On Friday, the IEA made me talk about the self-defeating dynamic gripping the global crude market again.
In their latest report, the IEA predicted that U.S. crude supply is set to push past 10 mb/d, overtaking Saudi Arabia and rivaling Russia. That is of course attributable to the OPEC+ production cuts which have helped drive up prices, thus coaxing out more U.S. supply.
That U.S. supply will (eventually) cap prices and when they start to fall again, the X-factor will be wide-open capital markets. Insolvent (or uneconomic) production isn’t purged as easily in a world where investors are engaged in a frantic hunt for yield and so, the market is no longer as efficient as it was.
Meanwhile, executive comp. in the U.S. is at least partially tied to the growth and/or addition of new oil and gas reserves (i.e. not to profitability). So, the incentive is obviously to keep adding capacity. Consider this out from Reuters back in October:
Activist investors are taking aim at U.S. shale producers, the companies most responsible for turning the nation into a global energy powerhouse, pushing them to stop rewarding executives for spending billions of dollars on new wells when crude prices are depressed.
U.S. crude output has surged past 9 million barrels a day largely because of the shale sector, whose output this year is up 27.5 percent. The gains are fueled by a boost of about 50 percent in capital spending, benefiting executives come bonus time but crimping shareholder returns. Investors want the higher spending to go to dividends and buybacks, not more drilling.
The shift they are seeking could dampen spending on new wells, chilling a shale boom that has benefited U.S. motorists and consumers. It could help the Organization of the Petroleum Exporting Countries, Russia and other producers who are trying to drain a global crude surplus. Booming U.S. shale production has largely thwarted OPEC output cuts aimed at lifting prices. Low oil prices, in turn, have hurt shareholder returns.
You get the idea. This an up-the-down escalator dynamic (that was the punchline from the post linked here at the outset). OPEC cuts, prices rise, U.S. production rises, prices are capped, prices fall, uneconomic producers remain alive (zombie style) thanks to wide-open capital markets, prices rise again, U.S. production rises again, and around we go.
For now, we are of course sitting at 3-year highs:
Although you should note that crude had its first losing week in five thanks at least in part to jitters over whether U.S. production will effectively neutralize the OPEC cuts:
Well speaking of OPEC, they had themselves a pow wow in Muscat this weekend and there were some notable soundbites.
Before we get to those, it’s worth noting that according to the joint technical committee meeting held Saturday ahead of the joint ministerial committee meeting on Sunday, the elusive “rebalancing” will occur in Q3 “at the earliest” and that’s assuming OPEC and its allies continue to comply with the cuts and also assuming production from Libya and Nigeria stays at December levels. Compliance in December was 129% while for all of 2017 it was 107%.
Ok, so obviously Russia is a big part of this equation and Alexander Novak was in Muscat for the talks. He called the cuts “successful” and also said Russia has talked about possibly cooperating after the cuts expire, “depending on the market.”
Al-Falih is all over the wires this morning. “It’s my personal belief that the market will rebalance at the end of 2018 or in 2019,” he told reporters, adding that “oil market fundamentals still need to improve [as] soft oil demand in 1H made us consider cutting for full year.”
He also said the oil cuts may have to be extended into 2019 if stockpiles build. That’s crucial. The Saudis seem to be angling from some kind of (basically) indefinite joint-action. “OPEC, non- OPEC agreed on cooperation beyond 2018, [but] producers didn’t decide on the mechanism for this cooperation,” he said.
Oman Oil Minister Mohammed Al-Rumhy also suggested cooperation will extend well beyond 2018. Additionally, he said the ministers meeting in Muscat on Sunday didn’t discuss an exit strategy from the global oil cuts.
As far as shale goes, Al-Falih (literally) said this: “[I’m] not worried about it”.
Yeah, ok man. Whatever you say.
This analysis of the oil dynamics current in play is too simplistic. The US oil price is being drug higher by Brent Crude. And, the U.S. is still a large (almost 50%) net importer of oil. The changing world price of money is going to continue to normalize the price of oil, which was sent down in dollar terms precisely when the ECB and BOJ began massive negative interest rate experiments in 2014. Now that the massive accommodation event is just about over, you will see what comes around comes around, coincidentally in 3Q’18.
Historically, oil trades at 12.5 barrels per ounce of gold in a normalized rate environment, We have a ways to go before interest rates and oil return to normal, but we are now on that path, thanks to the US Tax Reform Bill.
You can expect Europe to now push down on the fiscal policy accelerator, following the US lead, which will keep world demand for oil growing. As they do, the low volatility environment that has been witnessed in a a central bank capital controlled world will be in the dustbin of history. The US shale drillers are just keeping supply available, while they still have cheap access to some capital (it is much lower now) to make up for all the losses they incurred over the past almost 3 years. However, there isn’t enough oil left in U.S. fields to change reality for more than the short-term in a world where the Central Bank training wheels have been removed. The well life cycle is just too short, forcing an ever greater amount of capital to keep production levels from falling off a cliff. If money is free, this equation works. If the cost of capital is 20%, normal for E&P, then the production quickly begins to recede to 4.5 M bbl/day, which it was at in 2008, not the over 9M mark it is at today. I track the performance of shale oil wells, they are not what the media portrays. The production numbers will eventually correct as the cost of money rises.
when it comes to that “too simplistic” comment, I would refer you to my original post on the IEA report… here’s a fun quote:
“And it’s hilarious because oil market watchers have been telling me for the better part of a year how my assessment of this has evolved to become too simplistic (I used to write more in depth posts on oil). While that might be true, what I would say is that month after month it’s the same story. This dynamic never changes.
Until it does, I’m going to keep pushing the same narrative because there’s a certain elegance in simplicity and there’s nothing that illustrates futility more than a guy walking up the down escalator.”
I follow Berman. All here are saying mostly similar things.
Cost of capital, corp. incentives, Saudi.
…
But… they all talk too much and embellish, which just obfuscates.
There’s no professor to impress.
A few bullet points would suffice.
Precisely..Art Berman agrees with this analysis. The whole shale oil experiment is going to continue with huge depletion rates and higher costs..not exactly a formula for steady supply. Fiscal stimulus is next on the plate and, by definition, will increase demand. It will be interesting to see what the effects of higher gas prices have running head on against an economy already a patchwork of stickum and band-aids…stagflation here we come.
What “US Tax Reform Bill.”? All I saw was a bunch of sycophants throwing money at their owners.
What about the “stranded asset” syndrome? Now that everyone knows that the price of oil can go down, if the price is high today you want to bring your oil to market. Otherwise, you may get stuck with oil in the ground when the price drops. Maybe it will get cheaper to dig up that oil later with better technology, but if I were investing in these things I would want the CEO to dig it up now while the market is still ‘good’. So investors should want to incentivize the CEOs to dig it up faster.