’ll review some data that seems to suggest that we're about to enter an era of oil shortages, if we haven't already.
October Results: Up 9.6%
At the end of October, I had $48,042 in my TFSA account, which is up by $4,220 since the end of September. By comparison, the Canadian stock market went up by 3.9% while U.S. stocks went up by 7.2% in terms of Canadian dollars. Therefore, my portfolio beat the broader stock market in October.
Since the majority of my portfolio now consists of oil and gas stocks, it's no surprise that those stocks were responsible for my portfolio’s performance in October. Oil and gas stocks rose considerably even though oil itself went up by only 2.3% (to $46.59/barrel) in October. Indeed, it was not the price of oil but another event that caused oil stocks to surge last month.
On October 5th, Suncor made a hostile bid to acquire Canadian Oil Sands (COS). A hostile bid is an offer from one company (the 'acquirer') to buy another company ('target company'), without the blessing of the board of directors of the target company. In the offer, Suncor offered to swap every four COS stocks with one Suncor stock. In dollar terms, that translated to about $8.6 per COS stock, which is about 40% above the price at which COS was trading the day before the offer was made.
Although the ultimate decision of whether to sell the company lies with the target company's shareholders, the opinion of the target's board of directors matters in a takeover bid because companies often have "takeover defences". Such defences can significantly delay the takeover process or make it very expensive for the acquirer to complete the purchase. The target company's board of directors can voluntarily take down such defences, but in the case of COS, the board has been actively fighting Suncor's offer.
There's a simple reason that the COS board doesn't like the offer - it's too cheap. Even though Suncor offered to buy each COS share at 40% premium (i.e. $8.6/share) to its previous trading price, that price is still roughly half the price COS was trading at a year ago. The COS board knows that if oil prices go up significantly from here, their shares will go much higher than $8.6/share. Being veterans of the oil industry, they believe that oil prices won't stay at these levels for long.
On the other hand, it's easy to see why Suncor made the offer it did. Its board also believes that oil prices will go up significantly from here, which means that COS's true or potential value is much higher than even what Suncor offered to buy the company for. Of course, Suncor’s directors won't voice their opinion in public, since doing so will drive the price of COS higher. In fact, they'll do everything they can to paint a gloomy picture of the oil industry in order to entice COS shareholders to vote for a sale. But make no mistake - Suncor doesn't really believe that they're being generous with their offer.
Suncor's hostile bid had consequences beyond just Suncor and COS. It had a broader impact on oil and gas stocks, as investors tried to guess who could be the subject of another takeover offer. Several stocks that were viewed as potential targets saw their share prices go up significantly as a result, and that helped my portfolio last month.
Data on Oil Overproduction
While oil giants maintain their belief that oil prices will go up much higher in the future, oil prices have so far stayed at very low levels because many speculators haven't yet come to share that belief. For example, Citigroup's analysts believe that oil could still go as low as $32/barrel. Goldman Sachs, not to be outdone, predicted that oil could go as low as $20/barrel.
Speculators believe oil will go lower because they believe that there is a massive oil "glut" - i.e. the world is producing much more oil than it consumes. Four months ago, I argued against this case and said that the world was only slightly overproducing oil. The world has changed since then, so let me give you an update on the state of the oil market as I see it.
As famed oil trader Andrew Hall points out, investment banks tend to base their analyses on the International Energy Agency (IEA)'s oil supply and demand reports. The latest IEA report projected that in the period between July and September of 2015, oil production outstripped demand by roughly 1.6 million barrels/day. Investment banks argue that if this is indeed the case and if the situation continues, the world could run out of storage space for oil in about four or five months. Such an event would plunge oil prices to whatever price that's needed to shut in some of the current operating wells, which could be as low as $20/barrel.
However, the agency's reports often contradict third party analyses, and even their own inventory data. Indeed, if you look at the overproduction implied by inventory level changes, a different story emerges.
According to the IEA, the total inventory levels of oil and oil related products (i.e. gasoline, diesel, etc.) in the OECD went up by 100 million barrels in the four-month period between April and August 2015. This implies a total overproduction of just 800,000 barrels per day. Moreover, the implied overproduction has been going down.
In August 2015, oil inventories went up by 29 million barrels. While this may seem like a big inventory build, oil inventories normally go up during this month by 15 million barrels because of seasonal factors. Therefore, oil inventories went up by roughly 14 million barrels more than usual during the month, which implies an overproduction of less than 500,000 barrels per day.
Let me put the August overproduction number into context. The IEA reports that global production during the month stood at around 96.6 million barrels per day. If the world is indeed only overproducing 500,000 barrels per day, that means the world is overproducing by only 0.5% of its capacity. It's also worth noting that oil production around the world fluctuates by hundreds of thousands of barrels per day because of random factors like the timing of maintenance and weather issues.
Critics of this approach will say that IEA's inventory changes neglect to mention inventory builds elsewhere, especially in China. China has been accumulating oil to build up its own Strategic Petroleum Reserve (SPR), which is oil stored for use during emergencies such as a war.
However, there were indications that the Chinese SPR was nearly full even as early as March of this year. China may have built more SPR storage capacity since then, but it is unlikely they were able to build, in less than a year, enough storage space to make a huge difference to the implied overproduction.
Additionally, the gap between supply and demand of oil will have almost certainly narrowed since August. In September, the U.S. alone reported a drop of roughy 170,000 barrels/day worth of oil production. Given that oil companies have been drilling very few wells, U.S. production almost certainly dropped in October as well, and will continue to drop in November.
Production from OPEC countries, on the other hand, did register a small increase of 100,000 barrels/day in September, and was virtually unchanged in October (Reuters says production decreased, Bloomberg says it increased). Note that there's virtually no difference between OPEC's production in July and its estimated production in October.
Turning to non-U.S. non-OPEC countries, while we don't have access to good quality data, the data we do see points to flat production rates at best. Russian production only increased by 30,000 barrels in September, and 40,000 barrels in October, whereas Canadian production has been flat. October Canadian production, while higher than September production, is estimated to be lower than it was in the beginning of this year.
Since the combined oil production outside of OPEC, U.S., Russia and Canada have gone down in recent years, it's a safe bet to say that those production levels have continued to slide over the past few months as well. According to JODI data, the combined production rates of China, Brazil, Mexico, Norway and the U.K. went down by over 100,000 barrels/day between December 2014 and August 2015 of this year, and those declines are about to accelerate as project delays and cancellations finally affect production.
If we add up all the trends in oil production, we can't escape the conclusion: oil production has been going down. Even if oil production has gone down by just 100,000 barrels/day globally in September and October, the extent of overproduction would have been reduced by 200,000 barrels/day from supply reductions alone. But of course, we also have to account for demand increases.
According to the IEA, oil demand is expected to grow by 1.8 million barrels/day in 2015. Note that the IEA has a habit of revising its estimates to show higher figures, so demand growth could end up even higher. But even if we were to assume that the 1.8 million barrels a day is an accurate prediction, that implies demand growth of around 150,000 barrels/day each month. If demand kept up this pace in September and October, that would mean the extent of global overproduction would be reduced by another 300,000 barrels/day.
Together, between supply decreases and demand increases, I believe that the world has gone from overproducing roughly 500,000 barrels/day in August, to producing roughly the amount it needs today. In fact, we could even have a small shortage on our hands.
Other oil market veterans confirm this view. For example, Mike Rothman of Cornerstone Analytics has claimed that the world will enter into a shortage starting around this time. Andrew Hall has projected that oil inventories will fall starting in November, which essentially confirms the same view. PIRA energy group is only slightly more pessimistic, and thinks inventories will go down meaningfully in December instead. Furthermore, such projections are supported by what we've been seeing lately in U.S. oil inventories.
During September, total U.S. oil and oil products inventories, excluding ethanol and propane, went up by just 9 million barrels. This implies an inventory build of 300,000 barrels/day. Over the past four weeks in October, ending on the 30th, inventories actually went down by 3.3 million barrels, implying a shortage of roughly 100,000 barrels/day. Note that I've excluded ethanol because it's not derived from oil, and I've excluded propane as that's a byproduct of natural gas.
Now, obviously the U.S. is not the world, and it's quite possible that inventories are building in other places around the world. Furthermore, inventory numbers tend to jump randomly from week to week, so we may need to reserve final judgment until more time has passed. However, on the surface, the evidence is quite encouraging, and the U.S. data makes it more likely than not that we're entering into a period of shortage today.
As things currently stand, I don't think there's any way that we can escape going into a bigger and bigger oil shortage in the coming months. Oil companies have been delaying or cancelling big oil projects for over a year now. Those delays and cancellations will play a bigger role starting in 2016.
Furthermore, low oil prices have begun to cause some real dissent around the world. For example, Brazilian workers have gone on strike over Petrobras' proposed sale of its oil assets. The strike is estimated to cut Petrobras' oil production by some 270,000 barrels/day. I don't think anyone can rule out similar dissent in other parts of the world, such as in Venezuela.
As if that's not enough, winter weather is expected to disrupt shipping of oil in the coming months, effectively limiting supply to oil consuming nations. Inclement weather has already shut down a Russian port, and Iraqi production has a history of being disrupted because of winter weather.
In the meantime, oil production in the U.S. will continue to go down in the coming months regardless of prices, and demand will continue to go up because it always has.
U.S. Production Myths
Finally, let me talk about some wrong ideas people have regarding U.S. oil production. Some people think that oil prices won't go any higher than, say, $60/barrel because when it reaches that point, U.S. producers will ramp up production.
First of all, producing oil is not like turning on a faucet - it takes time to license, drill, and tie in production. While U.S. "frackers" can indeed produce oil much more quickly than more traditional producers, it will still take them many months to go from deciding to produce oil to actually producing oil. I've heard somewhere that the whole process typically takes around 9 months.
Secondly, not all frackers are the same. A few producers can indeed make a profit at $60/barrel, but the vast majority won't. For the vast majority, oil prices need to be $80 or higher to make it worthwhile for them to drill. Therefore, we will see only a small uptick in drilling if oil stays at $60, and this uptick probably won't be enough to increase overall U.S. production.
I believe that when the world recognizes that there's an oil shortage, prices will go up to at least the price that's necessary to support big oil projects, such as deep water drilling and the oil sands. I will deal with this subject in another article, but I believe that a typical big project requires at least $75/barrel. This is why I personally expect oil to go up to at least that level by fall of next year.