OIL: A New Business Model

In 2014

A while back I wrote, “The Middle East will have to find ways to protect future oil revenues. It appears that they have. Despite the falling price of crude from $100 a barrel to $80 a barrel and now to $75 a barrel, Saudi Arabia is maintaining production and other oil producing nations seem to be in sync.”

Remember, I said protecting revenues.  Not prices, not profits—revenues.

Falling oil prices, Middle East supply, and a slugging global economy are bad news for U.S. Oil Company revenue. 

Remember the basic business paradigm: increased revenue and a rising demand curve ultimately effectuate a rise in capital investment and operations spending: buy more equipment, drill for more oil. (And now, natural gas.)

However, spending money to increase supply is valid only if there is a demand curve growth and a reasonable expectation of increasing ROI.

Now, the oil producing nations are maintaining output to maintain market share.  Add to this that sluggish global economy; US production increases, and competition and we have analysts predicting energy stocks will fall along with profits.  In addition, advances in alternative energy may further impinge on market share and influence future R&D--both the activity and the strategy & planning aspects.

Now, onto the present.

We all know the concept of fixed costs and variable costs.  Now, I would like to discuss fixed demand v. variable demand.

The Metaphor

Mr. BigWell’s Analysis.

• Fixed number of cars

• Maximum gas tank capacity

• Fixed Demand:

• 20 gallon gas tank

• 20 mpg

• 40 mile commute to work each day

• 400 miles per week

• 20 gallons per week

• 1 million cars

• 20,000,000 gallons of gas per week

Now Mr. BigWell knows his fixed demand.

Then we have variable demand

• Weekend trip to the beach

• A visit to Grandma’s house

As gasoline prices rise, the variable demand will taper off.  Mr. BigWell knows this. He also knows that the fixed demand will cover his costs and he will make a profit.

When the Economy Flags

If the economy flags, unemployment will increase and the fixed demand will decline.

Now we go to Supply

Remember what I said?

However, spending money to increase supply is valid only if there is a demand curve growth and a reasonable expectation of increasing ROI.

You make a large profit at $100 a barrel.

You invest in supply

You ramp up supply beyond demand

Prices fall

The return from fixed demand falls while expenses rise

You increase investment in production to increase supply when you see a rising demand curve. 

Metaphor:

In some instances of fierce competition, Mr. Widget will sell widgets at a loss to put his competitor out of business. Then, increase prices. Or, to maintain market share.

Right now, with cheap oil and diminishing storage capacity, what can we look forward to if customers are “storing widgets”?

Mr. Widget is selling widgets at half-price.  Mr. MaxWell is buying up half-price widgets.

When the market turns around, Mr. MaxWell does not buy widgets. Mr. Widgets can’t benefit from the rising widget demand and the rising prices.

Years back, I wrote Energy Independence. (Then What?)  22. March 2012  

Saudi Arabia is no longer our customer. Saudi Arabia needs new customers. Saudi Arabia sells oil to China. 

When the oil prices turn around, China will not be looking to buy oil at $80 a barrel when they can use the $40 a barrel oil they have in their inventory.

Remember when I said, “China doesn’t have a housing bubble. China has a housing inventory”?

China will have lower energy costs and be better able to compete.  China will be able to switch from coal depressing the coal market, and benefit from solar and hydro-electric power.

Malcolm Forbes said, "Put all your eggs in one basket. And watch that basket." 

However, Warren Buffet is increasing his holdings in Alternative Energy. Berkshire Hathaway Energy.

OIL:  The Real Outlook.

Warmest regards,

Slim

slimfairview@yahoo.com

Copyright © 2015 Bob Asken

All rights reserved.