The bubble in oil...

The bubble in oil... Why Big Oil is hemorrhaging money... Small, highly leveraged oil firms are in big trouble... An upcoming opportunity you won't want to miss...

Lower oil prices are nothing new.

They're all over the news. Many Stansberry Research analysts have covered it extensively, including us here in the Digest. And we hope we've shown you some insights... and the headwinds the sector still faces.

Today, we'd like to share another important story... Something we doubt you've seen elsewhere. The numbers will surprise you. We hope you'll consider them carefully. It might be the most important message yet.

Now, for some facts...

As regular readers know, oil and gas production in the U.S. has soared over the past five years. The U.S. is now firmly one of the leading oil producers. Despite the glut – and lower oil prices – we're producing the most oil in more than 40 years.

We never bought into the theory of "Peak Oil" – the nonsensical claim that many oil and gas pundits touted that the world was running out of energy. We knew that dwindling production levels would lead to massive new investment... that human ingenuity would develop innovative technology... and that production would bounce back.

Sure enough, almost on cue, new drilling techniques (including fracking and horizontal drilling) appeared.

Throw in cheap money and high oil prices and you have yourself a boom...

But now it's a bubble.

Over the past 10 years, oil prices have taken a roundtrip.

Since 2005, oil prices have gone from around $40 a barrel to more than $140 a barrel in 2008. Then, in late 2008, they crashed to $35 a barrel. They returned to around $75 a barrel by the end of 2009, rose to more than $110 in 2011, and have since fallen back to $40 a barrel today. For the most part, between 2010 and 2014, oil changed hands for more than $80 per barrel.

Between 2010 and 2014, five of the world's biggest oil companies (ExxonMobil, Chevron, BP, Shell, and Total) accumulated a staggering $8 trillion in sales – roughly the equivalent of Germany and Japan's combined economic output last year.

Most folks would assume these companies were "minting" cash during this time. But they weren't...

For some, higher oil prices forever seemed like a sure thing. Many companies made huge capital outlays during this period... and borrowed heavily to do it. Despite soaring production and higher oil prices, these companies have been outspending their cash earnings for years.

After taking into account all of their cash outlays (such as capital expenditures, dividends, share buybacks, and acquiring companies and assets), these five Big Oil companies ran massive cash deficits every single year for the past decade.

Between 2010 and 2014 alone, their accumulated cash deficits mount up to an unbelievable $177 billion.

One thing is clear: This trend cannot last.

Oil prices aren't rebounding like they did in 2009. And we don't expect they will.

Dropping $177 billion in cash over five years isn't sustainable, no matter how deep these companies' pockets are.

And with oil sitting around $41 per barrel today, lower oil prices mean lower cash flows.

Based on first-half earnings, estimates put operating cash profits for these five companies down 25% by year-end, compared with 2014. They will have to cut capital projects much further.

So far, the majors have cut capital expenditures just 4%. But when you aren't covering your capital costs, sooner or later, something has to give.

Now, just to be clear, we aren't calling for bankruptcies in Big Oil. After all, these companies carry more than $1.4 trillion in total assets (more than $100 billion of which is in cash). Their combined debt-to-asset ratio sits at around 16%. While that's up from the minuscule 6% it was back in 2005, it still means these companies aren't even close to being overleveraged.

But we can't say the same for the entire sector. The debt-fueled boom is about to end poorly for some...

As Porter and the Stansberry's Investment Advisory research team pointed out in this month's issue, cheap money from the Fed found its way into the hands of smaller oil and gas companies, too. As we explained...

The first, and the largest, bubble is the enormous amount of capital that has flowed into the oil and gas business. As we've written before, $5 trillion has been spent on oil and exploration globally over the past decade – a figure that's three or four times higher than any amount of money spent over any decade previously. In the U.S., a large amount of this capital spending was financed with junk bonds and issued to small, Texas-based oil and gas firms.

In our Global Oil Value Monitor, we've looked at the last 10 years of data across 70 companies. And the outlook for these smaller, highly leveraged firms is atrocious.

Like Big Oil, these firms also ran huge cash deficits every single year over the past 10 years. Since the production boom started in 2010, they have tallied an enormous $205 billion in cash deficits.

Their debt-to-asset ratios have climbed from 19% back in 2005 to 32% today. That is double the amount of the oil majors. Some will argue that 32% isn't an alarming figure. But here's what they're missing...

In addition to expanding their debt obligations, these same companies also issued more stock... and lots of it. Since 2004, they issued $35 billion in new equity. By comparison, the majors bought back $334 billion in stock.

These 70 companies hold just $26 billion in cash, compared with the five majors holding $107 billion... Yet these same companies ran a $68 billion deficit last year and are on pace to rack up another $40 billion to $50 billion this year.

As we said earlier, lower oil prices mean lower cash flows. These businesses have a cash problem. They've issued $3 billion in new shares in 2015 alone to help raise cash. Cutting costs is already underway. Capital expenditures are down 34% versus last year.

Meanwhile, the losses are mounting...

As we told readers in this week's Stansberry Data Global Oil Value Monitor, the oil and gas companies we track have lost more than $60 billion in the first half of 2015. We expect even more losses later this year...

The average market caps of the companies in our Monitor have fallen another 10% over the last month. And the recently reported second-quarter results were dismal. To date, 91 of the 100 companies in our Monitor have reported second-quarter results. On average, revenue is down 26% from a year ago. Last quarter, the revenue decline over last year was 21%. Almost 90% of the companies reported revenue decreases. The story for earnings is even worse... On average, the companies on our Monitor lost $2.73 per share compared with a net profit of $0.20 per share for the same period last year. Last quarter, the average loss was $1.88 per share. Things are getting worse, not better.

As we explained, most of these accounting losses are the result of non-cash impairment charges that result when inflated balance sheets have to be written down to reflect today's lower oil prices. Accounting rules make companies estimate the value of their proved reserves using historical prices. Lower prices for longer will mean massive write-downs of their reserves and more impairment charges across the sector.

As you can see from the following chart, impairments for the companies on our Monitor are already much higher than the last oil crash in 2008...

Many people in the mainstream press think we're nearing a bottom. But based on criteria from renowned commodity investor Rick Rule, we think things will get worse before they get better.

As we explained in the Global Oil Value Monitor, Rule looks for bottoms in resource markets by tracking gross margins – which is the revenue a company earns from selling a commodity minus all the costs to produce it...

When the industry's median production cost exceeds the commodity's selling price – in other words, when it costs companies more to produce that commodity than the commodity is worth on the market – that industry is in liquidation... There are two potential outcomes at that point... either the price has to rise, or that commodity will no longer be for sale on the market. That is a strong sign that you're approaching or have arrived at the bottom of a cycle.

As you'll see in the chart below, gross margins tend to follow oil prices. They are down from more than 40% just a year ago, and they're headed lower...

Notice the latest decline in oil prices on the right side of the previous chart. We can expect gross margins to fall next quarter if prices stay around today's levels (or fall even lower). This means more large write-downs are coming.

The rules are changing...

And the wipeouts will be much larger than anyone expects. We haven't seen the bottom yet.

We're starting to see cracks in the bond markets. Dozens of these companies are showing distress signs. More than $12 billion has disappeared off the face value of the bonds on 25 of the most-distressed companies we follow. Many trade at double-digit discounts to par. But they are going to fall much further...

If oil continues to fall to less than $30, or even stays around $40 for an extended period of time, these bonds will trade for pennies on the dollar. That's when investors who understand the business – and can withstand the volatility – will step in and begin to buy. They'll make a fortune. And you can, too...

Right now, you should be building a watch list of the best oil stocks. Identify the ones with the best assets and strongest balance sheets – companies with good cash flow and relatively low operating costs and debt. The companies that will survive are the ones with plenty of cash to run their businesses and service their debts.

Yes, their share prices will suffer from lower oil prices. But their businesses won't be in danger of shuttering. And they will prosper over the long term as they buy up valuable oil assets as other companies go under or sell their assets at massive discounts just to stay afloat.

Fortunately for Stansberry's Investment Advisory subscribers who also receive our supplemental Stansberry Data service, these are the exact companies we follow in detail every month in our Global Oil Value Monitor.

We created our Monitor to take advantage of opportunities just like this. We track the entire capital structure of every company we monitor, including the equity and the debt in real time. We want to find the best companies with the best assets, trading at bargain-basement prices, when no one else is buying. We'll have to wait a little longer for a true bottom. But you can rest assured we'll be ready when it comes.

Right now, you can get the details on a special risk-free offer to read Stansberry Data. If you're already a Stansberry's Investment Advisory subscriber, you can extend your current subscription at no additional cost to what you're currently paying. Learn more here.

We're ending today's Digest with a quick note from Steve Sjuggerud...

If you've been to one of Stansberry Research's conferences in the last year or two, you know we do things the right way.

Last year, our conferences introduced hundreds of attendees at a time to an abundance of fascinating ideas. We featured appearances from WikiLeaks founder Julian Assange... Tesla co-founder J.B. Straubel... oil tycoon T. Boone Pickens... and many more.

And the event we have coming up in October should be even better. We've assembled an incredible group of some of the world's greatest minds, including former congressman Dr. Ron Paul, who will discuss why he's predicting a global stock-market disaster.

Attendees will also hear from visionaries like Mick Ebeling, whose EyeWriter invention allows paralyzed people to communicate by moving their eyes. We'll also hear from Josh Foer, who won the U.S.A. Memory Championship in 2005... and Penn Jillette (of the famed Penn & Teller duo).

Of course, as always, you'll have the chance to hear from and speak with me and many of my colleagues, including Porter, Dave Eifrig, Matt Badiali, and Dan Ferris, among others. For more details on how to join us for this fantastic opportunity, click here.

New 52-week highs (as of 8/20/15): Short position in iShares MSCI Canada Index Fund (EWC) and short position in Viacom (VIAB).

In the mailbag, a subscriber has a question about "junk" silver. Send us your questions, comments, and criticisms to feedback@stansberryreseach.com. We can't offer individual advice, but we read every e-mail.

"I thought the main reason to own junk silver, was to be able to use it (in small denominations) to barter for goods and services during a monetary crisis. Will 100 oz bars accomplish the objective? Would owning Silver Eagles also accomplish the same objective?" – Paid-up subscriber JPK

Brill comment: As we mentioned yesterday, junk silver has historically been much cheaper than any other form of physical silver. But it's popular for other reasons, too...

Like you said, it's easily divisible and can be used in small amounts, unlike larger bars. It's well-known and recognized by investors and non-investors alike. It's also "liquid" – meaning there has always been demand for these coins, so it's relatively easy to buy and sell.

But these things are true of one-ounce American Silver Eagle coins as well. And these coins are currently cheaper per ounce of silver than junk silver is today. As we mentioned yesterday, most dealers are offering Silver Eagles for 15%-20% over the spot price of silver, compared with 25%-35% premiums for junk. If "divisibility" is a priority, consider those instead.

Regards,

Brett Aitken and Justin Brill
Baltimore, Maryland
August 21, 2015