Oil Market Punishing Recency Bias

Overall, Peak Oil has now been replaced by Peak Oil Demand as a popular investment thesis, but timescale is as ever critical in investment. While the rise of electric vehicles is inexorable over the next 15-20 years as productivity drives a better power to weight and cost ratio for batteries, recently the popularity of SUV sales in both the US and EM implies a cyclical upswing in gasoline demand through end decade. Official statistics can often mislead based on poor sampling and opaque inventory accumulation.’ Macro Weekly Insight – May 18th 2017

The dramatic surge in oil since late summer has surprised the consensus and energy equities have in recent weeks been catching up with the crude move. The oil rally reflects the fundamental tightening we were writing about since late Q2. Crude futures moving into backwardation last summer saw oil tanker storage turn uneconomic and the popular ‘glut’ narrative which saw several high profile bank analysts predict $40-45/bl Brent this year is now shifting.

While global demand is still surprising to the upside amid unusually synchronized growth, and OPEC holding the line at least through mid-year, US shale supply ‘elasticity’ remains a key factor. By 2025, the growth in American oil production will equal that achieved by Saudi Arabia at the height of its expansion, the IEA has claimed in its annual World Energy Outlook, turning the US into a net exporter of fossil energy as shale liquids output reaches 13m bpd out of a US total approaching 17m. Recency bias or the behavioural tendency to apply undue weight to the latest data and simply extrapolate that trend is endemic in the forecasting game. History suggests that the IEA  (relied upon by IB analysts to derive their forecasts) has a very grubby crystal ball, having serially underestimated EM demand for instance – their shale forecasts don’t look plausible.

oil production

Source: US EIA

I wrote a note in July 2013 entitled ‘Are Oil Prices Ignoring a Technology Driven Supply Boost?’, highlighting that US output growth continued to surprise the consensus, while emerging market demand growth was already clearly peaking with Chinese fixed asset investment, but it took almost a year for the re-pricing of that supply shock to begin. Having been oblivious to shale’s impact back then, investors are being complacent as to its sustainability now, and the per rig output data for the key shale regions (which has been volatile recently) bears close watching as much as the overall rig count.

Consensus fears that shale DUCs (drilled uncompleted wells) will flood the market with supply again look unrealistic. When these wells are completed, it will be gradual and the natural decline in legacy shale production will be difficult to overcome – geology will likely dominate shale ‘manufacturing’ innovation. Production from the early Eagle Ford and Permian plays has been declining – it looks unlikely that net shale production will increase by more than a low single digit % in 2018.

We’re seeing a shift to capital discipline across a sector that generated negative free cashflow of $170bn over the past five years. While QE failed to ignite a wider capex recovery, it helped create an investment boom in tech and shale, but capital markets are growing impatient with a sector chronically unable to generate positive returns on investment. The days of shareholder value destructive shale output growth at any cost look to be over, as executive incentives evolve.

Offshore oil service stocks and rig builders remain unattractive versus onshore as global energy capex will likely remain depressed, aside from high IRR productivity led projects. Low marginal cost E&P plays look vulnerable to a round of M&A consolidation by the majors who have been replacing only about 60% of production with new reserves. If the consensus assumption that shale can reaccelerate output growth is overoptimistic, then OPEC will grow its effective market share again. Keeping 1.2 mb/d (plus nearly 0.6 m bpd from non-OPEC) offline for another year could push the market into a deficit situation, leading to accelerated inventory drawdowns and prices heading to the $80-90/bl range in H1 19. That’s a scenario worth stress testing in portfolios…