Disequilibrium Is The Norm
The primary difficulty most investors have in navigating oil markets is their starting assumption that supply and demand are magically drawn toward a point of fundamental equilibrium, where everything balances perfectly, and an economic homeostasis can flourish. This is simply not the world we live in. In fact, it is dangerous to manage a business based on that premise, and either widely profitable or toxic as an investment strategy.
“This is simply not the world we live in...these models tend to fail.”
While there is great cognitive value in creating models of oil supply, demand and inventories on both a macro (global) and micro (by company) scale, ultimately, these models tend to fail when it comes to predictive value. I’ll again highlight an informative graph from The Wall Street Journal that illustrates how three of the most prodigiously staffed, well-funded global institutions have fared on just one of the factors:
Rather, the combination of imperfect, lagging and opaque information; extremely long-lead-time capital intensive project implementation; and highly-leveraged, perhaps under-capitalized, financial pricing discovery result in a permanent state of disequilibrium. We are only in balance by accident, and only for short-periods of time.
“We are only in balance by accident, and only for short-periods of time.”
Presently, consensus supports a world-view of an oversupplied oil market, and with no place for that production to go (i.e. insufficient consumer demand), excess supply has been forced into storage.
Indeed, inventories are high, but the lack of dislocations in physical spreads suggests causality may be overstated. A more accurate characterization is that inventories have grown driven by an expectation of higher prices in the future (time spread signals). Unlike periods of true physical dislocation, to date, we have seen none of the logistical issues associated with futures expirations or storage constraints that become so obvious in the physical markets.
Clearly this downturn is macro and financial in nature, not physical. Analysts continue to adjust their “equilibrium” pricing expectations down to match the reality of pricing on the screen, driven by a plethora of negative news flow including:
- large inventory builds in products and crude (that may be driven more by year-end tax accounting and balance sheet considerations than actual supply and demand) that show no evidence of future drawdowns;
- unusually warm weather (from a financial trading perspective, not a climatic viewpoint) caused by El Nino dampening heating demand in the Northern Hemisphere;
- a flood of new supply expected to come from the lifting of sanctions in Iran;
- a firm Saudi stance that they will not lead an OPEC production cut;
- daily reminders from Syria that the Saudi’s and Iranians are not in a cooperative mood; and
- weakness in Chinese Yuan Renminbi/US Dollar and falling Chinese stock market amplifying concern over the magnitude of the slowdown in Chinese economic growth, and by extension, future demand for oil.
The impact of this deluge has been nothing short of a winter inferno, as far as oil prices are concerned.
"Clearly this downturn is macro and financial in nature, not physical."
The Fall in Oil Prices Has Accelerated
Short-Term Oil Prices, via CME website
While the 23% WTI price decline over November-December inspired my penned analogy about the horrible sound of a submarine’s hull being crushed at excessive depth, the first half of January’s 22% price rout sounds more like the crack of a head-on car crash. Visually, one can see the downward acceleration in the short-term price chart above.
Though prices have certainly crashed, spewing pieces of broken metal and glass across the highway - the market’s anxiety has not yet been subdued. It’s as if we are waiting for another impact, perhaps another car, to come smashing into the wreck adding yet more pain and misery.
“...the market’s anxiety has not yet been subdued.”
Indeed, examining the longer-term price chart below, in both 1985/6 and 1998/9 - two other times the Saudi’s announced their intention to pursue market share - prices fell to levels approaching single digits, below the cash break-even levels for a majority of global producers.
Long Term Oil Price Chart
Are we headed to those lows again? My analytical framework, which considers four primary factors summarized in brief below (fundamentals, technical, mechanical and macro), suggests that if we get there, which although not impossible, is a low probability, we won’t be there for long.
Brief Review of Primary Analytical Framework Factors
Fundamental analysis, looking at supply, demand, inventories, marginal costs, geological reservoir characteristics, and micro-scale company and project-level capital economics actually suggests that global inventories will come down aggressively in the second, third and fourth quarter of 2016. Consider the following:
- There is no massive overhang of capacity like there was in the 1980’s oil depression (approximately 15 million barrels per day when the Saudi’s decided to increase production).
- There’s no indication that demand has entered a protracted state of decline (subject to future macro qualifications on China below).
- Gasoline demand globally is very strong. Diesel and middle distillates less so, but temporary weather conditions and the drop in oil market activity itself may be the culprit.
- On the supply side, despite the failed expectations of shorter cycle-time responsivity for onshore tight oil development, based on the 18-month lag between the increase in oil rig counts and visible supply increases at the start of the cycle, US production should start to reflect the drop in rig counts by May 2016.
- Unfortunate investors who bought the first crack in oil price in March 2015 had expected to see evidence of falling North American production much sooner - reflecting the very short cycle time of individual well activity (micro scale).
- However, in aggregate (macro scale), due to rising volumetric productivity, falling service costs, pressure to maintain credit solvency and the delay in data reporting, we can only say that production has peaked, but not yet fallen in earnest.
- On a global scale, Wood Mackenzie’s estimate for cancelled and deferred project spending covering the 2014 to 2020 period had nearly doubled, from $200 billion in June 2015 to $380 billion. The magnitude of these cuts has yet to be fully incorporated into global supply math, and by no means has become visibly evident in falling global inventories of oil and oil products.
Given the intrinsic lag between action (capital spending decision) and response (new oil coming to market), global supply growth should come to a screaming halt in the 2017-18 timeframe.
Thus, based on fundamental analysis, it is hard to see why prices have fallen this far, let alone have accelerated to the downside in January. Pure fundamental analysis might suggest $50 oil prices, but the lack of definitive evidence in hard numbers (i.e. falling inventories) have sidelined fundamentals as a catalyst. The market is waiting on lagging data to prove an already lagging response.
Technically, we’ve broken every uptrend and floor going back to 2003. A real solid floor doesn’t seem apparent until you hit the January 1997 high of $26.62, or perhaps some fibonacci variant in that neighborhood. For the most part, we are in an ugly free fall with accelerating momentum that would need some kind of sideways movement (stabilization) before any price-based algorithms would send buy signals. Spikes in implied volatility in both commodity derivatives and oil-leveraged equity index derivatives indicate the bottom “may be near”, but of course they could spike further.
Everything is oversold, but anyone who has ever put in a buy order too early knows that saw about catching a falling knife. At this point, the only thing technical analysis really offers is that Big Mo (momentum) is down, so ride it or get out of the way.
Mechanical factors that force people to buy and sell tend to be contractual or physical in nature. The recent strength in physical spreads in the Permian due to new pipeline contracting are an example of a contractual motivation that mechanically impacts pricing, irrespective of any other motivation.
This market shows no evidence of mechanical disruption or dislocation. Storage tanks are not full, physical spreads are currently lagging, not leading, financial market movements.
The only widespread, common mechanical factor that can be seen is that financially over-leveraged entities (both companies and funds) can not “wait out” or endure further mark-to-market declines in oil prices without margin calls and forced liquidation. There may be some funds out there that are contributing to this self-reinforced liquidation cycle, but again, to my knowledge there has been no specific catalyst like Long Term Capital in the 1998/9 sell off or Bear/Lehman in the 2008/9 Global Financial Crisis.
Thus, mechanical factors offer no guidance on how far down the oil price may fall.
Macro factors - understanding global capital flows, interest rates, currencies, top-down country economic analysis - are the primary story in today’s oil market. News on Chinese stock market action trumps oil-specific news. I tend to put geopolitical considerations into the macro bucket, as opposed to the fundamental bucket, because motivation and actions in the geopolitical realm can only partially be explained by economics, and actions tend to correspond with the same general actors as in the macro arena.
Geopolitically, Saudi seems determined to beat Tehran and Moscow into financial submission, which only supports the notion that oil prices will continue to fall until one of those countries capitulates. With roughly $650 billion of firepower left, an official government burn rate of $85 billion, and unofficial burn rate of up to $150 billion annually, the game is still nowhere near its conclusion.
The lifting of sanction from Iran are both well known and more than fully baked into supply-demand math. If anything, consensus estimates for expected near-term increases are probably aggressive, given underinvestment in upstream development. Given the track record of Western companies negotiating and executing deals in Iraq, it’s hard to pencil more than an incremental 350k b/d in 2016 and a cumulative 850k b/d by 2019. In any case, from a fundamental perspective, “prego” it’s in there.
Thus, geopolitical analysis suggests that oil prices continue to fall, unless a true civil war or external national invasion breaks out in Saudi Arabia. Geopolitical risk is high and grows with falling oil prices, which should be noted in long-dated volatility.
“Thus, geopolitical analysis suggests oil prices continue to fall.”
Clearly, the Fed is trying to manage a return to a more normalized interest rate scenario following the bailout of the financial system in 2008/9. Ray Dalio’s credit cycle analysis would suggest that they’ve run out of tools and that only time, asset deflation, and a whole lot of capital destruction will reset the economy. In the commodity realm, in contrast to the real estate, consumer and technology sectors, we are there. Interestingly, however, the story in oil has more to do with the deceleration in the Chinese economy than in a slowdown in consumption and production here in the US.
On a relative basis, the US economic outlook is pretty attractive, and capital flows have propelled the strength of the dollar, which only reinforces the selling pressure on dollar-priced commodities like oil. Again, macro factors all point down until further notice.
China’s decelerating economy (it growing less quickly, it’s not actually contracting) has been the primary Macro negative for oil, far more so than US interest rate policy. Interestingly, China’s December’s oil trade data was strong, which should have alleviated selling pressure in the oil markets.
“China’s decelerating economy ...has been the primary macro negative for oil.”
Chinese crude imports surged to a record 7.8 million barrels per day from 6.7 in November (+9.3% y/y). For 2015 as a whole, China imported 6.7 million barrels per day of oil, up 10.4% (637k b/d) from 2014.
The chart below from Barclays Research (originally sourced from China Customs and Wind) shows consistent growth in Chinese demand:
Given the importance of Chinese demand, I pulled data from the EIA to compile the following chart on Chinese Net Imports:
A linear regression clearly illustrates the positive trajectory, but that’s not particularly meaningful given current market anxiety about structural weakness in China. Applying a moving average to the data does reveal that oil imports have been going through a regular cycle, which does offer fundamental confirmation that there is no tangible visible confirmation that China’s oil demand growth is over and the oil price must crash further:
“There is no tangible visible confirmation that China’s oil demand growth is over.”
It follows that the macro factors that are driving the oil price lower are much more monetary and forward-looking in nature; i.e. money flows, currency rates, local stock market activity, interest rate term structure and the like. There is no tangible oil market specific evidence that would point to a continuation of the crash. The macro world is looking beyond statistics and factoring in second and third derivative actions. If China’s structural growth crashes, then oil demand crashes. End of story.
What’s interesting then, is the dichotomy between the oil market’s need for visible proof of falling inventories before a bottom apparently can be made, and the overall macro market’s ability to look forward beyond visible proof of solid Chinese oil demand statistics.
A Circular Reference Error
We are left with the image we started with: The Saudi’s talking at OPEC while the figurative tank outside is on fire.
Our analysis offers little short term clarity on price direction. Macro and oil-specific perspectives are currently locked in a circular error, which leaves only momentum and the floor of insolvency as the arbiters of price. Confirmation that a bottom has indeed occurred will only be evident contemporaneously, or potentially at a slight lag, as the forward curve flattens, removing the economics of storage as a barrier to procurement of physical evidence of a tightening supply-demand balance.
Oil investors want to see inventories visibly come down.
Revisiting our initial thesis of excess and equilibrium reveals the foundation for a palatable strategy - for both financial investors and oilfield companies. The market is not trending toward a new magical point equilibrium. It has blown past equilibrium due to the intrinsic conflict between long-cycle capital intensive investment decisions and instantaneous, real-time, mark-to-market PNL of highly-leveraged financial investors.
Under the right circumstances, markets are incapable of stopping at equilibrium. Instead, financial leverage tends to exacerbate momentum, creating a self-reinforcing effect - an allergic reaction if you will. It will go until a critical mass of players are are incapacitated (bankrupt) or hard and fast evidence forces the crowd to shift direction like an epi-pen counters an allergic reaction.
Unfortunately, by the time hard evidence arrives, the market has way overshot, causing irreparable long-term damage, setting up a future round of instability. Knowing that North American production will eventually reflect the drop in rig counts, that $380 billion of necessary future investment was removed from the system before the latest declines in oil price, and that there’s not a structural overcapacity in the system suggests that long-term volatility has not yet peaked.
Indeed, a drop in prices from here only fertilizes the argument for the opposite structural imbalance occurring in the future.
The best way to position oneself in this market is to use near-term fear and excess to fund long-term investment.
[Note that my thoughts are strategic in nature, most appropriate for energy specialists in oil companies and large financial institutions, and not by any means to be misconstrued as individual investment advice.]
Oil companies that have proper liquidity should be looking at purchasing at-the-money real options - businesses and assets that may be losing money today, but post consolidation can be made break-even without any assistance from an improved commodity price assumption.
Institutional investors should be systematically accumulating long-term volatility in crude (with a bias for intrepid players toward long-dated, out-of-the-money calls), and a well-researched portfolio of highly-leveraged and distressed energy credit. This could be funded in whole or part by selling some near-term vol (and again for the intrepid, a selection of puts) and shorting select energy equities.The largest long-only investors should not be afraid to buy companies run by the highest quality management teams, or that are under-leveraged, provided they are willing to ignore reported financial results for Q4 2015 and all of 2016.
Extreme volatility benefits the Saudi’s in the long-term. It raises the cost of capital for market-driven non-OPEC investors, severely delays their ability to respond to future changes, and creates structural imbalances that they are capable of balancing. In the meantime, their geopolitical “gift” to consumers will help reinvigorate global growth, and perhaps ease the burden of structural change occurring in China, Europe and elsewhere.
© 2016 Matt Epstein
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