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Overall, Peak Oil has now been replaced by Peak Oil Demand as a popular investment thesis, but timescale is as ever critical in investment.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…


Having Tamed Inflation, Vietnam Tackles Overleveraged Banks…

Despite hosting a few interesting consumer stories such as Vinamilk, Vietnam has been from my top down perspective a highly risky investment destination, plagued by sustained macro instability. Having been touted by Asian brokers as a ‘mini China’,  perhaps it’s finally living up to that name as it undergoes a painful deleveraging process and local tycoons get hauled away in handcuffs amid political uncertainty. It’s positive that the authorities have followed through on stabilising the macro environment as reflected in falling inflation and a becalmed VND. However, the country’s overextended banks and their fast deteriorating loan quality (with NPLs already probably well over 10%) have been the trigger for recent headline grabbing events, which have seen the local market slump over 20%.

The chief executive of Vietnam’s Asia Commercial Bank (ACB), Ly Xuan Hai, was arrested last week and he could face up to 20 years in prison if found guilty of the rather quaint sounding charges of “deliberately acting against state regulations on economic management and causing serious consequences”. Moody’s lowered Asia Commercial Bank’s credit rating to B2 from B1 last week in the wake of these developments and put the company on review for future downgrades.

Annual GDP growth averaged more than 7% in the decade leading up to the inflation crisis of 2008, but has slowed to just 4.7% in Q2 2012 as the government tightened credit in an attempt to restore confidence in the currency, and dissuade its citizens from hoarding gold and USD. Slower inflation has created room for the State Bank of Vietnam to try to boost economic growth by cutting policy interest rates, but having cut rates by five percentage points already this year, the bank may have reached the point where further easing has limited impact, until bank nonperforming loans are dealt with, so they can boost lending. In any case, slashing rates much further risks reversing retail flows back out of the VND and into gold and the USD.

The State Bank of Vietnam’s Governor told the national assembly recently that the non- performing loan ratio is now at 10%, although the bank’s official figure as at the end of June was only 4%. The bank expects 5.1% growth in 2012, which looks ambitious as the slowdown reflects weak domestic demand. With consumer credit tight, most Vietnamese are taking a conservative approach to consumption, as wage growth slows and unemployment rises, while some of the highest gold holdings as a share of total household wealth in the world are no longer generating a spending windfall. Reflecting this, import growth on a YTD y/y % growth basis has slowed from 24-26% a month throughout 2011 to under 7% in August.

Business in Vietnam has long been characterised by a lack of transparency, weak corporate governance, and rampant fraud/corruption far exceeding anything seen even in less than exemplary Indonesia or China.  The corruption clampdown amid widening economic inequality and popular discontent at the politically connected business elite (sound familiar?) is long overdue, and has gone far beyond celebrity tycoons. For instance, eight executives at Vinashin received prison sentences of up to 20 years in April after the shipbuilder nearly collapsed in 2010, having run up around $4.4 billion in debt. With the boom unravelling, the rise of hardliners such as Communist President Truong Tan Sang, may pull the country from a reform path (and the shift in oversight of the anti-corruption governing body from the Prime Minister to the Secretary General of the Communist party is telling) but privatisation revenues remain crucial and regaining the confidence of foreign portfolio investors will be a priority. I concluded in that note last February that: ‘By the beginning of Q4, we should know if they have the stomach for this fight; if so, Vietnam will finally become a sensible long-term investment destination for portfolio investors rather than that ‘mini China’ investment sound bite.’

After a series of missteps, Vietnamese authorities have showed impressive resolve to restore policy credibility, and if they can now reform the banking sector and manage its NPL issues, the country can belatedly aspire to graduate from frontier market status later this decade. Although the local market remains largely a retail driven casino (with price trends correlating inversely with VND gold prices, a factor driving this year’s Feb-May rally), resumption of the delayed privatisation program would be a positive sign of intent and local consumer, pharmaceutical and infrastructure plays look thematically attractive longer term, while property and construction materials remain exposed to a prolonged downturn.

Banks may deliver a ‘dead cat’ rebound, but with acknowledged NPLs having gone from 2% at end 2010 to 10% now, and with a series of corruption scandals from the credit boom coalescing, they will be a volatile ride. The benchmark equity index has fallen 21% from its high this year on May 8th, and is now trading at a 9.4x PER, or about a 33% discount to the MSCI South East Asia Index. If for no other reason, events in Vietnam are worth watching as a precursor to policy changes facing China’s Communist party, where many of the same economic and social stress points as well as a loss of political authority are evident, albeit on a vastly greater scale. Furthermore, it’s not at all inconceivable that the two countries, with a historically uneasy and sometimes violent relationship, will come to blows in the not too distant future as domestic pressures drive geopolitical posturing.