Russia, Saudi Oilfield Mismanagement Will Bring Back $100 Oil

Today, Russian President Vladimir Putin pledged to cooperate with Saudi Arabia’s proposal to reduce oil production in an effort to boost oil prices. Bruce Pile says that Russia and Saudi Arabia may not have as much control over oil production as it appears. His analysis indicates that after years of Russian and Saudi mismanagement of their giant oilfields, production could fall enough to push oil back over $100/bbl within a reasonable time horizon for investors.

Bruce started his Marketocracy fund in January, 2001 and has outperformed the S&P 500 for more than 15 years now. Year-to-date, Bruce’s portfolio is up 24.60% which compares nicely to the S&P 500 which is up 7.84% over the same period. Before taking anyone’s investment advice, you should always check out their track record. Here’s Bruce’s.

Ken Kam:  What mismanagement have Russia and the Saudis committed?

Bruce Pile: Before you can understand the enormity of the problem, you must know what they have messed up. In a word, it’s geology. A conventional reservoir has an oil/water interface where pressurized water forces the oil up through the wells. Once the water migrates past this interface, as happens with faster rates of production, the drive mechanism for the reservoir is reduced. Oil gets stranded and can only be recovered by secondary methods at much lower rates and higher costs. Some water encroachment happens no matter what the recovery method over the life of the field, but geologists know just the right production rates to keep the drive at the optimal level through the field’s life.

But then we had geopolitical mayhem take over the oil fields. Saudi Arabia was the big swing producer (the Fed of oil) and, most of all, a four decade cold war was oil financed, and then we had an oil price war in the 1980s and 1990s between these two mega-players. It was a political soap opera, but suffice it to say that Russian centric geopoliticians began running the elephant oil fields of the earth. And they were not good geologists.

Kam: So over-production is the problem? How bad was it?

Pile: No one can say just how much over-production and damage was done, and the secretive governments involved have never volunteered this information, if they know it. The Wikipedia account for “Oil Reserves in Saudi Arabia” mentions Matt Simmons and his criticism of field management and noted:

Simmons also argued that the Saudis may have irretrievably damaged their large oil fields by over-pumping salt water into the fields in an effort to maintain the fields’ pressure and boost short-term oil extraction

As for Russia, I again refer you to the opinion of Matthew Simmons. He was an oil investment banker in the industry since 1973, was an oil advisor to the president and a member of the Council On Foreign Relations. He went through a mountain of SPE papers (Society of Petroleum Engineers) to write Twilight In The Desert in 2005. There was massive damage according to Simmons. He had this to say:

The oligarchs who own and operate most of Russia’s oilfields are aggressively tapping into the myriad pockets of bypassed oil … This performance demonstrates the steps that can be taken to boost production after a field has been reduced to pockets of bypassed oil that water sweeps leave behind. These practices have accounted for most of Russia’s surprising production rebound … all oil fields have their rate sensitivities. Ignoring this concept and over-producing jeopardizes future production. – Twilight In The Desert, Matthew Simmons, p.307

It was bad enough to cause military concern per this article in Air University Review in 1980. Way back then, he sounded just like Simmons, only talking about Soviet fields and predicting a production collapse by the mid 1980s, which happened. He pointed out:

serious overproduction” where “rewards for exceeding goals are given without regard to productivity over the long term … the consequences are … overproduction of existing fields using low productivity techniques that reduce the total amount of recoverable oil. – NATO and Oil, Air University Review, Jan/Feb, 1980, Major Chris Jefferies

Then after the cold war, we had a price war. As I mentioned in this article, the decisive weapon deployed against Russia in the cold war was the Saudis’ big production ramp and price war starting in the mid 1980s. There are those that claim this was in blatant partnership with Reagan, as this piece in the Telegraph details, with the main witness being none other than Michael Reagan, the president’s son.

The following graph depicts the general effect of over-production:

We’re not “running out” as you hear. But what is all important to the price of oil is the rate of recovery, not how much is recovered. Over-production hurts this badly post-peak.

Kam: The investing implications seem to be going long energy and short everything else!

Pile: Well, I don’t think you should short everything based on oil. The thing is, there is a lot of high cost oil out there yet to be drawn into the market by high prices. We found that out when oil was at $100 and climbing in 2012, which drew out a flash of American shale. The U.S. shale experience is not easily replicated globally. But it will be replicated! I don’t think the wave of oil bankruptcies is done, and oil stocks will go lower, but we are going toward a global secondary recovery cost norm based on bypassed oil, shale and other “dreg” oil. This gives a good opportunity in some companies, and we’ll look at a good one toward the end of this piece. Geologists call it dreg oil because of its high cost, low net energy, and rapid depletion. It’s expensive but there is a lot of it. So the real question is the price these companies need to give us a steady supply. Some expert analysis is needed here.

Arthur Berman is a consultant to several oil companies and provides guidance to capital formation and is an energy contributor at Forbes. He recently wrote an article on shale stating, “these plays cannot survive on anything other than sustained $100, $90, $95 oil prices and that is the bottom line.” Oil at $200 means demand destruction and belated switch-over to natural gas. I see oil modulated at Berman’s $100 for a while.

Kam: Is Russia’s production really so important to the future price of oil?

Pile: The simple fact is that global crude oil has peaked and come off the plateau except for two players – the U.S. and Russia. If you take either or both of these props away, we have a badly declining global crude curve.

On a global curve, you have a mild over-production bulge in the 1970s (see below) from a historic surge in the principal use of oil – the American driver. This amounted to over a doubling of miles driven from 1962 to 1977. Then a dramatic improvement in gas mileage and other oil uses cooled demand. Overall, what was soundly produced and consumed followed market forces pretty closely.

So how did the dynamic duo of field mismanagement, Russia and Saudi Arabia, respond to all this?

To these production curves, I have added in green the shape of the typical Hubbert curve for these countries.  The deviation from typical field management was severe and went on for decades.

Kam: The Hubbert curves shown above don’t show a peak in Russia and Saudi Arabia until clear out to about 2035. Won’t they keep the world adequately supplied until then?

Pile: Two countries up will be hard pressed to cancel out all the rest down. However, it is highly doubted among Hubbert mathematicians whether Russia or Saudi Arabia should be the typical Hubbert curve case as shown above. The single curves shown could be thought of as “what should have been.”

When there are two vastly different ways used to produce a large body of oil, sometimes a double curve is generated to better project the future. The Soviet era could be considered a whole separate set of physics, and would justify a double math treatment for Russia:

Sam Foucher, an oil analyst, presented the above in 2007 as his best Hubbert fit of what’s to happen with Russian oil. I have added the data points through 2015. It has proven to be pretty accurate so far almost 10 years later. It’s starting to look like a double plateau peaking.

This view of Russia’s oil future is from mathematicians viewing public data available on a secretive government from the outside. What do the Russian’s themselves foresee? Russia projects their own oil future with a couple of Russian think tanks in “Global And Russian Energy Outlook To 2040“. In that work, they conclude :

Conventional oil (excluding NGL) production will drop to 3.1 billion tonnes by 2040 from the current 3.4 billion tonnes, and the long-discussed ‘conventional oil peak’ will occur in the period from 2015 to 2020. (p35)

Russia and the Saudis are not the only over-production offenders. A study by David Coyne looks at the top 11 producers, and most over-produced. It was the large field owners that stepped in to the driving demand excess 45 years ago that were also playing all the political fun and games. The vast majority of the earth’s fields were run sensibly. But here’s the thing – The big 11 producers account for over 70% of the projected global peak production. They have done their deeds to the earth’s elephant fields, the irreplaceable ones that have been mostly exploited.

Kam: How should we invest if the world’s oil supply is in this much danger out five years or more?

Pile: There will be plenty of oil, but at higher prices. As the current glut from the first shale flash is worked off, prices will climb back to $100 and start mobilizing the other dreg oil around the globe. This cycling around the dreg operating oil price of $100 will probably be the future for a while.

Governments running oilfields is still a big problem , as this article “Oil’s Dark Secret” details. Since  90% of the post-peak half still in the ground is owned by state-run companies, ” production will be even more concentrated in the hands of the national firms of Russia and the Persian Gulf.” This means that publicly traded big oil is where all the badly depleted reserves are. They typically grow by acquisition. The small/mid caps that have demonstrated good results with little or no debt over the acid test of the last five years will have high leverage to oil and be the choice stocks. I am putting these stocks on a watch list for now to accumulate in my fund. I think this is the best oil strategy – scoping out what has passed the five year acid test just completed and watching for good buy points. My fund has avoided energy stocks for years, but I am beginning to accumulate. Oil pricing is in an unpredictable zone, and oil stocks could go down some more before they go back up. But they could be very good later.

Diamondback Energy (FANG) is a case in point. Without gorging on debt (debt/cap is 19%) they grew revenue/share 25% across the oil crash years of 2013 to 2016. And they managed to grow cash flow/share from operations 32% as well while actually reducing debt by 28% while their peers sank further into the red quicksand. They operate in the low cost Permian Basin, the leading oil producing area in the U.S. beginning with conventional production back in the 1920s. But now it’s the third shale sister along with the Bakken and Eagle Ford. Diamondback isn’t the biggest player in this basin, but is about the best with growth.

A problem you might expect with a fast growth, low debt operator like this is share dilution. And Diamondback must admit a little guilt here as share count grew from 47 million shares to about 71 million over the period cited above. But when they can deliver per share performance as they have during such a horrible oil crash, a little dilution is forgivable.

Kam: What about investors that don’t like the risk of the small caps?

Pile: There is also a much lower risk way to play the future oil scenario I’ve described. If we see trouble with net energy from the dreg oil (see this discussion) we will see high enough oil to precipitate a scramble to switch our cars and trucks to natural gas. There is the simple fact that in any such switch-over, you would see greatly ramped up business of the large, safe, high yielding gas distributors levered to volume – your favorite gas utility or pipeline stock.

My Take: Since 2010, in spite of oil’s ups and downs, Bruce’s portfolio has outperformed the S&P 500 for over 15 years. Few mutual fund managers could say the same.

Even though Bruce has done exceptionally well this year, a lot of people will not consider him as a manager until his most recent 5 year returns look good again. This is a mistake. In 4 more years, his 5 year returns might be excellent, but the factors that will have generated the return will have already come to fruition.

If you have an investment horizon of 5 years, and agree with Bruce’s analysis, the time to invest is after there’s been enough performance to be comfortable it’s not a short-term fluke, but before the opportunity comes to fruition.

Is one year of good performance enough to justify an investment. Not by itself. But when it’s on top of a 15 year track record of outperforming the market, I think it is.

To explore whether Bruce’s portfolio makes sense for you, click here to schedule a One-on-One with Ken Kam.

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