Why Oil is Rallying

Written By Briton Ryle

Posted August 17, 2016

So, I’ve been unapologetically bullish in oil all year. The number of drilling rigs bringing new oil to market is way down. And because of that, U.S. oil production is down just about 1 million barrels a day. And demand for gasoline is rising.

Yes, it will take some time for us to work off the incredible amount of oil in storage right now. But that will happen over time. 

Right now, however, I’m seeing signs of capitulation from oil companies. If you don’t know, capitulation means simply giving up, or “ceasing to resist an opponent or demand.”

In the investment world, capitulation has a special meaning. When we talk about capitulation in relation to investing, we are talking about the point where investors give up and sell their assets, no matter the price. Capitulation happens after sharp sell-offs, after investors have taken a brutal beating at the hands of sellers. Losses grow and grow until it looks like everything could be lost. They sell because they just want the pain to stop…

The irony is that capitulation is considered a bullish indicator. When investors capitulate and sell, it’s seen as a sign that there are no sellers left to dump stock and push prices lower. And that, in turn, suggests that prices can finally rise again. 

Of course, the timing for when prices rise after the wave of selling ends is not definite. Especially when the fundamentals haven’t changed all that much. Like with the oil markets right now: Saudi Arabia is still pumping as much oil as it can to keep prices low and drive marginal, high-cost oil producers (re: U.S. shale companies) out of business.

Still, it pays to watch the oil market for signs that the fundamentals are changing. And like I said at the outset, one big oil producer gave such a sign on its quarterly earnings conference call a few days ago…

Pump or Die

As a bit of a recap, the Saudi strategy of crushing oil prices to drive oil companies out of business has been somewhat successful. The Saudis undercut the primary assumption that led to the U.S. shale oil boom: that oil prices would stay high. At $90, it made sense for companies to sell bonds, raise cash, buy land, and drill for oil. 

At $40, not so much. Over 70 U.S. oil companies have declared bankruptcy because they cannot afford to pay the bills with oil down around $40. These bankruptcies are a form of capitulation. Banks and bondholders can’t take the pain anymore. They want out and are willing to take whatever they can get through bankruptcy asset sales. Textbook.

But the Saudi strategy may start hitting a wall. Because not all oil producers have to keep pumping oil to pay the bills. For big diversified oil companies, the situation is not pump or die. 

Bloomberg recently published a couple excerpts from a recent quarterly earnings conference call from diversified commodity company BHP Billiton (NYSE: BHP). First, here’s what BHP’s CFO had to say (emphasis mine): 

I wanted to point out that I think this is one of the strengths of having this petroleum business inside of a broader business, in fact, a shale business inside of a broader business. We have a very, very strong business particularly in the Black Hawk [a field in Texas’ Eagle Ford shale basin]. Those returns are available well north of 15 percent today at today’s prices given the strength of our position. But on the other hand, we’re able to — because we think that oil prices will increase, it’s better for us to keep those barrels in the ground and produce them in due course for higher prices and higher returns to shareholders.

And later the CEO said: 

In shale we have to be responsive to market conditions and produce when we think the prices are high and likely to remain so in order to maximize its longer-term value.

Do you see what they are saying? BHP plans to basically stop pumping oil until prices are higher. BHP will just let the oil sit in the ground. They can do this because they can afford to. BHP has written off over $10 billion worth of its oil investments. That’s basically taking the loss without selling. 

I would hope that the Saudis understand the difference between a “weak hand” and a “strong hand.” (Though, as an aside, the Saudi strategy has cost them so much cash that I really wonder at how well thought-out it was to begin with.) Basically, weak hands fold; strong hands don’t.

And that BHP call suggests that maybe we are close to the point where all the weak hands have folded. In other words, maybe we have already seen capitulation in the oil market…

Yep, Buy Oil Stocks

I am still in the camp of those that believe the Saudis can’t keep oil prices low forever. It’s too painful. The Saudis have lost well over $300 billion in revenue. Plus, they’ve spent $173 billion of their foreign reserves. They’ve cut subsidies for electricity, imports are falling, and consumer spending is barely growing. Put simply, the Saudi economy is nearly at a standstill.

In 2011, the Saudi economy grew 10%. Today, GDP growth is less than 2%. The budget deficit is 16% — and growing.

It’s been noted many, many times that “it’s all about the economy.” That might not seem to apply to the House of Saud. But it will. And when the Saudis finally give in and stop the pain of low oil prices, oil stocks will launch higher. 

There’s a recently announced “informal” OPEC meeting scheduled for September. Once again, a production freeze agreement is on the table. If one passes, oil stocks will launch higher. If not, I bet the selling won’t be that bad, because we’ve likely already seen capitulation in the oil market.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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