The Real Reason Oil Prices Are Going to Bust Again Before They Boom

Editor's note: "The cure for low prices is low prices," our friend and resource mogul Rick Rule often says.

That's the situation we're seeing play out in the oil markets today.

To learn more about it, today's Masters Series essay – adapted and edited for clarity from the third episode of Porter's Stansberry Investor Hour radio show – continues a conversation between Porter and oil-industry titans Cactus Schroeder and Flavious Smith.

In it, they discuss the oil industry's cyclical nature... why the financial bubble has created a commodity glut... and the concept of the "hoodoo"...

The Real Reason Oil Prices Are Going to Bust Again Before They Boom
An interview with Porter Stansberry, Cactus Shroeder, and Flavious Smith

Porter Stansberry: My friend Rick Rule has a wonderful saying: "In commodities, you're either a contrarian or a victim." And I don't know why, but that idea has really appealed to me philosophically and intellectually.

Back in 2006 and 2007, everyone was talking about "Peak Oil"... You had natural gas above $10... And you had the natural gas-to-oil ratio so completely out of whack. Every investment conference I went to, I could just watch billions in capital being allocated to this commodity market.

I knew that this boom was not going to end differently than any other commodity boom. So I'm like the one guy at the conference saying, "Yeah, it's probably not a good idea to buy uranium after it's run up 400%. And it's probably not a good idea to buy oil when oil's over $100 a barrel." Just common sense. But of course, you know the emotions of people... When there's big discoveries, everyone thinks they're going to get rich. No one realizes that there's big discoveries in the next county, too, and those people think they're going to get rich as well.

So what I'm trying to do by hiring Flavious and starting a new newsletter called Commodity Supercycles is to try to teach people that what they want to be ready for is the bottom in oil, not the top.

We're very interested in watching production come up, watching storage come up, and watching prices go down because we're interested in finding that point where we know that producing oil is no longer economic. And we're interested in knowing what the unemployment rate is in the oil patch.

Because if you start buying oil properties when unemployment's at about 50% in the oil business, you're going to do a hell of a lot better than if you're trying to buy oil properties when there's no unemployment as there probably basically is now in the oil business.

Cactus, I know you're in the industry and know more about the cycles than just about anybody. But why do you think the industry itself has such a hard time understanding this concept? Because it's not just investors who fall for these booms and busts. It's the oilmen, too.

Cactus Schroeder: Yeah, sometimes they'll think there'll never be another poor day. You saw these bumper stickers back in the late 1980s that said, "Please, dear God, give us one more boom and we promise not to piss it off."

Flavious Smith: I think I've got one of those.

Cactus: I've seen that same bumper sticker go through a couple of cycles already. So I think it's human nature. They get carried away in the moment. Whether it's somebody in the oil and gas business or whether it's somebody at the peak of selling buggy whips in the 1800s, they don't look around the corner to see the next thing coming. So you've seen it in several different industries, not just the oil and gas industry. But that's always been business.

That's why it's so interesting to look at companies that have survived for so many centuries – whether it's Hershey's chocolate or Beretta shotguns. They've been around through so many generations and they continue to have a demand. They keep up with the technology and everybody's going to want a piece of chocolate no matter how old they get.

So anyway, I think that's part of it in the oil and gas industry. Also, if you look across the oil and gas industry, you'll see probably 95% optimists and 5% pessimists. They're always thinking the glass of water is half-full. It's not just common to the oil industry. But it's more prevalent in the oil and gas industry.

Flavious: Cactus, one of the things that we're not very good at in the oil business is we don't do what's in our best interest. This is a really complex bottom we're going through. It's one of the oddest bottoms I've seen in a long time.

The biggest problem we're going to have is we're probably going to overproduce again. We're going to continue to drill these wells at $50 per barrel, thinking that we're going to make money. We're going to throw a lot more production out there at these low prices. Then sooner or later, as Porter says, we're going to go back to $30. And it's going to make another bottom, and we're going to see a lot more companies go broke.

Cactus: Yeah. I think that's one way to look at it. The other thing you have to look at is people that are producing a lot of high-priced oil. If you look at the North Sea... if you look at Canada... even if you look at the Bakken Shale... they don't have infrastructure. They've got to wrestle with cold weather and bad conditions.

Eventually, that oil price is going to register a fallout in these higher-priced production areas. What is that price going to be? How low does it have to get before they shut down all the mining of oil in Canada or before the North Sea just says, "Hey, we're done... We're folding up our tent and we're out of here"?

Flavious: We were up in the Bakken with Forestar. We were on the reservation up by EOG's stuff. It was $56 per barrel for our breakeven costs. If you're not getting $56, you can't drill a well.

Cactus: Exactly.

Porter: Let's talk about that for a second. Because on the financial side, I think I can explain some of this behavior. One of the things that's happened with the Fed policies around the world is the tremendous amount of liquidity that's been pushed into financial markets.

And everyone's desperate for yield in any form. Even in something as crazy as a securitized auto-loan security where 30% or more of the loans are subprime and you know for a fact that the underwriting was fraudulent. I mean, why people are buying these securities makes no sense until you understand that's the only way they can get the yield that they need to make their insurance contract good. They don't have any choice, either.

There's this dearth of yield out there. One of the ways people are getting yield is the futures markets. There is so much capital, so much liquidity's being pushed into all corners of the market that that's holding up the forward curve.

It's pretty funny... We're beating Saudi Arabia because of our financial markets as much as our drilling prowess. It's that futures price that's allowing people to still drill profitably. And I can't tell you when that's going to collapse, but sooner or later, it will. Sooner or later, people are just not going to keep losing that bet.

But it's a very interesting phenomenon that this is how a financial bubble can produce a commodity glut. Same way with all the funding that went into the oil business in 2010, 2011, and 2012.

OK, I've got one more question for both of you... I'm a firm believer in the idea of a "hoodoo." There are guys out there that everything they touch seems to turn to gold. And then there are guys out there that everything they touch eventually turns to s**t. Those are the hoodoos. You could learn to make money with both.

Now, I will tell you that the hoodoos are a lot more fun to be around. But you don't want to invest with them. Growing up, I met my first hoodoo. I don't want to say his name because he's a dear friend. But this guy went bankrupt four times. And he went bankrupt in the same way four times. He was a developer and he would do a big warehouse deal or he'd do a big apartment deal. Then he'd roll all the money he made into a bigger deal. So he would just "pyramid."

Well, if you pyramid and you never put any money aside, it's only a matter of time until you go broke. It's like people say all the time, "I drive a motorcycle. It's not risky. There's only a 1% chance I'm going to get in an accident."

Yeah, there's a 1% chance each time. So if you keep driving a motorcycle until you wreck, you will. Some people don't really understand statistics, but that's how it works. This is the case with this developer.

I would always know when it was time to get out of real estate because all I had to do was see that he was being really successful. When he bought a big house, when he bought a big plane, when he bought a big whatever, I knew, "Oh, time to get out." It never failed. So Cactus, I know you must know some hoodoos in Texas. And Flavious, I know you must know some hoodoos all over the oil business. Where are your hoodoos today? Are they celebrating or are they hurting?

Cactus: Well, I think these low oil prices weeded out a lot of hoodoos. You don't see very many. But the one thing that's a statistic – and I nearly got caught up in it myself – that I think can tell you when it's starting to top... when you start seeing private-airplane sales go up in Texas in the oil and gas areas. I think you need to start getting really careful then.

Porter: Yeah, that's a good way to lose a lot of money. By the way, I refer to my fishing boat as my estate-planning process. If all the money goes into the boat, you don't have to worry about paying taxes on it. What about you, Flavious? Any hoodoo stories?

Flavious: I really don't want to say it out loud to people because a lot of those guys are still my friends. But they've all gone broke.

Porter: Yeah, they're fun to have around.

Flavious: But I agree with Cactus on the airplane thing. The airplane market's been flooded for the last two years. My son is involved in the aviation business and he tells me you can buy a Learjet 31, the most efficient jet that exists, for sometimes a little more than $1 million. That's a $5 million airplane. So the airplane business has really changed. I'm with you on that. When people start buying corporate jets, you start to worry about what their future's going to be.

Editor's note: We're approaching what could be the last "supercycle" in oil you'll ever see. Porter and Flavious believe that oil prices could ultimately reach $500 or more per barrel... which has the potential to send certain investments up 1,000% or more. Nobody in the business has more connections and industry knowledge than Flavious. And for a limited time, you can access our premium resource research for nearly TWO-THIRDS OFF the regular retail price. Learn more here.