We Will See Oil Production Slow Down... Eventually

The industry is steadily holding its place around $50 a barrel, and analysts project that once the price reaches a certain number, drillers and frackers alike will be scrambling to get back on top of production. But we're all too familiar with the inaccuracies from analysts in the past, and investors need some insight on how true these statements are.

Also, we grab a letter from our mailbag as a loyal listener states his concerns for the well-known company Phillips 66 (PSX -0.66%), as news breaks that Warren Buffett has dropped a large amount of money into the company. Does he know something we don't?

A full transcript follows the video.

 

Sean O'Reilly: Donald Trump's autobiography has four Chapter 11s, on this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from Fool headquarters in Alexandria, Virginia. It is Thursday, September 17, 2015. Joining me are our energy authorities, Tyler Crowe and Taylor Muckerman. Guys, everybody enjoy the Notre Dame-UVA game over the weekend?

Taylor Muckerman: I saw the last minutes that mattered.

O'Reilly: Last minutes? OK.

Tyler Crowe: I've been watching a little more basketball lately; watching the international teams.

O'Reilly: European basketball?

Crowe: Actually, no. The South American or Pan American ones.

O'Reilly: What were you saying about Kobe Bryant's cousin playing?

Crowe: He plays for Venezuela.

O'Reilly: I'm speechless.

Crowe: It goes back to their dads playing in overseas places. It's pretty cool.

Muckerman: Your Notre Dame game, I take it?

O'Reilly: I was actually rooting for UVA.

Muckerman: Oh, yeah? Bummer. They had them until the last 10 minutes, or the last 10 seconds.

O'Reilly: It's a sad fact, but I had to be honest and be up front with who I was rooting for. First up, I wanted to discuss -- not oil price per se -- I wanted to be a bit more precise about what we're talking about. Oil production is starting to slow down and we wanted to talk about why it's actually going to slow down in a big way, but eventually.

There are lots of signs that oil production will slow down in the future. We just had a $2.1 million drop in oil inventories early this week that led to a surge in crude prices. What do you guys think?

Crowe: I don't want to say anything that's going to say, "It's going to happen in six months, it's going to happen a year from now." A lot of that...

O'Reilly: It's price dependent.

Crowe: It is price dependent and so much of that can happen at the whims of the market that we can't really give a lot of credence to. To give an example of this, if we look over the past couple of years, we've said the market has been oversupplied by 1 or 2 million barrels per day, and we've lost 50% of its price.

O'Reilly: It seems a little extreme.

Crowe: One million barrels is not even 5% oversupply of global market.

O'Reilly: It's 1.5%, or something.

Crowe: Yeah. Conversely, back in 2008 we were a couple million barrels undersupplied and prices shot up in the $120-$130 range. To look at that sensitivity of the oil price and say that due to the prices moving we'll see big production... It takes way more price movement than that actually to see it change for production. If we want to talk about some of the things that are actually going to cause a slowdown in production, almost completely price-independent, you have to look at some of the things that are going on a little bit further down the road.

We've got some slowing down of drilling permits and a whole bunch of other signs that a couple years from now we might actually see a short. We just don't know when that's going to happen.

O'Reilly: Maybe you can weigh in here, Taylor. What about this rumor that the second oil prices hit $60 again that all the shale drillers will turn it on again and bring rigs back and that will lead to oversupply again? Is that a fantasy?

Muckerman: I don't know what price level that would be -- $60 would make a little bit of sense for some of the best producers in the business.

O'Reilly: Correct me if I'm wrong, EOG said early next year they have all these fracked but not drilled.

Muckerman: Oh, they've got them drilled but not completed. The completion stage is generally the most expensive when you go in there and blast open the shale and start extracting the oil. Horizontal drilling has become pretty cheap comparatively. So they've got all these frack pads that are already seeing the drilling rigs going in there and doing their thing and now they just need to pump sand and hydraulic fluid in there.

O'Reilly: I think they're going to complete the wells at $65, or early next year.

Muckerman: That's very well the case, but if you look at EOG and they say $65, you have to imagine the higher-cost producers aren't going to be doing it at $65 per barrel. They'll probably be around $75 or $80. There are 10 banks that I looked -- mostly international banks -- and only one of the 10 that I saw, Standard Chartered, expects oil to be above $80 by the end of next year.

A lot of shale producers are still going to be priced out, but each level that you increase above there are producers that are just sitting there waiting. I think that's the problem with the overhang that's weighing on prices, at least in terms of people that say IEA predicts oil production down 400,000 barrels a day next year, and then Goldman Sachs said earlier this week...

O'Reilly: $20 might be possible!

Muckerman: $20 a barrel. They still expect a little bit of growth next year, but only 40,000 barrels a day of growth next year. If you find the medium between the two, we're still producing less next year than we produced this year. If demand maintains or grows a little, because we're arguably one of the few swing producers now, you could see oil prices creep back up.

A lot of projections out there don't expect it to get back to anything near what we saw last year, even through 2016. Of the 10 I looked at, JP Morgan was the lowest and they expect oil in the low $50s throughout next year. That's not much of an improvement.

O'Reilly: These banks' and economists' record of predicting oil prices is atrociously bad.

Muckerman: It's not great, but I think if you look at the overall -- which is why I looked at 10 and didn't just choose one or two -- there are plenty more out there. Like I said, these were mostly international banks that I looked at. The medium ground was there in the $55/$60/$65 range for all these banks. You don't want to take one in particular, but if you take them all, with a little bit of a grain of salt, you can kind of average them out.

I imagine someone will be close and as long as there's not too wide of divergence, I don't think the $55 to $80 a barrel is too wide a divergence because there are so many factors that contribute to this.

O'Reilly: The one sobering fact that I always keep in the back of my mind when we're talking about oil prices is the fact that it fell through the $80 floor and just plummeted last November what OPEC said they weren't going to cut. Last year all the banks were saying they could see $100 out to infinity. None of them saw this coming, and that's a sobering fact.

Muckerman: We're going to realize exactly what they think in the banks in the next month when they look at energy loans and start trimming credit lines based on lower oil prices.

O'Reilly: Money talks way more than projections.

Muckerman: I think you're really going to have to separate the wheat from the chaff next month when the bigger, more profitable, better balance-sheet-heavy energy companies still have those credit lines outstanding. Whereas some of the companies that are pushing their limits a little bit, some of the credit starts to dry out.

O'Reilly: Tyler, before we move on: There are basically no Mexico drilling rights being applied for right now.

Crowe: No. What we were just saying about slowing down production, and the price -- it's still a pretty short-term thing. We're talking 12 to 18 months. If somebody who's looking at the energy sector now as a five-to-10-year investment, it looks like...

O'Reilly: Which is what this Gulf of Mexico stuff is.

Crowe: Right. It looks like the seeds are starting to be planted for that sort of recovery over that five, 10 years where we're going to start to see a wane in supply again, which could bring back prices and incent a lot of people to give back into the market. Drilling permits in the state of Texas -- the Permian Basin, Eagle Ford -- a lot of the major shale places.

Muckerman: Some of the most productive in the industry.

Crowe: Some of the best in the U.S. The Permian is down two-thirds compared to this time last year.

O'Reilly: In permits being approved?

Crowe: Yeah.

Muckerman: Applied for.

O'Reilly: Applied for, I'm sorry. Yeah.

Crowe: You have the auction bids in the Gulf of Mexico that have been abnormally low.

O'Reilly: Like tumbleweeds going through there.

Crowe: The most recent actual auction was only $22 million, where two or three years ago...

O'Reilly: That was a rounding error.

Crowe: Yeah. We were looking at $300 million for auction blocks. This year alone, if we look at exploration production and capital spending, we've seen a global decrease of more than $200 billion in capital spending. When you have that much delayed, suspended, reconsidering for a later date, that's a lot of money, and that will eventually catch up to the market sometime. Probably within the next five to 10 years.

O'Reilly: Cool. Before we move on to our mailbag question of the day, I wanted to reiterate once again that a very special offer for our Motley Fool Stock Advisor newsletter is available to all listeners of Industry Focus. If you're a loyal IF listener you have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription to Stock Advisor. Just go to focus.fool.com to take advantage of that offer. Once again that is focus.fool.com.

Moving on to our mailbag question of the day, we had Aaron M. O'Malley. Thanks for writing in, Aaron. He wrote in...

Muckerman: A far distant relative of yours: O'Reilly, O'Malley.

O'Reilly: Of course. Actually we're mortal enemies. I'm just kidding. Come on, Aaron. I'll buy you a pint. He actually writes about a recent Buffett purchase: Phillips 66. He says: "I also wanted to ask if you could comment on the appeal of Phillips 66 at current prices given that it seems to have weathered the downturn in oil prices better than most, and also has attracted the interest of Berkshire Hathaway (BRK.A -0.28%) (BRK.B -0.68%), indicated by several recent large purchases of stock."

Buffett just threw a few billion dollars into Philips 66.

Muckerman: That's what he does. He just throws billions.

O'Reilly: He just throws billions of dollars at things. Correct me if I'm wrong, Tyler, but they're more of a midstream operator and do transportation, storage, refining for chemical companies.

Crowe: Yeah. A couple years ago in 2013, ConocoPhillips spun off its refining, marketing, logistics pipeline into Phillips 66. It took the integrated model and split it into two so ConocoPhillips could go off and do its own exploration production.

Muckerman: Upstream, and then they split off the mid- and downstream.

Crowe: Yeah. With Phillips 66 you have that play in the midstream pipeline where you're generating a lot of very stable cash flow and then a refiner which works on that opposite: As oil prices decline they get a better price on gasoline, or cheaper feedstock so when they go to sell gasoline they get a higher profit.

One of the reasons that it has weathered the downturn in oil more so is because it's built to do that.

Muckerman: I was going to caution against thinking about it as Aaron was. It didn't weather the downturn. Hopefully they're not comparing it to producers in terms of weathering.

O'Reilly: That was my next note here. The stock has been flat over the last year. It's at $70 and it's not actually down. It's just hanging out, making money, and refining things.

Muckerman: And paying a dividend. I don't know exactly what it is, but it does pay one.

O'Reilly: Is there a reason Buffett bought this over Conoco or any other?

Muckerman: That's a good question. In my mind, if you were going to buy into this heavily, you'd have to imagine that you think oil prices were going to remain low for at least some extended period of time. Maybe that's his thought process. Maybe he's buying into what these banks are doing, or maybe he knows something that a lot of us don't.

It seems odd to me to buy a refinery when owning oil is at a level that it has never been at. Not never, but in a very long time.

O'Reilly: Except in extenuating circumstances like global financial crises.

Muckerman: Even then, it wasn't that low for that long. It was a pretty quick bounce.

O'Reilly: It gave $37 a high-five and came back up.

Muckerman: Yeah. It was a pretty quick bounce then. It doesn't look like it's going to be that way now. I don't know. He knew something when he bought Burlington and then they started shipping oil all over the country with the rails. Maybe he knows something we don't. Personally, Buffett is obviously a great investor over the long term, but he's not somebody that I think an individual should really model themselves after.

O'Reilly: Right. The circumstances are different.

Muckerman: Buy and hold, sure. But the companies that he's buying, he's buying for reasons that you and I probably aren't going to want to buy for.

Crowe: You also have to keep in mind that he didn't just pick this up last quarter.

Muckerman: Right. He knows this company very well.

Crowe: He originally bought ConocoPhillips when it was an integrated company back in 2008. ConocoPhillips...

O'Reilly: Which turned out to be a boo-boo.

Crowe: Either way, ConocoPhillips and Phillips 66 have been part of the Berkshire Hathaway portfolio for almost eight years now. A few quarters ago, they did that exchange for stock for an all-out purchase of a segment of Phillips 66, which is called Lubrizol. Which is basically the marketing, distribution, and production of specialty lubricants.

He knows this business extremely well, it is a cash generator, and it has been for many, many years where it throws off cash and buys back a lot of shares, and pays a pretty decent dividend.

O'Reilly: It seems the Buffett angle that I thought when I read this question was that there seems to be very little downside.

Muckerman: It could be. Again, you look at a lot of the recent deals he's done and a lot of them have had tax implications that he's either traded shares and finagled, traded off a high-performing stock for one that he just used all shares to buy; he's saving money. He's automatically making a return off these deals before the stock even moves.

You have to understand what this deal means for them in the immediate term as well as the long term when you're talking about Warren Buffett. If I buy Phillips 66, it means nothing to me the next day. It could mean a heck of a lot to Warren Buffett when April 15 rolls around and the tax man comes knocking.

O'Reilly: Before we sign off, I wanted to go over one more. This is actually related to what we were just talking about with the refineries versus exploration and production. I wanted to ask a question of our energy experts here. Everybody keeps talking about how refineries are making tons of money today because oil prices are so low. That's, of course, the main input for refineries.

One would think, however, that refineries would function more like middlemen, earning a more or less "set spread" between crude oil and end products like gasoline. Why hasn't competition between refineries kept the profits being earned by these enterprises constant, thus passing on the savings to consumers of gasoline?

Who wants to go first?

Crowe: I'll take a shot at it.

O'Reilly: Why aren't my gas prices lower?

Crowe: One of the things you have to keep in mind with that relationship between crude oil and gasoline, or the refined products, is, generally speaking, the price for gasoline, diesel, and all the products that are refined have a tendency to lag the crude oil market. It more or less follows crude oil, but it lags it by a couple quarters, or a couple months.

O'Reilly: It's directionally accurate.

Crowe: Exactly. When you're in a time like this ,where you have oil prices falling very rapidly, it's going to take a little while for gasoline prices to catch up to the decline in oil prices. That amount of time where a company like a refiner benefits from the spread between the two is very lucrative.

O'Reilly: Why don't things happen immediately? Is it because of contracts, hedging?

Crowe: That's a great example. You have contracts where a refiner may take out some futures contacts on those refined products so they get a certain fixed price on those things going forward and that can cause a little bit of that lag. You also have to take into account that gasoline doesn't immediately go from the refiner to the gas pump. You have the delivery and logistics.

Something that has been sold at the refiner doesn't necessarily mean that you're selling at that instant price to the pump. The guy who's buying it at the gas pump, it may have been sold several months ago before it actually got there.

Conversely, say we were to have a rapid increase in oil prices. That lag in gasoline prices will impact refineries in the wrong direction and you could actually see margins for them compress.

O'Reilly: Got it. Anything to add?

Muckerman: You can export most anything the refiner produces. Whereas you can't export oil. From the United States, at least. Obviously, oil is an internationally priced commodity, but I think you're dealing with refiners being able to ship to the highest bidder.

O'Reilly: As I understand it, we have a bunch of refineries here in the United States.

Muckerman: We have a ton. We've got them all in the midcontinent, we've got some on the East Coast, California has a good selection, and then Canada has a bunch on the eastern side of Canada as well. They can export, so I think that plays a big role in refining prices. If you look at gasoline prices here versus gasoline prices in Europe, we're significantly cheaper.

O'Reilly: That lends itself to a fun little chart you've sent me earlier. The component of a gallon of gas. 47% of that was crude oil, which is great, but another one was the taxes.

Muckerman: Yeah, and that's set in stone. There's a floor that you're working with as well.

O'Reilly: Got it.

Crowe: Just going off Taylor, we were looking at it this morning and I remembered to pull it up. Over the past trailing four weeks, the United States on average has exported 3.7 million barrels per day of refined products. That gives you an idea of how much we're actually pushing out the door. That keeps gasoline a bit higher for the United States.

O'Reilly: Right. So it's the supply and demand and the fact that we're the world's refinery. Cool. Well, thanks for your thoughts, gentlemen. Have a good one.

Muckerman: You too.

O'Reilly: If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Tyler Crowe and Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening, and Fool on!