House of Cards About to Collapse

Jim Brown
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Exploration companies drill through miles of rock but it appears their foundations are on shifting sands. Companies are slashing expenses to the bone in an effort to survive and there are probably going to be a few that don't make it until oil prices rise again.

Transocean (RIG) is the largest offshore driller. The company was forced to cut its annual $3.00 dividend to 60 cents in an effort to cut the cash flow bleed. Companies hate to cut dividends and normally do it only as a last resort. They view it as breaking faith with investors and it normally produces further declines in the stock as investors leave for a more secure company.

The company also said the CEO was stepping down and he is resigning from the board. Shares of Transocean have fallen -76% since he took the helm in 2010. CEO Steve Newman got off to a bad start when the Deepwater Horizon exploded and sank in 2010. The company had to pay 41 billion in civil penalties. It has been all downhill ever since.

With oil at $50 a barrel the company is struggling to find companies that want to pay $600,000 a day for its premium rigs. Prices have declined to $400,000 a day and probably less if you could see what was being quoted today. In January the company said it had scrapped or would scrap 12 older rigs because they could no longer find clients.

Competitor Diamond Offshore (DO) eliminated a previously announced special dividend. Noble Corp (NE) cut its capex budget in half but said it would still keep its dividend. Ensco Plc (ESV) is one of the smaller players but they are also keeping their dividend. These small companies can't afford to pay it but they also can't afford to cut it or the drop in the stock price could put them in violation of some of their loan obligations.

The next problem hitting the sector is accounts receivable. Companies still drilling are defaulting on payments to service contractors, sand suppliers, pipe suppliers, etc. U.S. Silica had to raise bad debt reserves in the Q4 earnings by $6.9 million due to doubtful recovery from a specific unnamed driller. Service companies have been hit with a lot of demands to renegotiate contracts with price cuts of -25% or more.

With the active rig count imploding there is a huge oversupply of men, equipment and services going unused. The active rig count is down -664 rigs from the 1,931 high in September. Every one of those rigs accounts for 50-80 workers and dozens of service contracts for everything from mud, water, sand, pipe, technical services, fracking, site preparation, etc. With an average of 3+ wells per quarter per rig that is roughly 2,324 wells that won't be drilled next quarter. With an average cost of $7 million per well that means $16.27 billion in oil field spending has evaporated for Q1. It will be worse for Q2 since the rig count is still falling.

Analysts are now telling everyone to wait for the "second low" in crude oil before buying anything in the energy sector. Bank of American warned last week about the shrinking storage capacity that I have been writing about for the last month. The big name analysts are starting to pick up on it and that means the hedge funds will be taking appropriate positions.

Evercore's Ed Hyman said that energy stocks tend to lag oil prices. In the six previous V shaped bottoms in oil ended up with a double bottoms after the first rebound failed. In every case the recovery in energy stocks corresponded with the second bottom.

Cumberland's David Kotok said his clients are still underweight because they are not convinced a bottom has occurred. In the scenarios they have envisioned they see more downside risk than upside potential.

Barclay's Thomas Driscoll said his company was less bearish on oil prices but remained bearish on energy stocks. He believes production will decline in 2015 and that will produce a top for revenues.

In the truth is stranger than fiction department Sharon Stone is being sued for skipping a protest against Chevron. Company MCSquared said the actress did not show up for scheduled protests against Chevron in Ecuador. The company had paid her a $275,000 appearance fee plus it had spent $77,420.09 to "accommodate Stone's "diva-like" requests including first class airfare tickets and luxury hotel suites for herself and three companions, etc. Chevron has been fighting a fraudulent case for pollution in the Amazon Rainforest. The entire case was rigged against Chevron with the judge taking payoffs from the other side and letting the plaintiffs lawyers write his opinion for him. The trial had doctored evidence, coercion and bribery that resulted in an $18 billion fine against Chevron. However, over the last five years Chevron has been able to prove all the illegalities listed above and the award is uncollectable. I guess Stone and her entourage decided they did not want to appear on the side of the criminals even for a $275,000 appearance fee.

Active Rigs

Active drilling rigs declined -43 to 1,267 for the week ended on Friday. Oil rigs declined -33 for the week to 986. Active gas rigs fell -9 to 280 and a new 18 year low. Active rigs have now declined -664 since the high of 1,931 in September. That is a -34.4% drop.

Other than during the financial crisis the number of active rigs has been above 1,700 since the beginning of 2006. We are poised for a significant decline, possibly to the 1,000 level.

Baker Hughes warned that in those previous oil declines of 50% or more the active rig counts declined by 40% to 60%. So far we are only down -34% so we still have a ways to go. A 50% decline in oil rigs would be -805 from the 1,609 peak on October 10th. So far we have declined -623 oil rigs so we could lose another 180 before it is over.

Oil Inventories

Crude inventories rose another 8.4 million barrels to 434.1 million and the highest level for February since 1930. Crude inventories have risen +51.7 million barrels over just the last 7 weeks. Refinery utilization fell to 87.4% last week from 88.7%. Imports rose from 7.1 mbpd to 7.3 mbpd. U.S. production rose +5,000 barrels to 9.285 mbpd and the highest level since 1972.

Cushing inventories rose +2.4 million barrels to 48.7 million and a 6-year high.

Gasoline inventories fell -3.1 million barrels to 240.0 million. Gasoline demand rose +106,000 bpd and imports fell -66,000 bpd.

Distillate inventories declined -2.7 million barrels to 124.7 million. Demand rose +32,000 bpd. Imports increased +137,000 bpd. Inventories should rise in the coming weeks with tens of thousands of airline flights cancelled due to winter weather.

In the graphic below green represents a recent high and yellow a recent low.

Propane inventories declined by -2.23 million barrels to 59.24 million. Demand declined to 1.39 mbpd. With the cold weather continuing this week we should see higher demand over the next several weeks as late winter refills continue.

Natural gas inventories declined -219 Bcf to 1,938 bcf. Inventories are now -1.5% below the five year average of 1,968 Bcf and +42.3% above year ago levels at 1,362 Bcf. With only 3 weeks left in winter there will be no gas shortage like we had in early 2014.

The blue line in the chart below shows the current inventory relative to the five year average.


The market sold off slightly on Friday on the rebalance of the Morgan Stanley indexes, profit taking before the weekend and normal month end restructuring. With earnings winding down and Greece out of the headlines the attention of traders will turn to the potential shutdown of the Dept of Homeland Security for lack of funding and the various payroll and manufacturing reports due out this week.

Jim Brown

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