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Overall, Peak Oil has now been replaced by Peak Oil Demand as a popular investment thesis, but timescale is as ever critical in investment.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


Scottish Vote Highlights UK Macro Vulnerabilities…

The IEA commented in its latest monthly report that the recent slowdown in oil demand growth was ‘nothing short of remarkable’. With Brent oil testing a two year low at $97, perhaps a price chart should be put on billboards by the Scottish referendum ‘no’ campaign to remind undecided voters of the economic risks in becoming a northern Emirate. It seems a very long time since peak oil pundits dominated the financial media; over the past year, the oil market has shrugged off geopolitical volatility, comforted by clearly weakening EM demand growth as subsidy regimes are reformed and the surge in US shale output. An independent Scottish economy would be hugely reliant on the oil sector (the largest source of revenue after income tax, with the UK’s national statistics agency estimating £120bn in North Sea tax revenues through 2040, the Office for Budget Responsibility about half that). US shale oil drilling was once described to me by a Texan geologist as like ‘trying to draw blood from a junkie’ i.e. you have to drill lots of wells. Each delivers a few hundred barrels of oil a day but with rapidly declining wellhead productivity. Operating costs for a shale oil well add up to about $30/bl, but including land acquisition, financing and the need to replace 50-70% of output each year with new wells, the lifetime breakeven cost for an individual well drilled today approaches $75-80/bl. If we take that level as the floor on global prices, an independent Scotland would face huge budget deficits or have to slash promised social spending.

The rather dismissive London media elite attitude to Scottish independence (a ‘banana republic with kilts’ etc.) has certainly helped boost support for the nationalists. The radical devolution of powers now being offered to keep the UK together means the bill for subsidizing Scotland will at least double from the current £10bn a year and exacerbate already weak fiscal trends. Indeed, the UK’s constitutional structure is no longer tenable regardless of the outcome; a move to some form of devolved Federal structure now seems inevitable, perhaps along German lines. It’s ironic that a key Scottish nationalist argument for going it alone has been to escape Westminster austerity, because there’s actually been far less UK austerity than widely assumed and the combined fiscal and current account deficit is worse than any Eurozone peripheral member and all but a few emerging economies.

The merchandise trade deficit reached a near record £10.2bn in July while the deficit including services reached £3.3bn; recently revised data shows the positive investment income balance surplus on the current account disappearing in 2008 rather than 2012 as previously thought – we get the more recent annual revisions at the end of this month and they’re likely to be grim. While the current account deficit has improved from its 5.7% of GDP peak in Q4 last year to about 4.5% this year, combined with persistent fiscal weakness sterling remains acutely vulnerable to any shift in global investor risk perceptions. UK austerity has stalled for the past couple of years despite the political posturing, and government spending has continued to rise in cash terms; it’s up about £100bn since the crisis to over £600bn in the last tax year ending this April.

Tax revenues in the first four months of the 2014/15 tax year are almost 2% below their level in July 2013 in nominal terms; fiscal deficits have improved far faster in the US and Eurozone than in the UK since 2012, despite faster growth in the latter. In the last few months the underlying Public Sector Net Borrowing was higher than at this stage of the last three fiscal years, which is remarkable given the acceleration in growth to 3%. Spending will have to be cut by about 1% of GDP a year through the next parliament to approach a balanced budget by end decade, even assuming a very benign macro backdrop for rates and growth. The Eurozone as a whole and the US are both currently running a budget deficit in line with levels seen in 2004/5  –  Germany expects to balance its budget this year (whether that’s desirable is another matter). The UK in contrast has barely begun getting its fiscal house in order and once the referendum is over, that will become a focus for global investors as we head into the election next year and the EU referendum in 2017. Perhaps it’s not surprising that a record number of one-term MPs are leaving at the next election, because whoever assumes power in the UK will be inheriting a poisoned fiscal chalice. 

Technology Drives US Energy Revolution…

The dramatic shift in the US energy balance as a result of shale gas/oil fracking technology is a theme I’ve often highlighted, and the chart below has global ramifications across many industries. US oil imports will fall to their lowest level for more than 25 years next year according to the US Energy Information Administration (EIA). Net imports of liquid fuels, including crude oil and petroleum products, would fall to about 6m barrels per day in 2014, their lowest level since 1987 and only about half their peak levels of more than 12m during 2004-07. The figures reflect the spectacular growth of US production thanks to the unlocking of “tight oil” reserves using hydraulic fracturing and horizontal drilling in states led by North Dakota and Texas.

The declining US dependence on imports will reduce the trend current account deficit and offer long-term support to the USD, increase resilience to crude price shocks and generate high paying jobs in the energy sector directly (and the highest paying non-graduate jobs in the US right now are in North Dakota, so long as you don’t mind living in a trailer) and in associated industries such as rig engineering and construction. In contrast to consensus IB forecasts, the EIA also expects increased US production to put downward pressure on oil prices, with Brent crude dropping from a record average of $112 per barrel last year to $99 in 2014.

US crude production fell to just 5m bpd in 2008, but rebounded to 6.43m last year and is expected by the EIA to rise to almost 8m in 2014. At the same time, consumption has been falling, from 20.7m b/d, for all liquid fuels, in 2007, to 18.7m last year. The EIA expects that the US will still use less oil in 2014 than in 2011, as conservation efforts (notably a far more fuel efficient car fleet) pay dividends. The surge in production in the US has led some forecasters, including the International Energy Agency, to predict that it will overtake Saudi Arabia and Russia to become the world’s largest oil producer by the end of the decade. The EIA has been cautious about endorsing the more euphoric forecasts, which depend on factors that are difficult to predict including Saudi production spare capacity growth, stability in Iraq etc. The US will still next year be importing about as much oil as at the time of the shocks of 1973-74, and even if the US becomes completely self-sufficient in oil, it will not be able to ignore the potential threat to the world economy created by price rises and supply disruptions, and so would still have an interest in sustaining production in the Middle East.

In the 15th November weekly, I noted that: Coal’s share of total US electricity generation has dropped by more than 10% in the last four years, replaced by NG. And US coal production this year is expected to drop by 7%, despite surging exports, notably to Europe. Dirt-cheap NG prices have caused a major slowdown in drilling activity, which will help ease the supply glut that has plagued gas producers during the past several years, and is reflected in a 25% price jump in recent months while thermal coal languished below $80/tonne. The switching terms from coal for US power plants, having been compelling, have reversed since then. Added support comes from power demand bottoming in China.’ The US Energy Department forecasts that the average spot price of natural gas will hit $3.68 in 2013, making current thermal coal prices highly competitive for power generators while China looks set to import 240-50 million metric tons of thermal next year, or 10% more than in 2012 at a time when the US exportable surplus is shrinking.

Since the end of October, benchmark prices have risen around 10% with thermal coal from South Africa’s Richards Bay trading at $88 a ton.  Although China’s immediate appetite for coal may be muted with above average stockpiles, prices should be buoyed by seasonal restocking across the Northern Hemisphere in coming months. The price for top-grade coal should break $100 a ton by end Q1, and indeed an average thermal coal price of $100-110 a ton for 2013 is feasible, from recent lows sub $80.

Resurgent North American oil production is finally being matched by increases in pipeline capacity, releasing ‘trapped’ domestic supply onto the global market. As shale oil production surges, drillers and refiners have used trains, barges and trucks to move oil from remote mid-Western fields to coastal refineries but all are more expensive than pipelines. The Association of Oil Pipe Lines estimates that new US pipeline capacity totalling 500,000 bpd came into operation last year while US crude output rose 780,000 bpd. It’s a good bet that the WTI-Brent price gap, which has been running at $20-30 in recent months, will close toward $10 over the next 12mths or so. The new Seaway pipeline is set to almost treble capacity from Cushing, Oklahoma, the delivery point for WTI oil futures contracts, to the Gulf of Mexico export terminals, helping drain record stocks at Cushing, which have artificially depressed the WTI price.

Meantime, while gasoline prices dropping about 50c a gallon in recent months are a discretionary spending windfall for US consumers, broad credit and money supply trends in the US also remain supportive, with three month moving average growth of just sub 6% in total bank credit and over 8% in commercial and industrial loans. We’ve also seen four straight months of impressive gains in overall consumer credit. Consumer credit increased more than forecast again in November, led by borrowing for student loans and auto loans; the $16bn gain followed a $14.1bn advance in October. With sustained if modest gains in the labour market and strong demand for student loans and autos, consumer credit should grow further in Q1. Easing bank lending standards combined with an improved labour market suggests that consumer spending can withstand the 2% payroll tax hike from the fiscal cliff deal.