The Oil Bust - How Bad Will It Be?

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 07/08/2013

October 4, 2006

"I don’t think you’ll have the same pressure in energy markets that you had six months ago. We’ve got plenty of oil around." – Boone Pickens, Texas oilman and founder of Mesa Petroleum

I’ve been bearish on oil for months.

It was a lonely position to take. Saying anything bad about the oil industry is downright un-American… especially when Republicans are in the White House.

But I’ve seen many investment manias and this one had all of the trimmings. For the last year, I’ve felt like a teenager watching a horror film. I knew all of the plot elements by heart, and I knew exactly how the movie would end – everyone was gonna get cut to pieces.

First and foremost, the soaring price of natural gas and oil was caused almost entirely by financial speculation. Every 20-something who could use a computer to solve a differential equation was pouring money (other people’s money) into energy assets. Hedge Fund Research counts 68 hedge funds dedicated to energy… up from 14 in 2000. Doug Leggate, of Citigroup, says speculative financial positions account for more than half of the energy future contracts traded on the Nymex, up from 25% in 2000. In the last three years, the number of crude oil futures contracts and options contracts grew from 600,000 to 2 million.

After the speculators lit the fire… Wall Street fanned the flames and cooked up their investment-banking fees: There have been $350 billion in energy-sector mergers and acquisitions announced this year – up 50% from last year. Two jumbo deals seemed to mark the top: the $22 billion management-led buyout of Kinder Morgan and Anadarko’s "double or nothing" acquisition of Kerr-McGee and Western Gas.

Every big investment mania needs a financial guru and an idea guru. In the oil business, there is no shortage of interesting financial characters. This is the sector of 10-gallon hats and lizard-skin boots. But there is one man who out-Texans them all: Boone Pickens. What a name. What a reputation. And what enormous profits. In 1999, Boone was "busted" – a divorce had wiped him out. He was down to his last few millions. But he had a plan: He decided to keep pyramiding his grubstake, along with some partners’ money in natural-gas futures. Soon he was a billionaire – several times over. His commodities pool was up 700% last year, making ol’ Boone the highest paid hedge-fund manager in the world in 2005. Investors who gave Boone money in 1999 have made more than 28 times their money. Boone told BusinessWeek that he made more money in the last five years as a trader than he did in the 50 years he worked as an oil producer. (Talk about a financial bubble!) In fact, Boone made more money than any energy trader in the world. Curiously, the No. 2 energy trader, according to Trader Monthly, was 32-year-old Brian Hunter, until his now notorious Amaranth hedge fund collapsed.

The idea guru of this mania is dead – Marion King Hubbert died in 1989. Hubbert became the most famous Malthusian philosopher since Malthus himself. His theory was breathtakingly simple: Because oil is a finite resource and every well’s production reaches a peak at some point and then begins to decline, the world must be reaching a point of peak production. Hubbert got out a slide rule, did a few calculations, and predicted that world oil production would peak around the year 2000.

After this point – "Hubbert’s Peak" – there would be less oil available each year… until finally the world would be out of oil. It’s a great theory – simple, elegant, logical… but it’s wrong.

First, Hubbert’s assumptions about the life of each oil well were wrong. New technologies can "resurrect" old fields, dramatically increasing production in places Hubbert thought were "out of oil." And second, geologist have found oil in many places Hubbert didn’t know we could explore, such as deep oceans and very deep land-based wells. (One more thing about Hubbert I find truly intriguing: He was a technocrat, which was a movement of scientists and economists who wanted to do away with the price system and replace it with an economy driven by "energy credits." Apparently, free-market economics simply isn’t predictable enough for geologists… )

If we were on the verge of running out of oil, wouldn’t you expect to see a decline in the number of rotary rigs operating onshore in the United States? After all, the oil fields in Oklahoma and Texas are some of the oldest in the world. Hubbert believed that oil production in the U.S. peaked in the early 1970s. He thought we’d be out of oil by now in America. And yet, when you look at the Baker Hughes domestic rotary rig counts, you see that every time the price of oil goes up a bit, the number of rigs soars. And capital spending (to build more rigs) continues at the major U.S. drilling companies, like Patterson-UTI. Just one example: In 2000 Patterson owned 152 drilling rigs, 140 of which were in "ready to work" condition. By 2006, Patterson owned a total of 403 land-based rigs. That’s an increase of 165%.

And it’s not just Patterson. Since oil prices bottomed in 1998, the total number of working rotary rigs onshore in the United States has increased from 625 to over 1,600 – an increase of 160%.

But the best, surefire sign of a top in energy prices: collapsing hedge funds.

In 2001, Enron gamed the market, causing natural-gas prices to soar even faster and farther than they did in the 1970s oil embargo. But, by the end of 2001, Enron was bust and so were natural-gas prices. To give you an idea of the scope of Enron’s impact on the market, the number of domestic rigs increased by 85% in response to the Enron-inspired price hikes.

In 2005, an even larger wave of speculation propelled prices even higher. The "Amaranth spike" saw rig counts increase by 96%.

With the oil mania over, I think oil is going below $40 a barrel. I think it’ll stay down there for at least 12-18 months.

It’s a funny thing about commodities. The higher the price goes, the more supply gets discovered. They go boom. Then everybody gets killed. Just like a horror movie. Maybe that’s what those technocrats were trying to avoid…

Good investing,

Porter Stansberry

P.S. Soaring energy prices have launched some downright stupid investment ideas. My personal favorite: importing liquefied natural gas from the Middle East into the Sabine Pass, Louisiana. Keep in mind, to ship natural gas, you have to cool it to negative 260 degrees. And don’t forget that the U.S. has the world’s second largest reserves of natural gas. Why would we import it here? It doesn’t make any sense… but that didn’t stop investors from putting up nearly $1 billion for Cheniere Energy (AMEX: LNG) to build a huge LNG terminal. One more thing: The previous four U.S. LNG terminals (built in the 1970s and early 1980s) all went bankrupt following a decline in natural gas prices. I recommended shorting Cheniere in my Investment Advisory (June 2006). We’re up substantially on the position already… but I think the stock will go to zero, which means it’s not to late to establish a position.