Investors began to flee positions in emerging markets over the last week or two as concerns of slower growth and uncertainty surrounding Federal Reserve policy spread around the world.
Argentina appears to be standing at the precipice of a currency crisis, as the Peso declined 12% on January 23rd alone, the sharpest drop since its infamous devaluation and economic crisis in 2002. China’s growth has slowed and analysts are worrying more and more about its vast shadow-banking sector that has fueled an enormous credit boom over the last five years. Slow growth in Brazil, unrest in Ukraine, and further currency troubles in Turkey and South Africa (among others) all contributed to a rout for emerging markets (EM) as the first month of 2014 came to a close.
While the exact causes of investor nervousness in regards to EM countries are both unclear and multiple, the U.S. Federal Reserve’s “tapering” policy – its plan to gradually reduce the billions of dollars in monthly bond purchases – may have contributed to international investors pulling their money out of riskier bets in developing countries.
By curtailing bond-purchasing, the Fed will make the U.S. Dollar relatively more attractive as interest rates climb, incentivizing money to flow out from foreign currencies and back into the Dollar. The Fed’s policy is hardly sudden or acute (thus it’s nickname “tapering”), but it may be an example of learning…
Investors began to flee positions in emerging markets over the last week or two as concerns of slower growth and uncertainty surrounding Federal Reserve policy spread around the world.
Argentina appears to be standing at the precipice of a currency crisis, as the Peso declined 12% on January 23rd alone, the sharpest drop since its infamous devaluation and economic crisis in 2002. China’s growth has slowed and analysts are worrying more and more about its vast shadow-banking sector that has fueled an enormous credit boom over the last five years. Slow growth in Brazil, unrest in Ukraine, and further currency troubles in Turkey and South Africa (among others) all contributed to a rout for emerging markets (EM) as the first month of 2014 came to a close.
While the exact causes of investor nervousness in regards to EM countries are both unclear and multiple, the U.S. Federal Reserve’s “tapering” policy – its plan to gradually reduce the billions of dollars in monthly bond purchases – may have contributed to international investors pulling their money out of riskier bets in developing countries.
By curtailing bond-purchasing, the Fed will make the U.S. Dollar relatively more attractive as interest rates climb, incentivizing money to flow out from foreign currencies and back into the Dollar. The Fed’s policy is hardly sudden or acute (thus it’s nickname “tapering”), but it may be an example of learning who has been swimming naked only when the tide rolls out, an oft-repeated expression that has cropped up again recently on the bad news coming from emerging markets.
But for years EM countries have been the darlings of the financial world, and their catchy acronyms continue to headline notes to investors. Only now, it may be that the advice is no longer “buy.” Whether it is the BRIC countries (Brazil, Russia, India, China), or BASIC (Brazil, South Africa, India, China), or the newly coined MINT countries (Mexico, Indonesia, Nigeria, Turkey), emerging markets are beginning to look a little less safe than they used to. Investors were sold on the idea that EM countries offered higher yields than developed countries without substantial risk, a notion that may prove illusory. And if the world cannot depend on rapid growth from EM countries around the world, then the global economy may be in for a bit of turbulence.
Pullback on Oil?
So what does this have to do with oil? If a broad EM sell-off induces a global economic slowdown, or worse, it will significantly hit the price of crude oil – particularly since much of the demand for oil comes increasingly from developing countries. And if oil prices decline, it will seriously threaten high-cost producers, and may even force the marginal producers out of the market.
And which producers are working with high marginal costs? Drillers that are working in high-cost geological environments – i.e. unconventional oil from shale.
For example, the Bakken is home to surging U.S. oil production, perhaps surpassing the one million barrel per day mark at the end of 2013. This is surely a significant milestone, and the industry has sold the American public on the trite idea of “energy independence,” but the fact is that producers are working in a high-cost environment. The breakeven price for oil drilling in many parts of the United States can be as low as $40 per barrel, but for the Bakken it can reach as high as $80-$85 per barrel. To be sure, marginal costs are different for different companies, and better producers in higher quality areas can operate profitably at much lower prices. But for many less-than-optimal drilling areas, prices dropping below the so-called “sweet spot” of $80 a barrel presents difficulty for many companies. And Bakken crude already largely trades at a discount relative to the global (Brent) price because of a lack of pipeline capacity, as well as the mismatch between the light, sweet stuff coming from North Dakota and the heavier, sourer refineries on the Gulf.
Bakken drillers need higher prices because their wells suffer from high initial decline rates. In the second year of production, a typical shale oil well in the Bakken only produces 30% of what it did in year one, followed by years of gradual but consistent decline. Drillers need to drill more just to keep up with declining production.
Put another way, wells need to largely pay off with their first or second year of production, otherwise they will not make sense to drill. As the best wells get drilled first, more and more wells in the coming years will struggle to give a good return. In order for those lower-tier wells to make sense, higher oil prices will be needed. If oil prices drop however, drilling will have to be cut back.
To top it off, there are two more negative side effects for drillers from the Fed’s tapering plan. Should interest rates rise due to a monetary contraction, the cost of debt will rise as well. This will make financing capital expenditures much more expensive for drillers. And second, tightening monetary policy makes the Dollar a more attractive investment relative to commodities such as oil, which are often used as a hedge, putting downward pressure on oil prices.
Investors need to be wary of several companies operating in the Bakken. Kodiak Oil and Gas (NYSE: KOG) is one company that is highly vulnerable to a drop in oil prices. Many investment analysts love this stock, and have suggested it could have a breakout year. Kodiak has lowered its drilling costs by improving well design and importantly, particularly for this discussion, it has hedged 62% of its oil at $93.29 per barrel, insulating it from a drop in oil prices. Still, the company is entirely tied to the fortunes of the Bakken basin as a whole. As a small company (market cap: $933M) dedicated to the Bakken, it should be considered as a bit of a risk, especially if the economy turns sour.
Triangle Petroleum (NYSE: TPLM) is a small-cap stock that is another pure-play for the Bakken (market cap: $670M). Its stock rocketed over the last three years, quintupling from less than $2 per share in 2010 and surpassing $10 per share in late 2013. However, operating costs have risen over the last year, which knocked Kodiak’s stock price off track when the company released its numbers on December 9, 2013. It may have ridden the Bakken wave upwards, but rising costs present some red flags. And if oil prices drop, look out.
Oasis Petroluem (NYSE: OAS) is another small operator betting big on the Bakken, although with a market cap of $2.67B, it is larger than the first two stocks mentioned above. Its web site loudly says that it is “aggressively drilling the Williston Basin” in North Dakota, but it has higher costs than some of its competitors. Its drilling cost per well averages about $8.8 million per well, compared to around $7-$8.5 million per well for Continental Resources (NYSE: CLR), for example. As another small drilling company focused only on the Bakken, Oasis is risky.
Continental (market cap: $10.66B) is a larger company than Kodiak, Triangle, and Oasis, and is thus a safer bet. It has lower costs per well and predicts further cost reductions. But as the owner of the largest amount of acreage in the Bakken, it is still highly exposed. The company recognizes this, and is investing billions elsewhere, notably in Colorado. Continental is a much safer stock to own than the other stocks mentioned, but again, keep an eye on oil prices.
Whiting Petroleum Corp. (NYSE: WLL) is a similar type of investment as Continental. Its market cap is a bit smaller ($6.68B) than Continental’s, but it is similarly betting big on the Bakken as it is the third largest oil producer in the area. Whiting is also putting a lot of its CapEx for this year towards developing its acreage in the Niobrara shale in Colorado, an unproven resource base at this point. This adds an element of risk, but Whiting has done a good job reducing its per well costs. Still, Whiting is dedicated to expensive oil, as are most of these companies, which investors should keep in mind.
If you want exposure to the Bakken but are more risk-averse, take a look at Hess (NYSE: HES), a truly global oil and gas firm with production coming from North Africa and Asia, Hess is the second largest producer in the Bakken. With a market cap of $25.67B, Hess provides investors a bet on the Bakken while also offering a bit more safety since Hess is diversified around the world – Hess’ Bakken assets represent less than 25% of its production and reserves. Hess announced on January 23 that it will spend $5.8B on exploration and production this year, a 15% reduction from 2013. About half of that CapEx will be put towards shale.
Conclusion
So there you have it. While Fed tapering, turmoil in emerging markets, and the Bakken are seemingly unrelated events, they are indeed tied together. To be sure, I still believe that oil prices will only trend higher over the long-run, as low cost oil is continuously depleted, and I have gone on record as saying so. Indeed, if EM countries can avoid what appears to be an oncoming slump, there is quite a bit of room for oil prices to climb. If that is the case, the stocks above could be wise investments for the next few years.
Therefore, I’m not saying that it is necessarily likely that Fed tapering and EM trouble will cause a drop in oil prices, but investors should not rule out the possibility. Oil markets are nothing if not volatile, and it is the oil drillers with high costs that are the most vulnerable to a downturn. The Bakken has been one of America’s top success stories over the last two years, but companies going all-in on high-cost oil are not without risk.
