I’m going to do a few posts here, after a long hiatus.
Is it time to buy yet??
First lets look at
the supply demand balance.
The International Energy Agency, the group whose data really
showed the first signs of the glut in 2014, has stated that “the worst may be
over”(1). The factors that they site are
supply declines in non-opec oil, weaker than expected return to the market by
Iran so far, and continued demand growth.
IEA is predicting 2016 US supply will drop by .53mmbbl/d, which is less
of a decline than forecast by the US government Energy Information Agency
(EIA). The acronyms are annoying but
there isn’t much help to using them. IEA
is now calling for .750 mbd drop in supply for non-opec, vs .6 mdb just
a month prior. The supply effect has hit
the high cost producers: US tight oil, Canadian Oil Sands, and deepwater. Low cost producers, like most OPEC countries
have been stressed by low oil prices, but the price is not so low as to remove the economic justification for continued drilling. So most of the supply-side effects have come
from high cost producers. The most
dramatic effects so far have been seen in on-shore tight oil, because other
high cost sources like deepwater and oil sands are longer life-cycle projects. Gulf of Mexico production and Canadian oil
sands have actually been growing recently as projects commissioned in the high-price
era come onto production. Price will ultimately have an effect on these
sources of supply.
Overall supply is growing at about 1.5mbd yoy for the most
recent period: exceeding demand growth.
Supply in the last quarter of 2015 was still 2 mbd in excess of demand,
about the run-rate it has been on for some time now.
 |
| Fig 1) OPEC's growth rate is still very high, but neither the Saudis nor Iraq are expected to maintain their growth, and Iran's entry to the market has been rather tepid so far. (IEA, 1) |
 |
| Fig 2) US on-shore is finally shrinking, a year and a half after the price crash. (IEA 1) |
 |
Fig 3) Global E&P capex for 2016 is projected at 1/2 the level of 2014. These cuts will impact supply for many years to come. (Alix Partners report-2)
US onshore oil rig count has declined to below ¼ of peak
levels from 2014.
On the demand side, although China oil demand growth is now
slowing, IEA still predicts that we will see 1.2 mbd growth vs 2015 for global crude demand. Or roughly 1.2% yoy
growth rate. One of the reasons that we
haven’t seen stronger growth in demand triggered by lower prices is that taxes
are very high in most rich countries (other than US and Canada), so that the
decline in the oil price only modestly effects the overall cost of petrol. In many of the high demand growth areas,
consumers are also insulated from price changes by subsidies at fixed
prices. China’s industrial
slow-down has also coincided with this prices decline. Finally, prices effect oil demand mainly in the long term. People may drive less because fuel prices are high, but the effects of choosing to buy a more or less fuel efficient car (or ship etc) aren't immediately felt by the market. So while low prices have had a very clear
effect the supply side, they have not impacted demand nearly as strongly in the short term.
Global crude inventories:
The inventory build, unprecedented in history, continues. When you see that OECD crude stocks are 20%
above the five year average, and crude + Products stocks are maybe 12% higher
than the 5 year average, that doesn’t necessarily seem so alarming. In the US, according to EIA.gov, we have gone to 29 days inventory
in Products (5 year average) to 32 days supply currently. US crude supply has gone from 20 days (5 year
average) to 30 days currently (commercial stocks excluding strategic petroleum
reserve). But one thing to keep in mind
is that the vast majority of stocks are typical working inventories. Working inventories sit in a gas station or a
refinery or in some sort of transportation facility or pipeline. The rate of inventory build has not yet
showed signs of slowing. Inventory data was a leading indicator of
the glut in mid 2014, and if we think it may be a leading indicator of the end
of the glut, then we are not there yet. Inventory
build showed in IEA data long before the price crash.
|
 |
| Fig 4, 5) Developed countries' commercial inventories continue to build (IEA 1) |
 |
| Fig 6) EIA reports record crude stocks for this time of year. (IEA report, using EIA data) |
OPEC reborn?
The Mid February offer by Saudi Arabia, Venezuela and Russia
to stabilize production at current levels was dismissed by many as being
totally ineffective. But Russian
cooperation with OPEC makes sense on many levels, and could be a key to
stabilizing prices in the future. Right
now a deal is very difficult because Iran won’t cooperate unless it is allowed
to have a much higher level of production than currently, as they rebuild their
industry following years of sanctions.
Iraq had been another probable source of increased supply, although they
have had trouble in the past few years due to ISIS related instability and
budget problems. In 2001 Russia had also
agreed to curb output in cooperation with OPEC, but never did.1 IAE’s March Oil Market report speculates that
an agreement might target prices in the $50 range: much lower than previous
targets. This low price level would be
designed both to stimulate demand, and also prevent a big rebound in high cost
non-opec production.
A deal could be reached if there is political will on the part of the Saudis. The way it would work, would be that Iraq and Iran, and maybe several other producers, would have to be given a long term ceiling significantly above the current level of production in recognition that their level of production is artificially low at the moment. Because of sanctions, the the case of Iran, and instability plus a legacy of sanctions and war in the case of Iraq, their production is low compared to their hydrocarbon resources in the ground. So these producers could agree to limit growth in the near term, in exchange for a long term understanding that OPEC will make room for them to increase production at some point in the future when the oil market is healthier.
I have no idea how likely this scenario is. But anyone who is currently short oil should be aware that it is in all OPEC's countries economic interest, especially in the short term, to have a deal that raises the price of oil moderately above the current level- perhaps to $50 per barrel or a bit higher. A deal could cause a snap rally in oil, and a ripping rally in some of the less solvent E&P companies.
Conclusions:
Although EIA is expecting a decline of .76 mbd for US crude
supply in 2016 vs 2015, this only closes a part of the gap. We have seen decisive action on the part of
high cost producers to cut investment.
But these decreases in investment have not yet balanced the market, or
even really started to balance the market.
Most recent data suggests that the market is still as unbalanced as
ever. Iran production increases have underwelmed so far, but that doesn't mean more Iranian oil isn't on the way.
Everyone assumes the price must eventually go back up (and I
agree with this), but the question is when.
I wouldn’t be surprised if we see the market come into balance late this
year, with demand growth staying on trend and supply coming down somewhat, led by the US onshore declines. We then might see an overshoot, which where
supply is below demand and inventories start to clear to more normal
levels. When the price will recover is a life or death
question for some E&P companies. The
hedge portfolios have insulated them somewhat from the price declines, but
going forward they will provide less and less benefit. If the price does not recover soon a number
of companies may be at risk of bankruptcy.
Production levels will decrease and interest payments may significantly
increase.
I think there is still a somewhat drastic bear case in the near term. No one knows how much ability there is to store more
inventory. I think there is still a
not-negligible chance of another price crash, maybe to sub $20 levels sometime
this year. I think it is possible that we are out of the woods as
IEA suggests, but it is still quite dangerous to assume that. I am planning to evaluate which companies I
want to buy in the event of another leg
down and panic. The safest companies,
like the oil majors and even some of the bigger E&Ps like EOG may not be the ideal investments. The best
ones may be companies that might go
bankrupt, but don’t.
My next step is to catch up on where all these companies
are, after not paying close attention for quite some time. In particularly I want to evaluate the
following:
- Valuation on a trailing EV/EBITDA basis (of marginal value due to hedge effects), EV/BOED production and EV/BOE of P1 reserves.
- Leverage on net debt/EBITDA, and net debt/BOED, net debt/BOE basis.
- Do they have acreage which can plausibly earn an acceptable return at $50 oil?
- How is their debt trading?
- When are significant maturities for the more leveraged companies and what is their liquidity situation? I probably won’t bother to look at this for the relatively solvent companies.
- How has their debt situation, production, and sharecount changed since I last looked in late 2014? Many companies have resorted to equity issuance.
So I am not buying just yet, but I am starting to prepare so that I will know what I want to buy when I think the time has come.
1) March oil market report
IEA:
https://www.iea.org/media/omrreports/fullissues/2016-03-11.pdf
2) Report on industry capex from ALIX partners
3) EIA.gov
