“Environmental activism is becoming a new form of protectionism.”

This is worth reading:

An article from summer 2014 that explores how U.S. interests fund anti-oil environmentalist radicals to selectively target Canadian oil production as a roundabout protectionist strategy.

The Tar Sands Campaign pointedly ignores the dozens of tankers bringing foreign oil into the United States and Eastern Canada on a daily basis. Evidently, the only tankers this campaign opposes are those that would break the U.S. market’s monopoly on Canadian oil exports.

But in North Dakota and Texas where oil production is booming, there is no multimillion-dollar campaign to stop or slow down the oil industry. As far as I can tell, the only country where there is a systematic, multimillion-dollar, foreign-funded campaign to choke the oil industry is Canada.

Whether intentional or not, environmental activism is becoming a new form of protectionism. By exaggerating risks and impacts, activists exert such political and social pressure that major infrastructure projects can be stalled or stopped altogether, land-locking Canadian oil and gas and keeping Canada over a barrel.

— Read more at Alberta Oil Magazine

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$100 in 2011 and $19.81 Now: Canada Heavy Crude

 

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From Bloomberg.

— Read more at Bloomberg

A Bleak Update on Tourmaline Oil Corp. (TOU)

This summer CMR published a report on Tourmaline Oil Corp (TOU). We showed that the company sucked up cash harder than a black hole and becoming economically viable was nigh mathematically impossible.

Their strategy has been nothing more than bigness. They were not building a strong company and making acquisitions with internally generated cash, Instead, they gobbled up the proceeds fed to them by fanciful underwriters to buy assets so they could constantly trumpet record production numbers and drive up the share price. While Tourmaline’s C-suite speculators kept devouring funds with their capex and M&A binge, they were striving for a Hail Mary liquidity event when some bigger E&P company would hopefully buy them at a nice valuation.

The company just released its Q3 results and has only provided further support to this thesis. Tourmaline is still spending too much money with little to show for it. CMR analyst Daniel Plainview provides us with an update.

Tourmaline Oil Corp.; Q3 Update

A follow up from the quill of Daniel Plainview, Esq.

It has been a number of months since I took to this forum to share with the fine readers the patent market absurdity that is Tourmaline Oil.  While its shares have fallen since the summer (about 30%) this is by no means out of line with the declines of other Canadian oil gas companies.

Recently another quarter of financial results was announced, so perhaps it is a good time to see if this company has finally made a dollar.

tourmaline update

Nope.

(Also note that we have updated the chart to now include proceeds from asset sales; technically a positive cash flow item, as asset acquisitions would be negative. Not that it matters much.)

In the six months of new financial data we can see that Tourmaline continues to outspend what it takes in, in an effort to grow production (to lead to more of the same?)

Cash flow from operations were together another C$ 412 million, but spending (net of $0 new asset sales) was C$ 719 million.  Free cash flow was therefore -C$ 307 million for the last 6 months, bringing the grand total money pit to ~C$4.35 billion since 2009.

A positive development might be that it appear the company is now aware that they cannot promulgate cash flow and earning figures without the accompanying capital expenditures that drive the production.  In their October 14th press release they have budgeted free cash flow projections for 2016 and 2017.  In a low gas price scenario they free cash flow will be ~C$45 million followed by ~C$167 million, and in a high gas price scenario free cash flow will be ~C$103 million and ~C$414 million.

So hypothetically, at the high price scenario, investors might see positive cumulative free cash flow some time in the 2020s, but I won’t hold my breath.

Also worth noting is that the low gas price scenario assumes a median C$3.25/mcf price for Alberta natural gas.  Presently it sits at ~$2.40/GJ (or ~$2.53/mcf); so they only need their base commodity price to go up 28% too.

This is a company that grows production at any cost and has never had an economic business model.  It requires constant issuance of new shares and cannot maintain growth on a per share basis if valuations drop.  It is a house of cards waiting to fall.

It’s enough to make Tourmaline shareholders sweat.

Observations on the Royalty Review Panel Open House

In the following I will share the observations of a man who attended last night’s Royalty Review Panel Open House in Calgary, originally posted on Instaface or Facegram or whatever it’s called. This man is an entrepreneur in the Alberta oil industry, so it seems reasonable that he understands many of the underlying issues. His reporting rings true to me and it should deeply unsettle not just Albertans, but also the other Canadians who gobble up the transfer payments out of Alberta:

Well I went ahead and attended the Royalty Review Panel Open House in Calgary last evening to see what they had to say. They had lots of stand up displays with hundreds of factoids about supply, world prices, reserves and a whole bunch of other information most of us Albertans have known about for decades. Interestingly enough they had whiteboards for attendees to write comments, Trevor Marr took pictures and the attendees were hammering the government hard on the many points you’ve already posted, read, liked and shared on these pages.

I spoke and asked questions about the risk of engaging in a review at a time when prices are low and royalty revenues are already in full collapse. The Al Gore trained political hack, ATB CEO Dave Mowat did confirm that the government would be lucky to collect $3 Billion this year, down from $9 Billion last year. He couldn’t answer why if we were at $13 Billion prior to the last review and it contributed to a drop to $9B since and were now down at less than $3B, what good could possibly come from throwing two plus years of uncertainty into the mix now? He kept referring to how they were sure that they could OPTIMIZE the royalty rates. But no, the full report wouldn’t be shared with Albertans as a large portion of their process was so complicated it could only be done by 3 separate expert non public panels that they are hiring to work for a whole month. But the end result would be the best Royalty Rate system ever done and the OPTIMIZED recommendations would be provided to the NDP government by December 31st, 2015. He also said that since oil would be phased out over the next 20-30 years, it can no longer be viewed as a finite resource since we have more than will ever be able to be sold! He said the inability to get to markets wasn’t relevant to the rate structure! He also said if our oil wasn’t competitive in the world markets not having pipelines to those possible clients didn’t matter. He said it wasn’t their concern if other taxations such as corporate tax rate increases or carbon tax burdens were put on our oil and gas industry as they were only mandated to recommend a royalty rate structure that was based upon 4 core principles that could guide all the future rate reviews. He suggested that every two years or so they might want to adjust rates! He admitted that the $65 Billion in annual investment by the oil and gas industry was dependent upon both pricing and royalty competitiveness. He wouldn’t say how much lower the investment is this year nor how much investment might be withheld due to the not knowing what the rates are going to be. He couldn’t answer as to how long it might take the NDP government to implement their recommendations or even if they would.

I came away convinced that the whole process is a traveling Gong Show run by ideologues who are so enamored with their own intelligence that they actually believe that they can squeeze more revenue out of the resources that we own by performing a superb OPTIMIZATION of the rates. They have no concept of RISK. Dave Mowat declared that the USA is no longer a trusted customer, that they have become our biggest competitor and since they produce so much oil relative to our miniscule output, we cannot compete. I also spoke with Peter Tertzakian from the panel who accused the PC’s of not collecting enough over the past decades. He also had absolutely no concern that the revenues had fallen due to the low prices, he expressed a concern that Albertans weren’t getting enough revenue from the oil being sold with no concern that the O&G industry were operating at a loss as is!

In other words, much like Rachel’s NDP government, nobody on this Royalty Review Panel are prepared to Stand Up For Alberta! They do not understand risk management, product promotion, stability needs of large long term investment, spinoff benefits from capital investment, incentivization potential, access to tidewater ports and human cost impacts from reduced employment opportunities. We must redouble our efforts to wake them up. I got under their skin, Mowat tried to label me as smug but apologized when I called him out for attempting to assign a negative connotation on a brief facial expression I might have had while listening to another speaker grill him. Although someone in the back did holler that I should be the next Energy Minister. 🙂

Let me call attention to a few of the most startling comments here.

[Mowat] also said that since oil would be phased out over the next 20-30 years, it can no longer be viewed as a finite resource since we have more than will ever be able to be sold!

WHAT.

Dave Mowat declared that the USA is no longer a trusted customer, that they have become our biggest competitor and since they produce so much oil relative to our miniscule output, we cannot compete.

WHAT.

I also spoke with Peter Tertzakian from the panel who accused the PC’s of not collecting enough over the past decades. He also had absolutely no concern that the revenues had fallen due to the low prices, he expressed a concern that Albertans weren’t getting enough revenue from the oil being sold with no concern that the O&G industry were operating at a loss as is!

WHAT.

We shouldn’t be surprised by foolishness coming out of a Royalty Review Panel that is chaired by Al Gore fanboy Dave Mowat, but this is actually worse than I expected. If such considerations are guiding the panel’s recommendations, Alberta is in a lot of trouble.

The entire royalty review is based on asinine premises as demonstrated above along with the laughable pretense of caring what the public has to say.

NDP’s Royalty Review Czar Dave Mowat Is a Climate Change Propagandist Trained by Al Gore

I knew I smelled a rat when Notley’s NDP chose ATB President and CEO Dave Mowat to head the royalty review board.

In a process that will surely revolve around “fairness” and other uneconomic nonsense, why would the NDP pick a banker of all things to head the review?

Well, now we know.

mowatandgore

algorelies

http://www.canada.com/edmontonjournal/story.html?id=5371ac3d-3b2d-4825-a158-45fd0c3978bb&k=18066

Hmm, do you think his thinking might be a bit clouded by Algore’s lies?

Al Gore’s documentary is one of the most deceitful pieces of trash ever created. Rather than provide a thorough critique, it is sufficient to show this:

al_gore_graph

The x-axis there is supposed to be time. How does the data go backwards in time? That doesn’t make any sense!

I know Algore created the internet with his bare hands and all that, but did he invent a way to break the laws of space-time too? This is total nonsense — climate change propaganda at its worst.

Can Dave Mowat explain this magical graph? Was that part of his propaganda training with Algore?

Heck, the famous Algore graph shows CO2 increases preceding the temperature rise. You fail automatically at science if you observe that A precedes B and therefore conclude that B causes A.

Algore is a shameless liar and anyone trained to spread his lies should not be running a royalty review for Alberta’s oil industry.

It’s seems fair enough to say that Dave Mowat is biased. So he is the perfect guy to push the NDP’s agenda.

Market Lemmings Case Study: Tourmaline Oil Corp.

The fall in oil prices is starting to expose some of the waste in the energy sector, but this central bank fueled bubble is still rife with clusters of error.

The ‘boom’ phase of the business cycle — more accurately described as the malinvestment phase — is where a lot of things just stop making sense. People will shovel money into wasteful investments based on distorted credit conditions and hyped up expectations.

Today our case study is Tourmaline Oil Corp., a favorite in the independent energy growth company category. With a 52-week high of $58.73, the consensus analyst rating is “buy” while presently trading around $39 at 18x earnings. It recently issued $168 million in new shares (at $39.50/share).

CMR analyst Daniel Plainview shows why Tourmaline is an economic black hole relying on the “greater fool.” Regardless of whatever distortions manifest in the stock market, Tourmaline is its present form is a zombie company — not an investment, but just one of many ways to gamble in the stock market casino.

A Question for Tourmaline Oil Corp.: How Do You Make Money?

By Daniel Plainview

When trying to determine the proper price of a stock the conventional rule of thumb is to predict the amount of money that stock is going to make each year over the long term, and then discount those earnings to the present at an appropriate rate for the risk you are taking.

The inverse of this, but it is in essence the exact same methodology, is to use a Price to Earnings ratio to evaluate a stock. The higher the ratio, the more expensive the stock; the lower the ratio, the more likely you are getting a good deal, so long as the future earnings hold up.

But what if the stock you are looking at is in an industry that typically doesn’t make any money?  I’m referring to industries where the company earnings are often affected, to a large degree, by depletion expenses.

Depletion is a non-cash charge and it can ensure that a company generates plenty of cash flow but renders the conventional Price to Earnings analysis moot. Industries with high DD&A (Depletion, Depreciation & Amortization) are generally involved in resource extraction.

Because earnings are essentially meaningless for a lot of resource companies (not to mention the other accounting tricks that can affect earnings) it’s always a good idea to look at a company’s cash flows.  There are three types of cash flows:

  1. Cash flows from operations
  2. Cash flows from investing
  3. Cash flow from financing

While in any given period the cash flows in any of these buckets can be either positive or negative, over the medium to longer term (2+ years) one invariably wants to see that cash flow from operations is positive, cash flows from investing is slightly negative, and cash flows from financing is also negative; with the change in cash position from period to period being immaterial.

What a positive/negative/negative cash flow segmentation is indicative of is 1) the company is making money, 2) that it is reinvesting in the business to grow the business, and 3) it is able to return capital to the shareholder, or at least doesn’t steadily require new financing to fund its investments.

It is with this in mind that we now consider the Canadian oil and gas industry.

Recently the commodity prices that drive the cash flow from operations that Exploration and Production (E&P) companies generate took a tumble.  Both oil and gas prices fell by ~50% from their levels in the first half of 2014.

By itself a single year of lousy prices shouldn’t erode as much value in the markets as what occurred, but what changed is the market is now more pessimistic about prices for all future periods too.

Companies have responded by scaling back their investing, and cutting capital expenditures for the drilling of new wells and building of new facilities.

Generally speaking, oil and gas companies always have to be spending some money on new production in order to maintain overall production levels.  Well performance declines over time, and by how much depends a lot on the geology of the particular “play”.

A really good well might only decline at ~20% per year, but it still declines.  Newer unconventional extraction methods (drilling horizontal multi-stage frac wells into shales) can come down a lot faster: ~50% per year.

So ultimately the goal of any oil and gas company, in any environment, is to have enough cash flow from operations that it can pay for all the cash flow from investing (capital expenditures needed to keep production up), and still have enough left over to pay the shareholder.

Enter Tourmaline Oil: the oil company that has 85% of their production coming from natural gas.  Etymology aside, there are more serious issues with this company’s business model.

In their last earnings announcement in March, they happily proclaimed their 76% growth in cash flow. Sounds good… but wait! There is a footnote: “Cash flow is defined as cash provided by operations before changes in non-cash operating working capital.” So what about capital expenditures?

Here is a chart of Tourmaline’s cash flows, going back to 2009:

tourmaline

The cash flow from operations is in green, and the company’s capital expenditures (only a sub-set of cash flow from investing) are in red.  The black line represents the cumulative amount of cash flow from operations minus capital expenditures (or Free Cash Flow) up to each period.

What this shows is that Tourmaline has spent almost $4.7 billion more on drilling holes in the ground, than it has made from the hydrocarbons those holes have produced, since 2009.  Furthermore, over 25 quarters of results, they have never made more money than they spent: Free Cash Flow has never been positive.

In the company’s defense, they have grown production at an industry-leading rate.  But it really looks like they’re spending a dollar to make fifty cents, and making up for it on volume.

It has gotten to the point where if the company stopped spending money, but continued to earn cash flow from operations (and let us assume the same prices and only a 20% production annual decline), they could not make that money back.  In actuality Tourmaline’s wells probably decline a lot harder than 20%, but the story is bad enough as it is.

These harsh realities force us to ask the question: where did the company get $4.7 billion?  The answer is that they got it from new investors who bought shares in secondary offerings, and some money from raising debt.  It looks as though this external funding process will have to continue ad infinitum; another secondary offering being announced just recently for $168 million.

And investors should keep this in mind: the only reason Tourmaline is able to grow production on a per share basis is because the shares have a decent valuation, but the only reason the shares manage to eke out a decent valuation is because they are able to grow production on a per share basis.  If the shares were to fall enough in price, the amount of dilution created by external financing would make it impossible for the company to grow.

And the last point to make about the company: the management team in prior iterations at Berkeley and at Duvernay were able to successfully build up and then sell the company to a bigger fish.  Duvernay in particular made a lot of people a lot of money as it was sold at the height of the commodity boom in 2008 and Shell paid an unmatched valuation in the transaction (~27x EBITDA).

In fact, the only way Tourmaline’s business model makes any sense is with an M&A exit strategy: ramp up production at any price, and find a sucker to buy it just before the house of cards collapses.

But if investors are assuming Tourmaline will be similarly sold I would only point out that Tourmaline is now worth about $9.2 billion and is the 8th largest E&P company by market capitalization in Canada.  It’s getting to be too big for others to swallow, and suckers like Shell might be hard to find this time around.

Then again, they did just find another 4.25 million suckers…

(Click here for supporting calculations.)

The Price of Oil and the State of the Economy

A large number of people have been asking me about the price of oil and what it means for the economy. Rather than just repeating myself all the time, I am writing this article.

SOME CLARIFICATIONS

I feel it is important to clarify how the law of supply and demand works, because I hear a lot of incorrect analysis from people who should know better. If you understand the law of supply and demand, I recommend that you skip to the next section.

Consider the following statement: “The price of oil is falling, and this is increasing the demand for oil — this will push the price of oil back up!”

This proposition is completely wrong.

Let me show you an ordinary supply and demand graph, like anything you will see in an introductory economics textbook.

supply and demand

The x-axis is quantity, and the y-axis is price. The intersection of the demand curve and the supply curve is where the market clears — everyone can buy the amount they want to buy, and everyone can sell the amount they want to sell. Simple enough.

Now consider the following graph, which depicts a change in demand. Specifically, it shows an increase — the demand curve shifts to the right (D1 to D2).

What is happening here? Demand has increased, and the price goes up. What is not happening here? The increase was not caused by a lower price — instead, it caused an increase in the price. The rise in demand is the cause, the rise in price is the effect.

We know for a fact that the price of oil has fallen dramatically in the second half of 2014. Why? Reduced demand, increased supply, or both?

Much of the world is in economic trouble. China is slowing. Japan is a mess. Europe is a disaster. When much of the world is in recession or heading for recession, we expect the demand for oil to fall. And even in the US, where the economy is stronger, oil consumption has fallen 8% since 2010 (there are many reasons for this, but I will not go into it here). So falling demand is a reasonable explanation for the fall in oil prices.

There is also the issue of increasing supply. OPEC is still pumping, business as usual, even though the price is down. Shale oil producers have been producing in a frenzy. There is a greater supply of oil.

Here’s what it looks like:

The graph shows an increase in supply (the supply curve has shifted to the right). The market clears at a lower price. Less supply (S1) has become more supply (S2). The quantity demanded goes from Q1 to Q2.

The price of oil has been falling in the second half of 2014. It fell very fast. Supplies have not increased much since June. This makes me believe that falling demand is the primary cause in this situation.

Now let’s look at a situation where there is “inelastic” supply (meaning it is not very responsive to price) and a fall in demand.

This is an extremely “non-price-sensitive” supply. The Saudi head of oil production has proclaimed that they will keep pumping even if the price drops to $20 a barrel. The other producers need money, so they will keep pumping. They cannot trim production and influence the price. The Saudis have considerable influence in on the supply-side of the market. That’s why the supply is inelastic.

Let’s return to the initial proposition we considered: the oil price is lower, so there will be increased demand for oil. This is bad analysis. Part of the problem is in the fact that “demand” and “quantity demanded” are often used interchangeably. But essentially it is mixing up the issue in the first and second graphs.

The price of oil is down.  The supply has increased. The demand has not increased — the quantity demanded at the new price is greater than at the higher price. This is not the same as saying a lower price of oil will increase the demand for oil. An increase in demand would — in the language of economics — imply a rightward shift of the entire demand curve.

A falling price does not increase demand, it increased quantity demanded. These things sound similar, but they are analytically different and this is important to understand at an elementary level.

Now with that boring stuff out of the way, let us look at the current situation with the price of oil and the economy.

SHALLOW CONSPIRACY THEORIES

I regularly speak with a lot of presidents and CEOs in the Alberta oil industry. A commonplace view is that price collapse is all the result of the Saudis pushing down the price of oil because [insert reasons here].

There are some amusing conspiracy theories floating around as well, particularly that which avers the US and its Saudi allies are manipulating the oil price to drive down the price of oil to hurt some evil countries, like Russia (America’s archenemy) and Iran (Saudi Arabia’s archenemy).

(I want to quickly point out that this is perhaps the only time in my entire life where people have complained about oil market manipulation driving the price… DOWN! Usually it’s greedy capitalists or crooked OPEC producers manipulating the market to drive the price UP to rip everyone off. But I digress.)

Realistically, how much of the blame rests on the Saudis? Maybe some, sure. But I don’t think it’s that much.

After all, how much does Saudi Arabia have to do with the price of steel, coal, and iron ore?

stell

How much do the Saudis influence the price of copper (which, by the way, is almost as much of a barometer for the world economy as oil)?

copper price

COMMODITY COLLAPSE

We see that oil is not the only commodity with a collapsing price. Maybe instead of market manipulation, it’s a sign that the global economy is not as strong as everyone had hoped.

The phony economic boom of the last two decades is slowing down, exposing what the Austrian business cycle theory refers to as “malinvestment.”

The distortion in commodity prices are the result of central banks collectively expanding their balance sheets from $5 trillion to $16 trillion in the last 10 years.

We also need to think about think about China, which has driven a great deal of the marginal demand for commodities in the last several cycles.

China’s radical growth levels were not going to last forever, and investors should have known better. But I guess that’s why they call it a “mania” and “irrational exuberance.”

China went from $1 trillion GDP to $9 trillion GDP in 13 years — an insane growth level that would be impossible but for printing press finance.

The incredible Keynesian-mercantilism started by Deng in the early 90s resulted in China’s demand for oil quadrupling from 3 million barrels per day to 12 million per day. Before then, the $20 price for a barrel of oil was, all things considered, was pretty much the same as it was 100 years when adjusted for inflation. Which makes sense given the basic balance of harder-to-get oil and improving technological methods over time.

The story is the same elsewhere. In the crackup boom phase of the cycle, iron ore prices hit 9x their historic range at the peak, and copper prices hit 5x their historic range.

copper iron

As with the other industrial commodities, there has been massive investment in petroleum production to feed the world’s unsustainable growth projections. Huge scale undertakings in the Canadian oil sands, US shale, and various deep-sea drilling projects, driven by these consumption forecasts and cheap credit, have resulted in major production increases. The bubble finance hype machine over the “Fracking revolution” in US shale led to a 4x increase in oil production with wells that would be uneconomical in a sane world.

So now there is too much oil production and not enough demand. The market needs to normalize, and that means the price of oil (and other commodities) needs to fall so sanity can be restored.

US shale in particular is a nasty bubble — the next “subprime” crisis.

North Dakota needs an oil price of around $55 per barrel at the wellhead and a fleet of about 140 rigs to sustain production at the current level of 1.2 million barrels per day, the U.S. state’s chief regulator told legislators on Thursday. . . . Breakeven rates for new wells, the level at which all drilling would cease, range from $29 in Dunn county and $30 in McKenzie to $36 in Williams and $41 in Mountrail. These four counties account for 90 percent of the drilling in the state.

Breakevens in counties on the periphery of the Bakken play, which have far fewer rigs, range up to $52 in Renville-Bottineau, $62 in Burke and $73 in Divide.

But Flint Hills Resources’ posted price for North Dakota crude was just $32, Helms said, compared with almost $49 per barrel for WTI. Wellhead prices, which are roughly an average of the two, are around $40 and have been falling since the start of this year.

Even before prices hit these minimum levels, drilling will slow sharply. The number of rigs operating in the state has already fallen to 165, down from 191 in October, according to the department. . . .

To keep output steady at 1.2 million b/d for the next three years, the state’s producers need a price of $55 rising closer to $65 in the longer term to support a fleet of 140-155 rigs.

Helms’ projections confirm North Dakota’s oil output will start to fall by the end of the year unless prices rise from their current very depressed level.

http://www.reuters.com/article/2015/01/09/bakken-oil-breakeven-kemp-idUSL6N0UO2QR20150109?feedType=RSS&feedName=rbssEnergyNews

Unlike conventional projects, shale wells enjoy an extremely short life. In the Bakken region straddling Montana and North Dakota, a well that starts out pumping 1,000 barrels a day will decline to just 280 barrels by the start of year two, a shrinkage of 72%. By the beginning of year three, more than half the reserves of that well will be depleted, and annual production will fall to a trickle. To generate constant or increasing revenue, producers need to constantly drill new wells, since their existing wells span a mere half-life by industry standards.

In fact, fracking is a lot more like mining than conventional oil production. Mining companies need to dig new holes, year after year, to extract reserves of copper or iron ore. In fracking, there is intense pressure to keep replacing the production you lost last year.

On average, the “all-in,” breakeven cost for U.S. hydraulic shale is $65 per barrel, according to a study by Rystad Energy and Morgan Stanley Commodity Research. So, with the current price at $48, the industry is under siege. To be sure, the frackers will continue to operate older wells so long as they generate revenues in excess of their variable costs. But the older wells–unlike those in the Middle East or the North Sea–produce only tiny quantities. To keep the boom going, the shale gang must keep doing what they’ve been doing to thrive; they need to drill many, many new wells.

Right now, all signs are pointing to retreat. The count of rotary rigs in use–a proxy for new drilling–has fallen from 1,930 to 1,881 since October, after soaring during most of 2014. Continental Resources, a major force in shale, has announced that it will lower its drilling budget by 40% in 2015. Because of the constant need to drill, frackers are always raising more and more money by selling equity, securing bank loans, and selling junk bonds. Many are already heavily indebted. It’s unclear if banks and investors will keep the capital flowing at these prices.

http://for.tn/1xLDxc9

I think long-term Canadian oil sand projects will have a stronger future, because they have more fundamental validity and less bubble finance hype (although there is some of that, of course). And while it it doesn’t seem like it to individual market participants, prices ultimately determine costs and so lower prices will push costs down. Rates of return in the market tend to equalize across different industries — there is not legitimate reason why people should forever expect above-market wages and investment returns in the oil business.

CENTRAL BANKS BACKING OFF?

Because I believe the Austrian business cycle theory is correct, I think China’s tightening of monetary policy has been a major factor here.

Likewise the Federal Reserve, with its 7x increase in the size of its balance sheet, culminating with a “taper” and proceeding into deflation mode following the end of QE3. That’s right, deflation mode. They did not just “taper” the rate of growth on the monetary base then hold it steady. The Fed actually sold off 10% of its assets starting in September before jumping back into open market operations with $250 billion in purchases. This kind of behavior is very disorienting for the market, with capital markets adjusting to money being sucked out and then pumped back in. But it helps explain the strengthening of the USD and the bloodshed in the commodities markets.

fed deflation

Then on Jan 15 came the Swiss National Bank’s surprise decision to end its foolhardy 1.20 EUR peg before Drahgi opened the ECB money floodgates. In its Keynesian desperation to diminish CHF purchasing power, the SNB’s balance sheet increased fivefold since the financial crisis and it amassed assets equal to 100% of the nation’s GDP — which is even more extreme than the insane BOJ, if you can believe it. With this development, the franc soared against the Euro and the US dollar and baffled everyone, even destroying a couple of FX firms overnight in one fell swoop.

Things will get crazy as some central banks tighten and others keep printing. These currency dislocations could lead to a currency crisis somewhere, but that is hard to predict. In any case, the insanity meter is in the red.

WHAT ABOUT GOLD?

Gold and oil often move together. And when the US dollar strengthens, gold usually weakens. But we are not really seeing this. Gold has been quite resilient amidst falling commodity prices and is performing well so far in 2015.

gold price

In this case, I’m not entirely sure what this means. On the one hand, it could indicate that a recession is less likely. On the other hand, it could indicate that investors are worried and are hedging against danger, like more aggressive central bank interventions.

CONCLUSION

The “correction” is healthy. It means reallocating resources to their most economical use. But it is painful — like a heroin addict going into detox.

It would be good for the world if oil went down to $20 a barrel and stayed there for 20 years, but I think the “peak oil” thesis is basically correct, and prices will rise again. We might not see a radical swing like in the 2008 crash, where we went from $37 back to $80 within the year.

The timing for all this depends on what happens in the recovery phase. Major readjustments need to occur. These adjustments could be brutal and quick, and the economy could resume a healthy course within a year, so long as the myriad governments take a “laissez-faire” approach. If governments impair economic adjustment with more taxes, spending, and inflation, we’ll just get a huge mess because the economy is straining against maximum debt levels and a huge bounce-back recovery a la 2008-2009 is not going to work this time.

So there you go. Prepare for some trouble. Hold cash.

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