As EM Bulls Capitulate, Is Shale Oil Next?

‘The rise in offshore leverage across EM since 2009 has been broad, although focused in some markets in the banking system (e.g. Turkey where the loan to deposit ratio has reached 120%) and in others non-financial corporate. There is certainly no immediate prospect of a rerun of the 1982 Mexican or 1997 Asian crisis but the IB “buy the dip, this time is different” mantra looks as misplaced as their blind panic on the asset class in early 2016 deflation scare. When it comes to analyst group think, this time is never different…’ May 18th 2018 blog post

The views expressed back then and indeed since late 2017 have been vindicated by the relentless selloff across EM assets since, led by FX and the most crowded equity longs like Tencent –  the consensus has now reversed decisively to being bullish USD and bearish EM.  The Trump agenda was essentially to grab growth from the rest of the world and bring it home, thus delaying the potential end of US geopolitical dominance, and that is in GDP and equity market performance terms being achieved. We highlighted coming into this year the potentially toxic combination of a simultaneous USD and oil rally for vulnerable twin deficit emerging markets, notably Turkey, which has seen its oil import bill soar to 2008 levels.

EM FX correlations have risen sharply this year, but as with EM government and corporate bond yields still sit below the highs of early 2016 when the China deflation scare was at its peak. On a real effective terms of trade basis, several EM currencies now look cheap (including the TRY, BRL and ZAR) and corporate spreads are back at more ‘normal’ historical levels versus US high yield. There is certainly a risk of a further rise in correlations amid forced selling by investors if the IMF can’t effectively backstop Argentina and/or Turkey fails to adopt more orthodox monetary policies. However, we’re turning more constructive – we recently closed our DXY long and industrial metals tactical short positions from Q1. While the latest US employment and PMI data remains strong, the extreme divergence between US and Europe/EM relative economic momentum looks set to close in coming months.

One factor to watch closely is US shale oil, where there is growing evidence that we have seen an inflection point this summer for capex and production growth momentum, with Q4 outlook downgrades across the oil service sector. A reversal will have a high multiplier effect across the real economy and would likely shrink the WTI-Brent discount and squeeze US refining margins/utilisation rates lower while underpinning our $90/bl Brent crude price target into H1 19. While logistical congestion in the Permian is a factor, we’ve long argued that analysts are underestimating the risk that shale productivity is approaching a secular peak at a time when the sector is belatedly being forced by investors to generate positive free cash flow. In that scenario, assumed US production growth of about 1.5m bpd annually through 2020 will fall far short of expectations. This may well be the next overwhelming market consensus to crumble, with wide ranging macro implications…

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…