Lots of data, little new information and no improvement in clarity
The IEA has spoken:
“In this report we suggest that the surplus of supply over demand in the early part of 2016 is even greater than we said in last month’s OMR.”
At IP Week in London, Vitol’s Ian Taylor and Chris Bake projected an even dimmer outlook, as reported by The Telegraph (UK) [here] and Reuter’s [hereand here], respectively. The most informative substance, excluding the throwaway comments about never getting back to $100 oil, include:
“We’re all running the same sort of numbers, which do show a tightening in the second half of the year, which would therefore lead you to believe that we probably will see some firming of price. But substantial? I don’t think so.”
The predominant focus has been on a weakening of demand growth - Vitol’s own 2016 demand growth projection falling to 0.8-1.0 from a 1.35 estimate (million barrels per day) disclosed last October. That a substantial deceleration from the estimated 1.6 achieved in 2015, and below the IEA’s dour 1.2 forecast for 2016.
On the supply side, Saudi and OPEC remain full throttle, although Iranian “at sea” storage of heavy barrels haven’t flooded the market. Estimates of Non-Opec supply continue to weaken, but not in a magnitude to take the focus off of the demand side.
Our basic analysis remains unchanged from last month, as put forth in “Oil Prices - Winter Inferno Fertilizes Dangerous Future Volatility” 17 January 2016 LinkedIn Pulse; so we shall skip a full discussion on Fundamental, Macro, Mechanical and Technical drivers of oil price. Instead, we’d like to hone directly on actionable advice for institutional investors and oil companies. Please see our legal disclaimer here, but to be clear, our thoughts are NOT individual investment recommendations.
- Supply and Demand projections are inevitably human-biased emotional expressions, not dispassionate measurements and calculations. We posit that as oil prices fall, and observable supply and inventory trajectories have not changed materially in the past month, that demand estimates have been lowered to accommodate the reality on the street. This may not be the order of operations that most analysts are comfortable with accepting, but reality is that oil prices have fallen ahead of demand estimate cuts.
- With normal seasonal inventory builds underway, it will be almost impossible to get the visual proof the market wants to see that a rebalancing is occurring. Note, we use the term “rebalancing” loosely, as our basic thesis on the oil market is that it tends to be out of whack more so than is commonly accepted. That said, it’s an easy frame of reference to describe a general need for visual proof of a change in trend. As Vitol’s executives eloquently put it, we are all running the same sort of numbers, and we should see tightening in the second half of the year.
- In the meantime, as we posited previously, in the vacuum of fundamental data, only momentum and the floor of insolvency act as the arbiters of oil price. This is what analysts have recently been calling “price discovery” in the media. The price of oil will go down until something breaks, something big enough that we can all point to it and feel satisfied that the ramifications are profound and permanent. Perhaps it’s Deutsche Bank? The high-yield bond market? We published our outlook on high-yield default rates here.
- This remains a Macro-driven market, but interestingly, the dollar has weakened a bit as fears of global demand weakness have permitted the Fed to back off graciously from their path of steady and immediate interest rate increases. While this lockstep correlation has now broken (dollar strength/oil weakness), the pervasive talk of negative rates, the consensus on a breaking of China’s currency, and financial market volatility everywhere have only colluded to highlight the impact of further demand weakness on oil oil prices. This is not just a Macro market, it’s a market hyperfocused on demand weakness.
- The roadmap to recovery, or contemporaneous signposts confirming a bottom has occured, still encompass the following markers (not just one, and not necessarily all):
- Flattening curve - which is a prerequisite for the removal of economic incentive to store oil
- Evidence of inventory draws
- A major development in the Syrian War that enables the participants to agree on a production cut from OPEC (chatter without progress in Syria is just hopeful chatter)
- Resolution of the China Growth question, most likely expressed in the Renminbi exchange market
As bearish as things are now, we do not subscribe to the view that we are entering a lost decade for oil due to massive over investment. Oil and liquid hydrocarbons are not logistically-constrained regional commodities like natural gas. While a decade of investment has done little to globalize US gas prices, we have certainly seen the impact of pipeline and rail unlocking Bakken, Niobrara, Permian and Eagle Ford oil differentials. The oil market is truly global, and therefore the regional natural gas market, in our opinion a poor template for comparison.
Yes, there was way too much debt financing of the boom, as financiers and investors alike failed to appreciate the impact of oil price volatility. Thus far, the resulting incentive distortion has prevented North American production from becoming the marginal swing barrel once widely projected. Moreover, it has contributed to the misallocation of financial risk that currently plagues the Macro outlook. But we are of the view that despite the relatively high development costs, that the US tight oil and liquids industry is not capable of over supplying the world in the long term. What we are seeing is the uncomfortable result of risk-averse capital allocation decisions creating medium-term dislocations that manifest themselves superficially as “market share” battles.
The real math is that OPEC is not squeezing out tight oil in a market share battle.OPEC is squeezing out more traditional E&P in frontier locations, something that should be very concerning for the Western supermajors. Arctic development has died. Deepwater has paused. Exploration has stopped.
The truth is that capital has voted to shun direct exploration risk en masse, much preferring the return profile of onshore liquids development utilizing advanced technologies and techniques, over the return profile of finding new reservoir development opportunities via deep water or harsh environment exploration and development.
Unfortunately, the one-dimensional comparison of costs per barrel by region that are readily available in analyst’s monthly publications fail to capture the irrationalities of human biases in terms of risk-reward preference. People - individuals, investment committees, regulators - place far more weight on negative outcomes than can be explained by probability statistics alone. Expected return, or the sum of probability weighted outcomes, is not the sole driving factor of capital allocation decisions in the oilpatch. Rather, time (in the measure of of both discounted cash returns, and information that “de-risks” future outcomes), risk of absolute loss, and the magnitude of dispersion of returns play a very substantial role in addition to expected return.
What we may conclude from this line of thought (although deeper study is recommended) is that the tight oil industry is here to stay. Compared to traditional E&P, by virtually eliminating the binary nature (wide return dispersion) of finding costs, leveraging continuous technological development, and the ability to address reservoir development decisions (drilling and fracking) apart from marketing infrastructure decisions (truck, rail, pipe and vessel) result in a very competitive and attractive barrel.
The ramifications of this thesis vector are quite profound:
- Extreme negativity on the overbuild in deepwater assets is warranted. The outlook for seismic, floating offshore drillers and certain equipment and marine construction players is quite ugly.
- Political constraints on “finding” and “large-scale development” are far more extreme than are currently expressed in the supermajors earnings dialogs, which tends to be a precursor for consolidating acquisitions.
- Even though a large portion of energy debt will need to be converted to equity, and MLP investors as a whole mistook current yield as a proxy for debt-like principal protection, the underlying assets themselves will not become white elephants. While the industry needs to be recapitalized and consolidated using more appropriate instruments or management of oil price volatility - the industry in North America, specifically, is not dead.
Investors who are highly selective, and strategically position themselves to thrive in a volatile environment, as opposed to those just trying to time a unilateral bounce in price, will thrive. We posit that the displacement of marginal traditional E&P by tight oil will be bumpy, uncomfortable, and at times quite volatile. Rather than a cap on pricing, the net effect will be to destabilize the predictability and smoothness of non-tight-oil supply. Once the Macro demand story has sorted itself out, long-term volatility is in for some very interesting turbulence.