Bubbles all have the same characteristics of unrealistic expectations but are incredibly difficult to recognize until after the effect.

Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone. While some economists deny that bubbles occur,  the cause of bubbles remains disputed by those who are convinced that asset prices often deviate strongly from intrinsic values.-Wikipedia

2008 housing bubble and ensuing financial market rout

“We recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact,” -Alan Greenspan

2000 Dot Com bubble

In  2000, AOL purchased Time Warner for US$164 billion. Shortly thereafter the bubble burst and technology stocks suffered a remarkable collapse.

“When I cast my vote for 100 million shares, I did it with as much excitement as I felt the first time I made love…I voted for it because we will have a stronger company that will create value. It’s not so easy to go out and recreate AOL.”-Ted Turner, AOL stockholder

The stock market had its worst week since 2011 finally waking up to the broader implications of the sudden and unprecedented crash of  crude oil, a commodity that is essential to the functioning of the modern world. In spite of what some are attributing to a global slowdown, the main reason crude plummeted was a good old fashioned price war. The Saudis, with their abundant and cheap to access crude reserves got tired of ceding market share to North American shale producers and fellow OPEC members. The best way to gain back share is slash prices. And they did, multiple times while jawboning the market down as well saying they saw $60 as an equilibrium price at the most recent OPEC meeting, when crude was going for near $75 in the days before the meeting. Financial speculators (no one knows the extent of the financial speculation in the futures markets versus the bona-fide hedgers) jumped on the bandwagon accelerating the rapid descent.

Oil stocks and their related services companies swooned, some losing 80% or more in value. This brings back recollections of recent busts like the Dot-com, telecom bust of 1999- 2000 and the housing and banking collapse of 2008. I’m not smart enough to predict if today’s oil price collapse will result in a bear market like the previous bubble bursting did but it’s important to note that oil and gas infrastructure build out in the US since 2008 has been the biggest engine of job growth. Some analysts say it accounts for 30% of all capital spending in the US.

In doing this piece, I spent some time researching who predicted the rout in oil and perhaps more important, what does this person think now.   The most prescient was a June 2014 Forbes article from Jesse Colombo, 9 Reasons Why Oil Prices May Be Headed For A Bust

Jesse’s correctly foresaw the oil price crash. He writes,  “Despite the optimism that many people have about the shale energy boom, I believe that it only slightly delays the ending of the “cheap oil” era and that Peak Oil theorists will still be right in the longer run. While a crude oil correction is likely to occur within the next few years, I do not expect oil prices to remain at low levels for a very long time. The energy returned on energy invested or ERoEI for shale oil is far lower than for conventional oil, which is evidence that cheap oil is becoming much more scarce even though overall U.S. oil production has increased.”

….” Shale energy extraction is a very capital-intensive business that relies heavily on cheap credit to survive. Shale oil wells experience much faster decline rates than conventional oil wells, which means that energy companies must keep drilling at a furious pace just to maintain their production – a very costly proposition that is typically funded by copious amounts of debt.

In addition to cheap credit, the shale oil boom’s entire existence is predicated on today’s relatively high oil prices. If the price of oil dropped below $70-$80 per barrel, many shale energy companies would fail in a short amount of time as the industry experiences a bust, and investors and lenders would sour on shale energy after taking serious losses. Ironically, this shale energy bust scenario would ultimately lead to even higher oil prices in the longer run after the world realizes that shale energy doesn’t quite live up to its hype.”

And the oil-price plunge may not end soon. The Saudi’s say the equilibrium price of crude is around $60 per barrel.  The equilibrium price is only achieved when supply and demand equal each other.  The Energy Department also issued a report later in the day Friday,December 12, predicting that American oil production would average 9.3 million barrels a day in 2015, 700,000 barrels more than this year. That is a small downward revision of production previously predicted by the department, but its report emphasized that “all the decrease in forecast production growth comes in the second half of 2015.”  Clearly equilibrium will take some time. Bank of America Merrill Lynch says U.S. oil prices could drop to $50 in 2015.  Some are projecting prices into the $40’s.  When markets correct, they often overshoot both on the upside and the downside.

There are conflicting reports about at what price shale oil is economic. Certainly its not a one price fits all equation as producing wells are sunk costs and some basins are more profitable than other. According to Zero Hedge WTI Crude just burst below $58 and is now over 46% below the peak in June. Since the initial leaks of no production cuts at OPEC, WTI is down 25% (gold and silver are up 2-4%). At these levels only 4 of the US 18 Shale Oil regions remain economic

breakeven shale
Source: Bloomberg New Energy Finance


GS Shale


































Hi Crush, a major frac sand vendor believes major basin breakevens are much lower


CreditSuisse Breakeven Shale Analysis
CreditSuisse Breakeven Shale Analysis

























That begets the question, if a company can’t make a profit selling its goods or services , what value if any does it have?  Bubbles don’t repeat themselves in the exact same manner, they usually have a different twist that makes them hard to recognize in the present. It’s only when the “reality” on the ground changes, does perception recognize it. When Time Warner bought AOL at the height of the dot-com business, few people questioned the wisdom of that.  In fact it was the opposite, analysts extolled the vision.  Just because hundreds  of companies were not yet profitable and perhaps never would be profitable didn’t deter investors because they saw a path to riches. Granted in part this was the greater fool theory but many companies were in a land grab for revenue growth and profits would come later. It was the reality that these profits would never materialize or would be much slighter  that caused the dot-com telecom meltdown.

Oil and gas companies that were profitable at prices over $80 barrel with projections  of $100 and more for years to come spent money freely acquiring acreage in the most promising shale deposits.  What if oil stays at $57 or even $40 for an extended period of time?  Does it matter that they were once profitable if they can’t carry their debt burdens?  You will be surprised at how perceptions change once the obvious is mainstream.  So have we just witnessed a massive bubble with the American oil renaissance?  Was the oil and gas infrastructure in the US and the billions spent on it based on a false premise, that the price of crude was only $80-$100 because a cartel was propping it up?

Is the price collapse of crude just a temporary supply demand imbalance.  Exxon’s economists certainly think it is.  According to Exxon’s most recent energy forecast for 2015-2040, “oil is still expected to remain the number one energy source and demand will increase by nearly 30%, driven by expanding needs for transportation and chemicals. During an analyst meeting covering the outlook, William Colton, VP for Corporate Strategic Planning for ExxonMobil, said “Oil remains uniquely attractive for transportation as liquid fuels continue to set the standard for convenience and performance in terms of energy density and the ability to store large amounts of energy in a small volume.”

Normally we look at insider buying as a key determinant of our strategy.  After all who better to know the business than the people running it.  One shortfall of this strategy is that insiders are often no better prognosticators of black swan type macro events like the crude oil collapse or the financial meltdown of 2008.  For example Harold Hamm, the oil man that pioneered the Bakken in North Dakota and until recently America’s richest oil man pronounced a bottom in crude back in November.   Continental Resources  lifted its hedges in early November when oil was trading at around $83 a barrel, leaving it unprotected as prices slipped another $20, the most dramatic drop since the 2008 crisis.

“We view the recent downdraft in oil prices as unsustainable given the lack of fundamental change in supply and demand. Accordingly, we have elected to monetize nearly all of our outstanding oil hedges, allowing us to fully participate in what we anticipate will be an oil price recovery.” Harold Hamm, CEO Continental Resources

Unfortunately there are more examples of myopia by in the know executives. In July 2008, Bob Steele, the CEO of Wachovia bought $16 million worth of his company’s stock only to watch it collapse nearly worthless as the housing market correction  turned into a global financial collapse. Wachovia was sold to Wells Fargo for a token $1 per share.  Steele had paid $16 per share and pronounced the bank healthy only three months earlier.

The very important question, is the U.S oil renaissance a bubble market like the dot- com valuation that Microsoft , Cisco, Oracle and others saw and their prices never to return to those lofty levels or is it just a blip on the road to the future like Exxon’s economist predict.  One measure of investor safety might be to buy some time.  Company’s that have hedged 2015 production will have better cash flow.

According to a report from Reuter’s  Oil’s slide to the lowest price in more than five years is carving a divide between U.S. shale drillers who heavily hedged future production and those who didn’t.

While financial hedges are commonly required by many oilfield lenders, the industry’s mid-sized U.S.-focused shale field producers pursued varied strategies when it came to protecting future revenues, according to a Reuters review of filings and interviews with bankers and experts.

Those decisions are now coming back to haunt some drillers. Best-known is Continental Resources, which lifted its hedges in early November, when oil was trading at around $83a barrel, leaving it unprotected as prices slipped another $20, the most dramatic drop since the 2008 crisis. Continental’s share price has been more than halved since late June.

Significant insider buying at Continental Resources

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Apache Corp and Whiting Petroleum are also exposed to lower prices and have underperformed some peers over the past two weeks.

There has been no insider buying recently at Apache or Whiting although Apache had significant buying last year at higher prices.

At Devon Energy Corp, the effect of tumbling prices “may not be nearly as large as you think” because of hedging, said Dave Hager, Devon’s chief operating officer, at the CapitalOne Energy Conference on Wednesday. “We’re in outstanding shape as a company.”

Devon, which pumped over 80 percent of its oil from U.S. shale fields last quarter, stands out as the most aggressive hedger among the larger-cap U.S. oil drillers. It has hedged about 140,000 barrels per day (bpd) of crude for all of next year, equivalent to 80 percent of its third quarter output, according to company filings.

If U.S. crude prices were to remain at about $65 a barrel next year, those hedges could net Devon an extra $1.3 billion in revenue, according to Reuters calculations.

Devon has been “very good at not drinking the Kool-Aid” in an industry that had been counting on years of high prices, said Rick Rule, chairman of Sprott US Holdings, an asset management firm that doesn’t own stock in Devon.

For the past several years, hedging was a relatively minor consideration for investors. Oil prices stayed fairly steady at about $100 a barrel, meaning most hedged positions were neither heavily in nor out of the money.

Now that the crude price has almost halved in the past six months, and predictions grow for a prolonged slump in prices, investors are scrutinizing filings to understand which corporations were clever enough to have locked in prices prior to the slump and therefore have enough cash on hand to pay increasingly expensive service contracts.

Most large-cap producers, unlike Devon, don’t hedge as a rule, and many such as Occidental Petroleum and ConocoPhilips have even outperformed Oklahoma City-based Devon in recent months, aided in part by their refinery holdings, which generate additional revenue when oil prices are down.

Some analysts point to Apache as an example of the perils of not hedging. While Devon’s shares have fallen by 32 percent since June, Apache’s have dropped by 44 percent as investors raise alarms about a potential cash crunch.

“They’re basically naked and don’t have any cash flow protection,” said Leo Mariani, a senior analyst at Capital Markets.

At sub $60 prices it looks like the vast amount of North American oil shale drilling is uneconomic or greatly reduced in value.  Its important though to remember that many of these same companies drill for natural gas and have been switching efforts to drill for oil versus gas.  Those companies will shift or shut down cap ex spending to account for the price collapse.

The critical question then is when does crude oil go back up in price or does it? The Secretary General of Opec announced on Sunday, “If there’s no new investments and new supplies to the market, prices will end up over $100,” Mr. el-Badri said.  Could that have been a Freudian slip. I believe that’s precisely what OPEC wants.  No new investments in North America and a stable market share for OPEC at $100 per barrel.  “Our expectation in OPEC is that after 2020, the oil industry in the U.S. will decline” due to the nation’s low reserves, he said. The U.S. won’t become self-sufficient in oil and will continue to depend on Middle Eastern supply, El-Badri said.

Unless there is a policy response from the U.S Government to tax foreign imports of crude, there will be a very bleak outcome for North America oil and gas in my opinion.