Game Theory Starts to Weigh on OPEC’s Production Cuts

Last week, CSX Corporation (CSX -0.79%) fell 5% in one day when CEO Hunter Harrison announced not only his plans to leave the company but also some serious doubts about the company's future.

On this episode of Industry Focus: Energy, analysts Taylor Muckerman and Sean O'Reilly explain what has Harrison so disillusioned with CSX's prospects, and whether or not the rest of the railway sector should be worried, too.

Also, the hosts dive into what it means for OPEC that Saudi Arabia and Ecuador both failed to comply with their production cuts this month, what's behind a new six-week high in oil prices, and more.

A full transcript follows the video.

This video was recorded on July 20, 2017.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, July 20th, 2017, so we're talking about energy and industrials. I'm your host, Sean O'Reilly, and joining me in studio is a guy that I think we used to have on the show, Mr. Taylor Muckerman. Maybe you remember him. Morning, Taylor!

Taylor Muckerman: [singing] Way back machine.

O'Reilly: Yeah, right? I was like, where's Doctor Who, or whatever. Welcome back. You're looking tan, you're looking good. Looking happy.

Muckerman: It's summertime. I am, indeed.

O'Reilly: So, how was your time abroad?

Muckerman: It was good. Working remotely for a few weeks.

O'Reilly: Went to one of the benefits, of course. One of the benefits of working for The Fool is, little bit of flex schedule, work it out with your manager, go to Portugal for a month. [laughs] 

Muckerman: Yeah, I work from about 3 p.m. to 10 p.m. Made it happen.

O'Reilly: Is it the same as London?

Muckerman: Five hours, yeah.

O'Reilly: Is it six in the winter?

Muckerman: No, it's five. Then you cross over into Spain and you hit the six hour mark.

O'Reilly: Got it. OK, very good. We chatted the whole time on Slack and everything.

Muckerman: Slack, email, Skype, I even joined in on a podcast for Pro Canada from Portugal. It was kind of funny.

O'Reilly: Did you mentioned the fact that you were in Portugal?

Muckerman: No, no, no. We just let it fly. We had Ian Butler from Toronto on Skype, or on (unclear 1:24). And then, Jim Gillies from Toronto on (unclear 1:28). Myself from Portugal on (unclear 1:30), and Brian White, I think he was here in the studio, by himself.

O'Reilly: Can you confirm, Austin? Yay or nay?

Austin Morgan: I was not part of that.

Muckerman: Yeah, I think that was Ann Henry.

O'Reilly: I'm going to ask her later. Was Brian alone in a room? [laughs]

Muckerman: He might have been remote, too. I don't know. But, yeah, technology is changing the game. Even though IBM forced their entire workforce back into the office, we can still make things happen here.

O'Reilly: Whenever I see a company do that, actually wonder if they're just trying to find a reason why their business isn't doing great, and it's like, maybe it's your fault with the business.

Muckerman: Yeah, I think so, and they definitely lost some talent as a result, because people lived in cheaper places.

O'Reilly: Well, they built their lives around this.

Muckerman: Yeah, absolutely, and they were forced to now move to bigger cities. But, we digress.

O'Reilly: We do digress. Bringing it back to oil and energy and industrials. Really quick, you sent this over to me yesterday, I think I had seen it on the top of my Yahoo Finance news feed or something. Ecuador is pumping over their OPEC limit. That's not nice, of course. This comes after, I think this came out one or two days ago, but OPEC's compliance with cuts slumped this past month. 78% compliance, this is not great.

Muckerman: They're not playing nicely. That's more toward historical norms.

O'Reilly: Right. It was like they did this correctly for a couple of months, it was 95% compliance in May, and Algeria, Ecuador, Gabon, Iraq, UAE, Venezuela, they all started pumping, and that upset major compliance from Saudi Arabia, Kuwait, Qatar, and Angola.

Muckerman: Saudi Arabia failed to comply in June's, too.

O'Reilly: Oooh, awkward. "It was your idea, guys!"

Muckerman: Obviously, if the biggest producer fails, the smaller guys with much more reliant budgets on oil ...

O'Reilly: Hasn't Russia supposedly complied? Which, of course, begs the question, do we know? But, anyway. Definitely seems like we get something that pops up that derails this production cut plan every month. It's, "Oh, we have a field that does this, so we're going to produce more now," and all this stuff. And this of course brings us to the fundamental flaw of any cartel, which is, you have an incentive to cheat.

Muckerman: Yeah, when it's not signed in blood.

O'Reilly: You get in a room, you agree to something, you leave the room and tell your people to do the opposite. [laughs] 

Muckerman: Yeah, exactly. Especially when you would allow Libya and Nigeria, two members, to completely remove themselves from the production cap because of internal strife.

O'Reilly: Right. "We need the money." Everybody needs money.

Muckerman: They all need the money.

O'Reilly: Interesting, because the original agreement called for, Russia was in on it, and technically Russia isn't part of OPEC, but any time OPEC makes a decision they pretty much call Putin up. They produce 10 million barrels a day, right?

Muckerman: Yeah, right in line with Saudi Aramco, 10.5 million barrels per day.

O'Reilly: They're supposed to be doing this until March 2018.

Muckerman: They're supposed to be.

O'Reilly: It's only July 2017.

Muckerman: [laughs] Yeah, they realize it's not working.

O'Reilly: It's like they're cheating in the first quarter of the race.

Muckerman: I mean, technically they extended the cuts after they didn't work for a year.

O'Reilly: I definitely think they're expecting, the thought definitely crossed my mind, that when they cut, oil would immediately go to $60. I'm sure that's what they were hoping.

Muckerman: Fracking continued to happen.

O'Reilly: Yeah. Are we at the highest ever now? Have you seen that, U.S. production?

Muckerman: I think they're expecting to close the year around 9.6 million barrels a day.

O'Reilly: Yeah, that will be the highest.

Muckerman: And then up to 9.9 at the end of next year. Up from 8.5 last year.

O'Reilly: Yeah, and up from 4.5 10 years ago.

Muckerman: Yeah, and the rig counts more than doubled from a year ago. Still way shy, it's in the mid 900s now rigs on staff, and it was in the 1900s.

O'Reilly: Where are all these rigs? Are they just sitting in a field in Texas?

Muckerman: Some of them. Some of them are missing a few parts, because --

O'Reilly: I was about to say, I know they're missing a few parts.

Muckerman: -- they've been disrobed.

O'Reilly: Call up DistributionNOW, we need your parts.

Muckerman: Yeah, because rather than just taking a broken down machine and putting a new machine there, they just take parts as they need them from these "stacked" machines, rigs. So, we're still about 1,000 shy of the peak. 

O'Reilly: Where does that put us at? 600, 700, and it bottomed out at --

Muckerman: No, we're in the mid 9s, and I don't know what it bottomed out at, but a year ago, they were in the mid 4s.

O'Reilly: Yeah, that's what I thought. Anyway. Moving on to the railroad sector, this is a fun little story that you sent over to me the other day. CSX's shares, I didn't even notice this, so thank you for sending it, CSX's shares dropped 5% on Wednesday, July 18th after its quarterly conference call, but not because of the results. During the call, CEO Hunter Harrison said that he expected his tenure to be short. That in and of itself might be jarring. We can talk about it, but that might not be the whole reason the shares dropped. Also on the call, noted that 700 layoffs may be on the way.

Muckerman: Yeah. There's a few things on the call that I think caught --

O'Reilly: They're talking about shrinking fleet, cars, and coal pricing, and I was like ...

Muckerman: Yeah, they're not going to add any cars for coal, they're not going to add any extra lines for coal. And coal was CSX's lifeblood for many, many years, simply because of its route up and down the Appalachian Trail, essentially. So, that caught people off guard. They basically came out and said, "Fossil fuels are dead. Not in the immediate term, it's not going to be in two to three years, but it's going away in my view." It's a very long-term view.

O'Reilly: This is the guy that's supposedly going to be going in six months.

Muckerman: Yeah, I know. So, when you look at this company, a fifth of its second-quarter revenue came from coal, around $530 million. But if you look at the same quarter in 2011, they had $1 billion of coal revenue. So, the industry is struggling.

O'Reilly: Now, didn't coal pricing go up a little?

Muckerman: A little bit. We're still exporting coal. That's where most of the rising volumes for CSX came from. 8.2 million tons of exports, 11 million tons was the decline in U.S. deliveries.

O'Reilly: We might need to do another railroad show again. We did that one month ago.

Muckerman: Yeah, we talked a little bit about the Canadian rails, mostly, along with Buffett's interest in the railroad sector.

O'Reilly: And Buffett's railroad, Burlington Northern, we pulled out the results there and they earned less money last year than they did the previous year, and it's because of this oil stuff. They used to make a bunch of money bringing oil from The Dakotas down.

Muckerman: There was a couple years spike in that. It was a very short-lived boom for the railways that had access to it.

O'Reilly: I just have to wonder about these stocks long-term, because it's not even a ship you can turn, but it's a big ship to turn. It's like, OK, if fossil fuels are dead in 30 years, what are these railroads going to do?

Muckerman: If you look at oil as a percentage of overall revenue, it was kind of a blip, but it was a nice blip for the couple years that they had it, because it was unexpected.

O'Reilly: And the pricing was amazing.

Muckerman: Yeah, because oil companies had to pay up, because they needed that transportation, because pipelines are so far behind, which, they've caught up somewhat. And the downturn in oil prices prevented companies from being able to afford the higher price demanded by these rails. But, coal, I think, has a much bigger impact than the decline of oil by rail, on certain railroads. Not every railroad cares about coal. CSX is certainly one that has cared about coal more than most in the past. And now you see Hunter Harrison basically saying sayonara, it's gone in a few years. He did say that the last car load of coal that shipped out of this country, I want to be the carrier that ships it. So, a little heartfelt nod to the industry, but he's not going to be there when that last railcar likely ships, as he did say he's more of a placeholder CEO. He's really like a vagabond that jumps from train to train making his way across North America. He revolutionized to CN Rail, boosted his own personal stock as a rail line CEO, then he went to Canadian Pacific, then he was poached by CSX activist investors, jumped the ship to CSX after he had only recently joined Canadian Pacific. So much did CSX want him that they paid him the $84 million that he gave up by leaving CP.

O'Reilly: Wow. And he's going to peace out, and take his $84 million --

Muckerman: They didn't put a date on how long he's going to be there.

O'Reilly: That's so much money. That's LeBron money. [laughs] 

Muckerman: [laughs] Yeah, that's LeBron on court money. He's got some side hustles that might be worth a little more than $84 million. Apparently he has the fastest growing pizza chain in the United States.

O'Reilly: Oh, I didn't know that. All I know is, when I went to Beijing in 2008 or 2009, giant LeBron cardboard cutout in the McDonald's. Like, I can't escape this guy.

Muckerman: Well, Yao Ming retired, they had to replace him with somebody.

O'Reilly: Yeah, they did. But when you were talking about, he wants to ride the last one that leaves the country, have you seen Dr. Strangelove, the guy riding bomb? I'm picturing, do you want to ride this and wave your cowboy hat?

Muckerman: No, he doesn't want to personally be on it.

O'Reilly: Oh, OK.

Muckerman: He wants the last train of coal to be shipped on a rail to be on a CSX line. But, he says that now, but maybe he works for --

O'Reilly: 20 years from now? 30?

Muckerman: Norfolk Southern in 10 years, and then he wants the last trailer of coal to be on that rail line.

O'Reilly: They'll pay him in coal. Before we had out here, we have to mention a couple of inventory draws out of Cushing here in the United States.

Muckerman: Yeah, attuned listeners might have noticed the price of oil is at a six-week high.

O'Reilly: Yeah. Brent over there on the London Mercantile Exchange, yesterday it closed up of $0.86, 1.8% closing just below $50. Oh my gosh, we're almost at $50 again, Taylor! Yay!

Muckerman: Whoo-hoo, almost.

O'Reilly: U.S. crude is about $47, always trades at a little bit of a discount. But, that was because the EIA said that U.S. crude stocks fell 4.7 million barrels during the weekend of July 14th, this exceeded estimates of a draw of 3.2 million barrels. Also of note that I actually wanted to highlight was, if you include inventories of all petroleum stuff, particularly gasoline in this case, inventories fell by 10 million barrels for the week, which is fun. When we were talking about this before the show, you were like, oh, seasonality. But on the other hand, does that 3.2 million that was anticipated factor that in?

Muckerman: Probably a little bit, yeah. They play the trends. But they were also way wrong on inventory builds over the last couple months.

O'Reilly: To your point, every time I see these, I'm like, aren't they cute?

Muckerman: Yeah. They expected a draw off a handful of weeks ago, and it was up, inventory was up a couple hundred thousand, maybe a million barrels. So, it's just surprising. Inventory data seems to be the only thing really driving oil prices up or down, because they're pretty stayed when it comes to the window that they've been trading in, in the $40s.

O'Reilly: Right. And again, no matter what happens with oil,if it goes to $20 because of electric cars in five years or if it goes back to $70 or $80, no matter what, my opinion on U.S. traders focusing on U.S. inventory data, it's ridiculous. We have the only good data, and that's why they do it, but we're 15% of the global market.

Muckerman: We have the best data. It's not good data, it's the best data.

O'Reilly: We have the best data on a sixth. So, who cares? You know?

Muckerman: They're happy. They're starting the second half of the year off on an upward trend after the energy commodities part of Goldman Sachs' commodity index was the worst performer of the first half. Down 11% in the first half of 2017. That includes gasoline, natural gas, gas oil, heating oil, crude oil, WTI and Brent, all of them in the negative.

O'Reilly: This was the worst-performing sector --

Muckerman: The worst performing sector of the Standard & Poor's Goldman Sachs Commodity Index, GSCI. You look at Lean Hogs, though.

O'Reilly: Pork bellies! Buy pork bellies! [laughs] 

Muckerman: Lean Hogs up over 40% in the first half.

O'Reilly: I'm going home tonight and watching Trading Places tonight, thank you.

Muckerman: Lean Hogs, followed by Chicago Wheat, Kansas Wheat, it must be the index or the commodities floor that they're talking about, because I don't know if Chicago grows much wheat unless it's on rooftops. And the Feeder Cattle --

O'Reilly: How's coffee doing? I always wanted to buy a coffee future.

Muckerman: It's down about 10% in the first half, right there in between natural gas and gasoline.

O'Reilly: I'm going to buy the dip on coffee, because long-term.

Muckerman: I mean, the way we just plowed through that nitro cold brew keg in a day, 24 hours. Had a happy hour to celebrate Founders Day on Monday --

O'Reilly: I think Dylan Lewis from Tech show had about half of that.

Muckerman: The keg of cold brew was gone. Some folks don't know, you're not supposed to drink an entire cup of cold brew, it's a little stronger than average.

O'Reilly: I did notice that Dylan's hand was shaking a little bit. But he's still alive.

Muckerman: I'll have to go back and listen to that show.

O'Reilly: Do you want to? Yeah, let's do that after. So, before we head out, anything cool you're watching?

Muckerman: One quick note, not many people are putting sugar in their coffee, because the price of sugar down a little over 30%. Over 30%. Just one thing. Cool thing that I'm watching? In the sector or on TV?

O'Reilly: The sector. We already talked about Portugal.

Muckerman: I told you before the show, I've made it a goal of mine to hone in on some of the renewable sectors of energy so that this show can provide a better future for our listeners.

What about you?

O'Reilly: I just... Uh.

Muckerman: What do you mean, "uh?" 

O'Reilly: So much hamming it up, talking about pork over there. [laughs] 

Muckerman: [laughs] Oh, hamming it up. You got it, buddy. Making bacon.

O'Reilly: Well, we missed you, and it was an absolute pleasure chatting.

Muckerman: Yeah, it was good to talk about pork after coming from a country that thrives on cured meats.

O'Reilly: Boom. Yeah, did you just survive on charcuterie boards over there?

Muckerman: Yeah, we had a massive prosciutto leg that we could just slice off meat for breakfast.

O'Reilly: [laughs] You bought it at the airport and ate it for a month? Duty free?

Muckerman: You could legit eat it for a month. And when we left, we lathered it up in olive oil and wrapped it in a towel and put it in the fridge.

O'Reilly: Oh, wow. Cool. Very nice. You should bring some to the office.

Muckerman: I wish I could have, but the darn airlines won't let you take pork.

O'Reilly: Oh, they took your cheese?

Muckerman: They let you bring cheese, but you can't bring pork back, you can't bring fruit or pork.

O'Reilly: Unbelievable.

Muckerman: But you can bring cheese. I didn't, though, because some of the best Portuguese cheese is fairly smelly.

O'Reilly: Got it. On that note, that's it for us, folks. Be sure to tune in tomorrow for the Technology show with Dylan Lewis. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [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 these stocks, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening and Fool on!