At this moment, up in the shale play of North Dakota, there are some out of work roughnecks, shivering the night away, inside their idling camper vans. These wiry men, running low on the savings they put together from their last paychecks, are wondering in their dreams when they will be called back to work.
Outside these tiny homes on four wheels, there are bug-eyed oil field accountants in Gortex snowsuits, taking giant puffs from the exhaust pipe bongs that burn the refined North Dakota black.
These barrel counters are getting ready for next month’s quarterly reports for their respective shale play companies. Both March Madness in College Basketball and St. Paddy's Day approach, but another more important date in March has already ambushed any distractive relief that basketball and heavy drinking might have brought in this most bitter of months.
Yes, a very important date in the oil patch, March 2nd, has already come and gone. And that day was not favorable for the barrel counters. On that date, just a couple of days ago, the price of a barrel of oil left the numbers guys a tab that many of them will not be able to pay.
In their oil price shock, the dazed accountants are coming to grips with last quarter’s smoke and mirrors oil reserves and earnings. And last quarter was very bad. This current quarter they are realizing will be a bitch. And the 2nd quarter of this year will be even worse if Oil doesn't get its price on - and it looks like it won't.
When this quarter's oil reserves, profit margins, and earnings publish in April, the gambling money in the fracking belt will flare off into the night sky. The last few dollars remaining will be revealed as the “chump change” investors were chasing as the coins rolled through the sewer grates outside Williston’s now closed stripclubs.
Or in other words, if you thought the recent oil patch downturn was bad in early 2015, wait until the curtain pulls back on the real Shit Show next quarter.
Before we go to the tape, let's run some very simple and basic capitalistic ideas by you who’ve been sucking on the sweet tailpipes in the oil patch too long:
- If you're an oil sector company needing to borrow money for capital expenditures or just to keep the lights on, you will need high oil prices to get financing.
- The more reserves you can claim you have underground, the more financing for which you might apply and might actually receive.
- When oil prices come down - and recently they have fallen off a cliff - you’ll show smaller profit margins for the oil you pump to the surface. Smaller margins usually mean smaller profits unless you cut other expenditures (such as labor) to the bone.
- Reserves - the underground stuff oil companies list as collateral for loans - reduce in size when oil prices crater. Lenders want to know not how much oil is down there in your lease, but how much of that oil at today’s prices can be profitably extracted.
So how do we account every quarter for a barrel of oil when the price is always moving? How can the accountants adjust the reserves, the profit margins, and earnings when a barrel of oil is whipsawing like it has over the past six months?
Here's how: the price of oil in accountant's bookkeeping resets constantly once every quarter. This "factor" price is an average of the 12 preceding month's first trading days all averaged together.
Well, can't this "average" be overly compensated for on the low side or high side, depending on the trend price of oil?
Oh yes. And sometimes in a big way as we are about to see going forward this year.
And next quarter, when we report this quarter's (Q1 2015) earnings, we are going to witness the Big Hurt.
You see, in last quarter's (Q4 2014) accounting, the price of oil was averaged over 12 months to be $95 a barrel. We call this the "paper price".
(Note: oil stocks began tanking because of the decline in the price of oil to $50 a barrel, not because of the actual accounting of oil last quarter was at $95 a barrel. Meaning all those reserves, margins and profits (for the most part) for Quarter 4 sounded better than expected in the just released earnings reports for Q4.)
So, what are we looking at as the new "averaged" price of oil (or paper price) for this current quarter's accounting?
Come closer to the page, this is going to get interesting.
The closing prices for sweet crude on the first trading days of January, February and March of 2015 are the following:
2 Jan 2015 - $52.81
2 Feb 2015 - $49.83
2 Mar 2015 - $49.79
If you are an investor or swing trader who has been playing the oil sector recently, and you think the bad news is all factored in, you need to question your assumptions.
Seriously, if you think we have hit bottom in the oil sector stocks, you need to consider what is going to happen next month, April 2015. That's when companies report their earnings built on a new price of oil for this first Quarter we are still in. And this new price of "paper" oil is quite a bit lower than last quarter's overly-generous $95 per barrel.
Don't just take my word for it. (And we'll do some math to illustrate in just a second.) As a just released Bloomberg article’s headline says:
“The Price of Oil Is About To Blow A Hole In Corporate Accounting”
Yes, and that hole will look like a howitzer shell went through a paper target just 100 yards away.
And the reason for this is the price of oil for corporate accounting purposes is lagging, by almost 50% now, the real market price of oil at this morning’s opening.
The wise will take a few minutes now to think about what a new paper price portends for the oil sector plays when this current Quarter's (Q1 2015) earnings begin reporting next month.
But before highlighting some of that Bloomberg article, let’s talk about these SEC guidelines which gave accountants in corporate suites the $95 a barrel price for Q4's earnings reports. How was that paper price of $95 derived?
Very simply, the price of oil used in corporate accounting for earnings season is set like this:
You take the price of oil on the opening trading day for a month and write that down. You also take the price of oil on the opening trading day for the preceding 11 months and write them down.
Once you have those 12 months opening trading days’ prices, you add them all and divide by 12 to get this magic number accountants used in any earnings season for the price of oil.
Again, last quarter, the paper price of oil per barrel was $95 for accounting purposes. And yet, on the last trading day of 2014 (which was December 31) the price of a barrel of West Texas Sweet Crude closed at $53.71.
Even the blind sees where this is leading.
So that you just don’t take my word - or Bloomberg's - let's do some simple math right now. Let us see how and why $95 was the magical number used by oil sector accountants back in Q4. Let’s go back to 2014 and average in all 12 of those closing prices of the first trading days of each month:
2 Jan 2014 - $ 95.44
3 Feb 2014 - $ 96.64
3 Mar 2014 - $104.86
1 Apr 2014 - $ 99.69
1 May 2014 - $ 99.21
2 Jun 2014 - $102.45
1 Jul 2014 - $105.20
1 Aug 2014 - $ 97.62
2 Sep 2014 - $ 93.25
1 Oct 2014 - $ 90.70
3 Nov 2014 - $ 78.19
1 Dec 2014 - $ 69.31
If you add those 12 opening day prices for a barrel of oil for the respective 12 months of 2014, the total comes to $1,132.66.
If we take that number and divide by 12, we get an average price of $94.38.
I am guessing the accountants round up to the next even dollar. Or maybe Bloomberg's writer did? Regardless, the figure used in the Bloomberg article was $95 per barrel for accounting purposes for Q4 '14.
What might be the new number for Q1 2015 be?
Well, let’s go back to the past 12 months and their opening day prices, shall we?
1 Apr 2014 - $ 99.69
1 May 2014 - $ 99.21
2 Jun 2014 - $102.45
1 Jul 2014 - $105.20
1 Aug 2014 - $ 97.62
2 Sep 2014 - $ 93.25
1 Oct 2014 - $ 90.70
3 Nov 2014 - $ 78.19
1 Dec 2014 - $ 69.31
2 Jan 2015 - $ 52.81
2 Feb 2015 - $ 49.83
2 Mar 2015 - $ 49.79
Adding those 12 opening day prices for the past 12 months we get $988.05 as the total. We must divide that total by 12 to get our new "paper price" of a barrel of oil for this current quarter of Q1 2015
So,
988.05/12 = $82.33
Let’s round that up to $83, assuming that’s what the accountants will do.
Okay, last quarter (Q4 2014) oil was pegged in quarterly reports at $95 a barrel. This current quarter (Q1 2015) corporate accountant will peg "paper oil" in quarterly reports at $83 a barrel.
That right there means the price of a barrel of oil has dropped by 13% when accounting begins for this new quarter ending March 31st. In turn, we will see smaller margins, smaller profits, and fewer "recoverable" reserves. (We already know through numerous reports from the shale fields that oil rig counts are falling rapidly.) All of this will make it harder for the oil companies needing loans to find financing.
Let's finally read a few paragraphs from this Bloomberg piece I've been referencing:
“Companies use the first-trading-day-of-every-month calculation to estimate future cash flow and to tally how much crude can be profitably pumped out of the ground. The SEC introduced the formula in 2009 as part of wider changes in how the regulator required drillers to report reserves. Prior to the shift, the value of the reserves was measured based on the oil price on the last day of the year, which also caused distortions.
There are no current plans to revisit or modify SEC reporting rules, Erin Stattel, an SEC spokeswoman, said in an e-mail. She declined to comment further.
Most shale drillers are reporting increases in what’s known as proved reserves. The SEC requires oil producers to submit an annual tally, along with an estimate of the present value of the future cash flow from those properties. The estimates are limited to what the firm is reasonably certain it can extract from existing wells and prospects scheduled to be drilled within five years. The reports are based on factors such as geology, engineering, historical production -- and price. To count as proved, the resources must be economic to develop given existing market conditions.”
Please note that last sentence which I have highlighted. Let's drive this thought home: Reserves are not real "reserves" unless we can profitably bring them above ground. Period.
Thought for the day: Some of those "reserves" which were profitable at $95 a barrel last quarter are not going to be profitable this quarter at $83 a barrel. Hence, per SEC regulations, those newly "unprofitable" barrels underground will not longer be counted as "reserves".
As has been said time and again, we will never run out of oil underground. Some of it will always remain because the energy expended to bring it to the surface would exceed the energy the hard to get at oil would supply. Or, in easier to understand words: this hard to get at oil is nowhere near as profitable at $83 a paper barrel as the stuff in the desserts of the Middle East and North Africa.
When oil margins shrink in the shale regions, there’s only one way to keep the earnings up: pump more oil. But as mentioned moments ago, oil rig number are declining with the real spot price of oil
If you can’t get the loans needed to keep the oil coming to the surface, and the depletion rates of the fracked wells are speeding up, when does a company pull the plug on wells? Or do the companies simply layoff more workers, and stop adding to the glut so as to preserve some borrowed cash to continue making interest payments on their loans?
I don't know, but I do know I don't intend to be in any oil sector stocks during the next 6 months.
Here's my bet: next quarter when oil sector companies begin reporting this current quarter’s reserves, margins and earnings, I believe we will see many of their charts take out their recent lows.
Or as the Bloomberg headline once again warns:
“The Price of Oil Is About To Blow A Hole In Corporate Accounting.”
If you’re playing the oil sector now and are dozing at the “sell” button on your trading screen, you might want to put on a big pot of coffee and check your assumptions at the next closing.
Things will only get worse going forward if oil continues to bump along at $45 to $55 a barrel going into Summer. Think about it: oil going sideways for the next three months means an even lower "paper price" for Q2.
Now is not the time to be going long on oil stocks, at least in my mind.
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