Given our experience and background, it only made sense for us to first focus on an industry we are intimately familiar with: oil & gas. These next few weeks’ blogs will focus on global oil (crude) price, fundamentals and recommendations, but for today, we will set the stage with our thinking by discussing the following:
- Forces behind the decline in oil prices
- Forces behind the recent upward pressure on prices
- Our expectations over the next six months to two years
Because any oil price discussion could easily fill enough pages to write a short novel, we will gloss over some of the technical details and talk about prices from a level suitable to a wider audience. We tried our best to not completely geek out on this so forgive us if this is overly simple. Of course, should you have any questions or comments feel free to email us or post your comments.
63% Drop in Oil Prices – How did we get here!?
North American Supply Growth and Import Displacement
Since oil (West Texas Intermediate, or WTI, the U.S. crude oil benchmark) reached its peak in summer 2008 of ~$135/bbl (as we write this, about $50/bbl), prices came crashing down immediately thereafter as a result of the Financial Crises which resulted in global recession that endured for many years (and even continuing through today, some may argue). At about the same time the global recession had started, North American independent oil and gas producers had also started pioneering commercial use of new and more efficient drilling/production methods to extract hydrocarbons. These technological innovations are known as hydraulic fracturing and horizontal drilling. In essence, these technologies allowed producers huge efficiency gains who were able to extract larger volumes of oil and gas in a much shorter period of time than they had previously been able to achieve, therefore enabling them to be more profitable at a lower price. This concept is what’s known as a producer’s “break-even” price, which is the price needed to make the decision to spend money to drill a new well while receiving a sufficient rate of return. (Note that for the purpose of this article we are referring to half-cycle break-evens, which exclude the cost of land or lease acquisition, assuming the producer already owns the land and simply needs to make a decision as to whether or not to drill a new well). North American break-evens range widely by individual well and resource play, but since hydraulic fracturing and horizontal drilling have become commercially applicable, break-evens in some of the key plays in the U.S. such as the Eagle Ford, Bakken and Permian range from as low as $35/bbl to $50/bbl, according to information from a variety of consultants, banks and producer presentations, resulting in tremendous amounts of new supply coming to market at extremely low costs. See the graph below from a presentation by Continental Resources on break-evens across numerous U.S. plays.
The Effect of Innovation and Resulting Supply Growth
Due to these advances in technology, the U.S. was able to completely reverse 30 years of supply decline to reach historical highs in a very short amount of time, ~ 7 years, an amazing feat, to say the least. Looking at this from a global perspective, over the past 10 years, oil supply growth between 2005 and 2010 was pretty much flat (source: 2015 BP Statistical Review), but between 2011 to 2015, supply grew annually at an average of 2% per year. See the chart below (source: EIA) for an illustration of the dramatic change in U.S. supply which was the primary driver of this growth.
On the demand side, however, the U.S. is what’s known as a developed (or mature) economy, therefore its demand for crude oil and crude products (gasoline, diesel, jet fuel, bitumen, etc.) is limited and not growing as fast as a developing country like China, for example. Due to limited demand in the local market, U.S. production started to directly compete with international imports, which are more costly to purchase than local production. As a result, imports from countries in West Africa and Latin America were displaced and had to find a home in alternative markets around the world. The chart below (source: EIA) will give you an idea of the amount of imports displaced from the U.S. over the past several years.
The effect of supply growth in the U.S. was tremendous and had displaced approximately 3.6 MM bbl/d into global markets since 2008. As we have seen so far, U.S. oil production growth has fundamentally changed the supply/demand dynamics of the U.S. oil markets and next we will see how it, compounded by a few other factors, has also fundamentally altered the dynamics of global crude markets.
China and the Rest of the World – Slowing Demand Growth
Subsequently on the other side of the world, notably in China (the world’s second largest consumer of oil), although oil consumption is still growing, the rate of growth has slowed significantly as a direct result intentional slowing of economic activity. In 2013, Chinese leaders identified the need for China’s economy to diversify away from being primarily driven by foreign investment and manufacturing to being more reliant on household consumption (currently 36.5% of GDP). By doing this China would be able to establish a more sustainable and balanced, but slower, rate of economic growth while achieving the same level of living standards as other developed economies, such as the U.S. As a point of comparison, household consumption accounts for about 70% of U.S. economic activity.
Chinese GDP had been roaring in the late 2000’s pre-Financial Crises at double digits (12.7% in 2006 and 14.2% in 2007) but fell to 9.6% (source: World Bank) in 2008 and never really found firm footing afterwards. In 2011, GDP grew at a rate of 9.5% but slowed immediately over the subsequent years to 7.8% in 2012, to 7.3% in 2014 and 6.9% in 2015. Oil demand growth from 2005 to 2010 averaged 7% per year but has then slowed from 2011 to 2015 to 5% per year. Though Chinese oil demand growth has slowed, they are still the world’s second largest consumer at 12 MM bbl/d (source: 2015 BP Statistical Review), surpassed only by the U.S. at nearly 20 MM bbl/d (Global oil demand is just north of 90 MM bbl/d). We believe slowing oil demand growth will persist for the foreseeable future given the shift in economic policy in China. In fact, the International Monetary Fund (IMF) has recently even lowered its growth expectations of China for 2016 and 2017 to 6.3% and 6.0%, respectively.
Lastly, when we look at the bigger chunk of oil demand in non-OECD (inclusive of developing countries such as China, India and Indonesia) countries, growth over the 2005-2010 period averaged 4% per year and has come down to 3% over the past five years while OECD demand growth has been flat to declining over the same period.
In summary, global oil demand growth simply isn’t what it once was, driven primarily by slowdown of growth in China.
OPEC Fighting for Market Share
There is one last piece to the puzzle and that is OPEC. OPEC is an organization made of 13 oil-rich members, who collectively decides how much oil they would like to pump and export to the rest of the world annually. The largest and most influential of these members is the Kingdom of Saudi Arabia, the world’s largest producer until the U.S. surpassed it in 2014 (and may have potentially regained top honors given recent decline in U.S. production). Saudi Arabia has been pumping and exporting oil to the rest of the world for decades and has enjoyed very profitable margins as it has always been the swing producer, meaning it would export more oil as needed by global markets or reduce oil output as needed. It is largely believed that in the past, the reason oil had to be at or at least $100/bbl was that that was the price Saudi Arabia needed not to cover its production costs (widely thought to be as low as $5 to $15/bbl and a hotly debated number at that), but to fund its social welfare programs.
The Kingdom is an absolute monarchy ruled by one family, the House of Saud and has for decades kept its 30+ million population content with government subsidies, both direct and indirect across a variety of sectors such as education, healthcare, welfare, electricity, transportation, infrastructure, water and agriculture. A key point to note about the revenues for government expenditure is that 87% of those revenues comes directly from its oil industry (source: CIA World Fact Book). So, with a 50% drop in oil prices, one could expect a near proportional drop in government expenditures on social programs. While Saudi Arabia has announced plans to diversify its revenue, shifting gears in economic diversification simply cannot happen that quickly. As a result, we’ve seen Saudi Arabia’s oil output remain stubbornly high in the face of competition from the U.S. and low oil prices as Saudi Arabia fights to maintain market share in order to continue to generate revenue for its government-sponsored programs. Remember that $35 – $50/bbl break-even range mentioned above for U.S. producers? It is no coincidence oil prices hit sub-$50/bbl earlier this year as that is the range Saudi Arabia may have to output oil at to maintain its market share and drive its competition out of business.
On top of all this, we also have production returning to the market from Iraq and Iran, the latter having its international sanctions recently lifted. Both countries are also heavily dependent on oil revenues. Russia is another big player (third largest producer in the world). Its production has also risen steadily over the years as it is also dependent on oil revenue and is expected to keep up production simply to maintain its market share.
Lastly, it is also understood that during the price decline of the past two years, North American producers had deferred well completions. What this means is that they drilled the well with the intent to produce oil, but due to the low oil price environment, they delayed completing the well (ie. Producing oil from the well in layman’s terms) until a more favorable price environment returns. Though the exact size of the inventory is unknown, but if it is anything like what happened in the U.S. natural gas market a few years ago (then estimated to be between 2,000 to 3,000 gas wells), the inventory would not be insignificant and could easily bring on new supply in a very short amount of time.
As mentioned above, the industry has witnessed an extraordinary shift in market fundamentals combined with political motives of some very heavily vested players. Here are the main points that have gotten us to this current environment:
- Technological innovation has allowed U.S. producers to output larger quantities of oil in a shorter amount of time and at a much lower cost than they could historically
- Global oil demand growth has slowed, led by China
- Saudi Arabia’s need to maintain market share and therefore maintaining output
- Oil revenue dependent countries like Iran, Iraq and Russia either continuing to pump incremental volumes to generate revenue or returning to the global market
100% Rise in Oil Prices – What’s Happening!?
Since January of this year, oil prices have rallied significantly, up nearly 100% to now $50/bbl. Will prices continue to rise beyond $50? What’s happening? In short, there are a few short-term events driving the price increase but we believe these are only temporary. Though prices may rise to as high as $60/bbl in the short term, we believe anything above that price will be short-lived and that ~$45/bbl is the new norm for many of the reasons we described previously. However, let’s first get into what’s driving the near-term upward pressure.
Supply Declines and Outages in North America and Abroad
North American oil production has been on the decline recently thanks to a pullback in drilling activity. Without rigs drilling, new wells cannot come online. Data from the Energy Information Administration (EIA) shows production for March 2016 is down to 9.1 MM bbl/d from a high of 9.7 MM bbl/d set last year in April.
Secondly, fires in Alberta have disrupted nearly 0.5 MM bbl/d of oil supply in Canada and Nigeria disruptions are heard to be as high as 1.5 MM bbl/d. In short, expectations around supply declines and outages have added fuel to the near-term bullish price sentiment.
Technicals and Market Psychology
The chart below shows oil price daily trading activity for the past 18 months.
There are a couple key points to draw from this chart. First, price has been trading above the 50-day moving average (blue line), which indicates bullish price sentiment. Traders love trends and are quick to pile on when these things form. We’ve certainly seen that since March, particularly in the Commitment of Traders (COT) report below.
This report simply shows the open interest (or net long/short position) of each type of major trading entity. The interesting line here is the green line, which represents “Managed Money” or hedge funds/speculative traders. As you can see, they have become significantly more bullish over the past three months.
Going back to the technical chart above, in the short term, though market sentiment has turned bullish recently, there are two main levels of resistance (ie. Price ceiling), one at approximately $50/bbl and another at $60/bbl. The last time price tested $50/bbl was in October 2015 where we saw a massive selloff. The previous ceiling was $60 ~ $62/bbl and was eventually met with a large amount of selling. Another key reason we see $50 to $60/bbl as a price ceiling is that that is the price needed for many U.S. producers to be profitable as indicated in the Breakeven Economics slide near the beginning of this blog. Subsequently, we expect to see increased amounts of financial hedging (ie. Selling futures contracts to lock in longer-term prices) at these prices by North American producers to guarantee some minimum level of cash flow in this extremely competitive environment.
Putting it all Together – Our Price Expectations for the Next Six Months to Two Years
There are a variety of factors affecting oil markets and although it is difficult to place a precise number on price, we feel confident about the following price ranges:
- Price ceiling should come in to around $50/bbl and push as high as $60/bbl
- Price floor should fall to around $40/bbl but could go as low as $30/bbl
Essentially, we see range bound trading for crude between $30 to $60/bbl for the next few years. Our reasoning for the price ceiling of $50 to $60/bbl may be summed up below:
Major Shifts in Fundamentals (Long-Term Dynamics)
- U.S. producers’ lower break-even costs and ability to bring on incremental supply in a short amount of time – Bearish for prices
- Slowdown in global demand, led by China – Bearish
- Reluctance of Saudi Arabia and to a lesser extent, Russia, to relinquish market share, resulting in incremental supply or unwillingness to rationalize production – Bearish
- Financial hedging by producers putting downward pressure on oil prices – Bearish
- Bullish sentiment driven by temporary supply outages in Africa and Canada and declines in the U.S. – Bullish
- Incremental supply from Iran and the return of previously disrupted supply from Iraq – Bearish
- Although this was not talked about earlier, another macro risk is the possibility of the Federal Reserve raising interest rates in the face of higher oil prices (which make up a large portion of the Consumer Price Index) in order to rein in possible inflation – Bearish
- Well inventory in the U.S. adding supply to the market – Bearish
As for the price floor, we see it being somewhere between $30 to $40/bbl as that is the point at which the majority of the most prolific U.S. oil plays become unprofitable. Of course, there could be instances where prices may trade outside that range. For example, unexpected massive supply disruptions could cause price to spike upwards but we feel these spikes will be limited and unsustainable as producers will be quick to either hedge or bring on incremental production to capture those margins and follow it up with production increases.
In summary, the upside to oil price is expected to be limited and we anticipate prices to trade within a $45/bbl (+ $15/bbl) over the next two years, which makes investing in oil companies tricky as there is no clear direction on major price trends upward or downward. Nevertheless, the purpose of this blog is to help you identify and invest in quality companies. Though the oil price environment may not look great at present, we will help you filter through the numerous publicly-traded entities out there and identify quality ones who may be well-positioned to outperform their peers and add value to your portfolio.