Pipelines to Nowhere
December 14, 2015
Oil prices just keep going down. This week Brent Crude closed at $37.93 per barrel, down another 12% for the week, and the latest price drop over a longer period. Brent Crude was $57.33 a barrel at the start of 2015, and since June 20th last year oil prices have fallen 67%! Just like the dot.com crash and the housing market debacle, we are witnessing the bursting of another asset price bubble. What are the reasons for the steep and rapid decline?
Back in the spring of 2014 headlines trumpeted the newly achieved US oil independence. This independence was catalyzed by a steady run up in oil prices. Oil prices moved from the $60 to $70 per barrel, then onto $90, before settling in a range of $90 to $110. These high prices stimulated oil exploration across the US as newly developed extraction techniques allowed the unlocking of oil in areas never previously exploited. Over a five year period the US moved steadily to being able to claim oil independence, and then the music stopped, and the oil market slumped.
What triggered the beginning of the price drop is debatable. Some claim a slowdown of the Chinese economy and the expectation that the global demand for oil products would fall. Others note the strength of the US dollar which has increased over 22% (since July, 2014) against a basket of its trading partner currencies. But others looked to OPEC as the real reason.
As the US’s supply of oil rose, our demand for imported oil fell. OPEC, the cartel of oil producers including Saudi Arabia, Iran, Iraq, and Venezuela, once controlled the price of oil. The sharp increase in US production changed all that. At $100 per barrel US producers were very happy, and any price above $60 made the US competitive. However, OPEC’s cost of production is much lower, and its response has been simple. Flood the market with oil, cause the price bubble to burst, and force the shut down of more expensive US production. As oil prices dropped the inevitable occurred and US production began to fall. The oil service giant Baker Hughes reported recently that 50% of US oil rigs recently in production now stand idle.
But the unraveling of the oil market may not be over yet. OPEC met two weeks ago and effectively cleared every OPEC member to produce as much oil as they wanted. The oil spigot has been turned wide open.
The oil pipeline companies, often structured as Master Limited Partnerships (MLPs), have been seriously hurt by the oil price decline. Traditionally paying a high dividend, or distribution, these stocks had been attractive to investors seeking income. The combination of high oil prices, the need for pipelines in remote areas, and low interest rates caused the pipeline industry to explode. The industry borrowed money to build the pipelines to obtain the rewards of moving the newly found oil to refineries. Now, as rigs are idled, the flow of oil has dropped precipitously, and the pipeline companies are having to decide whether to maintain their dividends, or to preserve cash to pay the debt incurred during expansion. One of the largest players in the pipeline market, Kinder Morgan, shocked the market this week by cutting their dividend by 75% so it could maintain its debt payments and preserve its balance sheet. At the close of the market last Friday, Kinder Morgan’s stock price is down 63% since April.
Carl Gambrell
