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Overall, Peak Oil has now been replaced by Peak Oil Demand as a popular investment thesis, but timescale is as ever critical in investment.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

 

Has US Healthcare Inflation Peaked?

The soaring cost of healthcare in the US over the past 20 years has been a hugely distorting economic trend as a key driver of personal bankruptcies, by depressing private sector wage growth as employer insurance bills surged and absorbing 17% of GDP or about twice the developed economy average. Are we at an inflection point? Among the various measures of healthcare inflation in the US, the broadest is the BLS calculation of the cost to private sector employers of providing healthcare benefits, now down to 2.4% y/y, the lowest since 1981. A recent survey by payroll processor ADP on the rise in medical insurance premiums paid by large employers has tumbled to 1.7% y/y.

‘Obamacare’ has certainly boosted transparency but technology seems to be finally suppressing healthcare inflation in the way it has in so many other sectors; doctors and nurses now routinely carry tablets to take patient notes, cutting out layers of administration and overlap. ‘Diagnostic algorithms’ are now entering common usage, so much so that the nurses’ union is conducting a media campaign with the punchline “Algorithms are simple mathematical formulas that nobody understands.”Well the geeks in Silicon Valley certainly understand them and investors are slowly waking up to the implications of ‘deep automation’ software spreading across the service economy.

Robotic pharmacists are already being introduced at some hospitals and the Food and Drug Administration has issued a patent  for the first ‘human interacting autonomous robot’ for medical use, mirroring developments in Japan. The RP-VITA robot allows specialists anywhere in the world to communicate with patients, has data ports that connect to digital thermometers, stethoscopes and ultrasound imaging as well as integrating medical records. Meantime, the explosion in wearable monitoring equipment for vital data from Apple, Nike etc. will eventually be integrated to deliver pre-emptive healthcare intervention. The best doctors will be freed from mundane patient diagnostics but like the London taxi drivers protesting against Uber’s arrival which I covered recently, their mediocre peers and those relatively well paid nurses will see their wage premium steadily eroded. 

That has huge implications on a macro level; firstly, healthcare was the single largest source of aggregate private sector earned income growth in 2000-2009 and it’s hard to see what replaces it; secondly it was the major service sector contributor to CPI growth (alongside college tuition and the associated $1.2trn student debt burden, a sector also vulnerable to tech disruption) and if this downtrend continues, again it’s hard to see what replaces it. Lastly, healthcare costs were the major driver of the long-term structural deficit in the US (via Medicare/Medicaid entitlements) with total spending until recently projected by the CBO and other independent analysts to top 20% of GDP by end decade – a sustained fall in healthcare inflation has dramatic implications for the equilibrium rate for USD (higher)/bond yields (lower)/US fiscal deficit (lower). Indeed, medical spending accounts for 17% of the Fed’s preferred personal consumption (PCE) inflation measure and the slowdown in healthcare inflation means that sustaining the 2% target rate medium term (equivalent to 2.25-2.5% CPI) will be difficult, partly explaining this year’s ‘surprise’ Treasury rally, although investor repositioning from a bearish duration consensus and ECB easing expectations also played a major role.

Tech trends are net bullish for emerging markets as an asset class by allowing development to ‘leapfrog’ infrastructure/human capital constraints but the macro impact on long-term developed world inflation/interest rates/employment market ‘slack’ is still widely ignored as economists stick to their orthodox models. Indeed, that is the basis of predicting a classic if belated wage and investment cycle as the capital stock is getting old, funding costs are at record lows, the utilization rate is climbing to pre-crisis highs etc. That’s all fine in so far as it goes, but of all the investors I talk to, tech VC people seem to understand the wider economic implications of the disruptive business models they’re investing in best. US capex trends YTD remain weak and the core orders segment of the April durables goods data sustained that trend. While there will be some belated cyclical pick-up, we’re almost certainly seeing a structural down shift in investment intensity in GDP and revenue growth as technology related capital goods which have a strong deflation price trend become a bigger share of overall spend. As noted previously (and in stark contrast to Japan and EM) S&P buybacks plus dividends exceeded capex last year, although institutional surveys suggest most US investors now want to see companies ramp up investment.