Oil Price Recovery Derailed
The oil-price trend is down. The momentum of recovery from lows in January to a peak in June has been broken by the resurgence of macroeconomic-related fears, and the emergence of fundamental data suggesting high refinery utilization rates may have overestimated end demand, resulting in unseasonable refined product inventory builds (gasoline). In layman's terms, the glut in crude is now just a glut in gasoline, potentially confirming resurgent fears of global demand weakness.
North American Activity is Increasing
Reflecting cautious optimism following five months of oil price recovery, seasonal budgeting considerations, and in stark contrast to the real-time downdraft in prices, activity rates continue to march steadily higher.
Rig counts have increased steadily this month, in particular in the Permian. Even more telling, the major oil service providers Halliburton and Schlumberger confirmed anecdotal evidence that well completion activity (proppant usage, fracking horsepower at work, crew movement, and pricing) bottomed in the second quarter.
Completing the large inventory of DUCs (drilled but uncompleted wells) offers more attractive marginal economics than fresh drill and complete. Thus, we would expect completion activity to respond much faster than rig count and more accurately depict capital spending activity and future production trends.
Rising activity now means that eventually the rate of decline of North American production will shrink or potentially even stop. As discussed below, we do not view the current uptick as sufficient to reverse aggregate decline, and more importantly, view most future productivity forecasts with extreme skepticism given our expectation of "catch up" cost inflation at the service level. Nevertheless, rising activity will undermine confidence in fundamental supply-side declines as a catalyst for buying the dip.
Long-Term Recovery Milestones Not Yet Confirmed
Revisiting our roadmap to recovery, published in our February 11th monthly, "Oil Prices - Price Discovery Spurs Widespread Declarations of Oilmaggedon", we posited that two or more of the following milestones must become apparent in order to validate a long-term recovery had firmly taken hold:
1. Flattening curve - which is a prerequisite for the removal of economic incentive to store oil
2. Evidence of inventory draws
3. A major development in the Syrian War that enables the participants to agree on a production cut from OPEC
4. Resolution of the China Growth question, most likely expressed in the Renminbi exchange market
The results are not encouraging.
1 - Forward Curve Still in Contango
The term structure of forwards and in relation to cash markets continues to discourage current withdrawals from storage.
2 - No Evidence Crude Inventory Draws Exceed Normal Seasonality
Even a casual observer can visually confirm that the trajectory of US crude inventory withdrawals (the downward slope of the blue line above) is not meaningfully different than the five-year average. That suggests nothing special is happening to supply/demand other than normal seasonality, and prior market enthusiasm over weekly inventory draws was misplaced. A deeper analysis reveals troubling builds in gasoline inventories. Indeed, comparing the total inventories of crude and refined products against a five-year average as a proxy for inventory surplus reveals that in aggregate, the surplus has stopped falling and is now rising.
Moreover, Gasoline Builds Problematic; Overall Inventory Surplus Stopped Falling
3 - Syria War Rages On; Iran and Saudi Maximize Production
As seen in the infographic produced by the Institute for the Study of War (click to enlarge), the major participants in Syria's civil war seem to have prioritized the elimination of ISIS as a common goal. Unfortunately, even if that worthwhile effort is completely successful, that leaves Iran and Saudi backed groups still at complete odds with one another.
To date, there is no visible path to peace, and therefore, no reason for either Saudi or Iran to consider moderating production irrespective of price.
While some analysts have suggested the latest increase in Saudi production is only a temporary surge to offset sumer related power demands, it's clear to us that on an aggregate basis, the increases in production (sanctions relief, increased drilling) from Iran, Saudi and Iraq have largely offset the declines experienced on a year-over-year basis in North America.
Additionally, the unsuccessful coup in Turkey will undoubtedly change the regional dynamic affecting the civil war in Syria, the fate of the PKK in Northern Syria and Iraq, and the ongoing proxy struggles between Shiite and Sunni factions.
Turkey, purged of moderating internal influences, becomes more strategically threatening to Iran. Furthermore, despite recent tactical moves towards détente with Russia (and the potential bonus that Russia would love to see NATO lose Incirlik), a purged Turkey will become more of a strategic threat to Russia as well. For the purposes of analyzing oil prices, more strategic pressure likely translates into greater price volatility.
4 - Chinese Growth Question Lingers
The Yuan Renminbi continues to weaken against the US Dollar, suggesting that markets are not confident in the reported stabilization of headline growth at 6.7% in the second quarter. Strong Chinese refinery utilization rates and growing refined product exports further obfuscate the true internal demand picture. While Goldman Sachs Commodities' math suggest the demand picture in China is robust, our interpretation of growing product exports is twofold: (a) products are flowing away because internal demand is not as good as the published numbers suggest, and (b) growing product exports are a tactical maneuver by teapot refiners to circumvent capital controls. Either explanation is quite bearish.
Beyond Our Roadmap, Comprehensive Analysis Signals Incremental Negatives
Our comprehensive analytical framework for navigating oil prices encompases four broad categories: Fundamental, Macroeconomic, Mechanical and Technical. For the purposes of this article, we shall summarize notable data or our analytical conclusion in each as follows:
As discussed above, inventory data suggests that there's been no real underlying change in supply/demand balance beyond normal seasonality. Combined with high inventories, that leaves the complex vulnerable to macroeconomic fear exacerbated by negative technical momentum. Recent data, in particular those highlighting gasoline inventories and refining margins, have been incrementally negative. Of note from a tactical perspective, we've already passed the traditional high water mark of seasonal refinery demand.
We do not view the recent uptick in rig counts and overall activity as a real threat to oil prices. Even in the ultra-short-term North American tight oil plays, the aggregate impact on supply lags considerably more than bottom-up corporate and project analysis would suggest. Furthermore, considering the noted scale in context, the uptick will most likely result in a decrease in the decline rate, as opposed to an outright reversal in trend (i.e. supply increase).
More importantly, we are very skeptical of analysis that embraces current cost assumptions as a realistic starting point for future projections. The development of the entire oilfield service industry was predicated by the movement away from an integrated oil development model in favor of the greater flexibility and reduced downside volatility engendered by utilizing third-party service providers. In plain English, that means that aggregate returns for oilfield service, equipment and drilling providers are by definition more sensitive to lower oil prices than oil companies themselves.
Thus, today's prices for drilling rigs, fracking fleets, equipment and personnel are for the most part below economic break even levels, albeit they are incrementally cash flow positive. With any kind of sustained recovery, price inflation at the service level will rebound at an accelerated rate once utilization hits certain base levels. Models that don't factor in this period of accelerated price inflation (cost for the producer) and the coincident loss of productivity (retraining/redeploying crews) will overstate the real-world supply impact of recovering activity. For modeling purposes, there's no reason to assume the lag between spending and production on the upside will be any shorter than the lag we've observed on the downside.
Indeed, shale will continue to displace certain longer-lead time conventional exploration projects, because risk-averse investment bias favors development over exploration. In the short-term this may lull spectators into believing shale might "cap" oil prices. But we are particularly concerned about the ability of shale in aggregate over the long term to compensate for the aggregate global impact of capital spending cuts estimated at $300 billion or more. The abandonment of the Arctic, for example, could be a 20 million barrel per day impact in 25 years. The extreme long-term nature of major development spending and the short-cycle time shale industry are bound to result in less, rather than more, market price stability (i.e. more volatility).
Our analysis of Brexit last month, "Oil Prices - Brexit, Uncertainty and Volatility: the Macro-Beast Returns" concluded with a plea for producers to call us to revisit their hedging programs, as it was clear to us that macro analysis beyond the simple impact of here and now would be needed to understand the potential impact on oil prices.
Indeed, the profound geopolitical negativity of Brexit remains relatively muted in the press in favor of micro-analysis of the specific impact on individual industries and political groups. The fact is that Brexit has set the precedent for increased protectionism globally, and the potential impact on global growth should be highly concerning, particularly in light of the fact that global monetary authorities don't seem to have the tools left to overcome further fiscal mistakes.
While terrorism, violence and the political cycle dominate this summer's popular mindshare, these expressions of friction emerge from the greater interplay of larger forces, including those that shape income distribution, worker migration and quality of life. Beyond the sound bites of twitter and television, we expect that alarm over the diminishing returns of monetary policy will become more tangible as summer turns to fall. Thus, stories such as "China's growth sucks in more debt bucks for less bang" (Reuters, 23 July 2016) will become more numerous until some financial crisis emerges such that 60 Minutes does a story explaining what negative interest rates actually mean for the masses.
The recent 6.7% print on Chinese GDP notwithstanding, most macroeconomic data outside of the United States has been incrementally negative. With the mega-trend of falling interest rates since 1981 approaching an inevitable conclusion, macroeconomic uncertainty is bound to grow, which remains a key foundational underpinning to our positive outlook on oil price volatility.
Mechanical factors tend to be short term in nature. Index rolls, options expirations, margin calls all have the potential to drive pricing one way or the other, having no regard whatsoever to fundamental, macro or technical realities. One longer-term mechanical factor that tends to be overlooked is the growing popularity of ETF's and commodity indexes as a mechanism for speculating on oil prices. Note that our definition of speculation includes all investors passively participating in oil prices and commodities "as an asset class", not just day traders and directional gamblers.
Setting aside the short term impact of index rolls, we believe the growth in ETF's and index investing does permanently increase the "weight" of the front of the forward curve. In other words, ceteris paribus, a larger non-cash permanent investment in oil price instruments most likely increases the tendency for contango, and thus the appeal for real-world storage. Intuitively, this makes sense. For every billion dollars of permanent paper investment in oil, some proportion will make its way into real world storage.
While we don't expect that this factor has been able to completely distort supply, demand and storage statistics, we think that looking inventories compared to ten-year average storage numbers would tend to exaggerate the overhead.
Most technical systems are mathematical expressions of historical price data that endeavor to signal trend momentum, trend exacerbation, and trend reversal. Currently, the trend is down and seems poised to continue that way.
Ideal Time for Volatility Strategies
Despite a slew of incrementally negative signals, we view non-directional volatility positions, rather than short-directional positions, as the most attractive investment opportunity.
Oil companies and physical asset buyers are in the position to create what we consider the ultimate investment, a positive-carry / long-volatility scenario. Financial investors have the ability to pursue select rolling volatility strategies (expressed exclusively with futures options) that should produce attractive return-risk. Unlimited financial investors (the few free to invest across capital structures, asset classes and security types) can synthetically duplicate the positive-carry / long-vol positioning available to physical asset owners, but at a much higher risk and leverage ratio.
Details on construction and execution of these strategies are available via consultation, please contact us here.
We have over 20 year's experience navigating oil and gas prices as well as public and private investment opportunities across the petroleum-based energy sector (Upstream, Midstream, Downstream and Marketing).
Our most unconventional insights include:
"Oil companies have been mislead into pursuing ineffective and overpriced hedging strategies."
"Oil markets do not trend toward equilibrium. Balanced markets only happen by accident, and disequilibrium is the norm."
"The real cost of debt (including bankruptcy risk) for companies exposed to commodity prices is far higher than advertised, leading to poor capital allocation decisions and sub-optimal strategy execution."
Matt Epstein leads Aremet Energy Consulting, an independent advisory boutique based in Greenwich, Connecticut. With over 20 years experience as an energy specialist, Mr. Epstein is regularly engaged by oil companies, investment managers and commodity traders for assistance managing commodity price volatility, and for innovative financial structuring solutions. Follow his regular commentary here.
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