The Doha summit

OPEC + several other large non-OPEC producers are meeting in Doha tomorrow to discuss a production freeze at January levels to stabilize the oil market.  Russia, Venezuela, Saudi Arabia, and Qatar have already signed an agreement to this effect.  The key stumbling block is that several countries are producing far below "normal" levels because of sanctions, in the case of Iran, and political instability, in the case of Iraq and Libya.  Iran in particular will not agree to freezing output at current levels.  An agreement could be reached if it acknowledged the particular circumstances of these countries, and allowed them to increase production moderately.  The Saudis explicitly have said they won't cap output unless Iran does, and Iran has called this "ridiculous".

A bloomberg article came out quoting Saudi Prince Mohammad Bin Salman as saying they could increase production to 11.5mbd (from 10.2) "immediately", and could increase to 12.5 mbd in 6 to 9 months if they chose.  And then he dropped this:

“I don’t suggest that we should produce more, but we can produce more,” said the prince, who is the king’s son, second in line to the throne and a leading force in the country’s economic policy. “We can produce 20 million barrels of oil per day if we invested in production capacity, but we can’t produce beyond 20 million.” 

http://www.bloomberg.com/news/articles/2016-04-16/saudi-prince-says-he-could-add-a-million-barrels-immediately

This is a rather incredible statement.  It suggests the Saudis could take the price of oil below $30 immediately, and keep it there more or less indefinitely.  It would hurt them certainly, but it would totally cripple other OPEC countries.  The Saudis could make up for much of the loss from lower prices with higher export quantities.  Talking down the price of oil hurts the Saudis in the short and medium term, but if it can get the rest of OPEC back in line and put the fear of god into the high cost producers, it may be well worth the short term pain.  The Saudis may well just be talking big to bring OPEC, and especially Iran, into line.  But it is worth taking a look at the recent trend in rig count from them and their close gulf/Sunni alies Kuwait and UAE:

http://peakoilbarrel.com/international-rig-count-still-falling/

Saudi, UAE, and Kuwait are drilling like there's no tomorrow (don't pay attention to the wacky analysis, just the charts pulled from baker hughes data).  Many of the Saudi rigs are for gas, since they are trying to cut their wasteful use of crude oil for power generation, and free up more for export.  Oil price optimists might argue that this increase in drilling is to replace declining existing fields, and that may well be true.  But the alternative interpretation is that the Saudi's long term plan has changed.  With the emergence of shale and viable electric vehicles, the end of the age of oil may seem nearer now than it did five or ten years ago.  The Saudis don't want to be stuck with a hundred billion barrels of easy oil in the ground if and when the world moves away from fossil fuels, suggesting that they may need to produce more of it sooner rather than later.

All of this demonstrates how the future of oil prices (and US E&P companies) cannot fully be known through careful analysis of supply & demand, production costs etc.  There is a political aspect as well.  The choices made by the Saudi leadership, and to a lesser extent the leadership in Iran, Iraq, Russia, Venezuela, and other countries will effect the future viability of US on-shore production.  If we recall the start of the oil price declines in 2014, it started with modest oversupply to the market in early 2014 caused primarily by increases in supply from US tight oil.  But it accelerated when it became clear in October, 2014, that the Saudis would not remove supply and stabilize the market.

Is it time yet?

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 

http://www.alixpartners.com/en/Publications/AllArticles/tabid/635/articleType/ArticleView/articleId/1878/Global-Oil-and-Gas-Industry-Outlook.aspx#sthash.Iz8BK0lS.dpbs

3) EIA.gov

Is there anything worth buying yet?

If we do see a recovery in oil price in the short term, there are LOTS of oil stocks that can go up by several hundred percent.  And one thing I have grappled with in my mind, is whether I am being overly pessimistic.  Even if oil prices will probably stay low, if (to use entirely hypothetical numbers) there is a 30% chance that they could recover to $60 by june, then it may be worth buying stocks that would go up by 300% under that scenario, even if they might go to zero under another scenario.  We may be reaching the point of maximum pessimism.  In not buying, I accept that i am likely to miss the bottom, but I am waiting for some sort of concrete sign that oil prices are likely to stabilize.

Below are my views on the various equity segments.  I haven't been spending any time on this really so I would caution that these are impressions as opposed to any sort of deep analysis:

1) E&Ps- LOTS of them will most likely go bankrupt, and they are generally carrying too much debt to be attractive as acquisition targets.  They are running out of rope for several reasons.  Their scope for further cost reductions and efficiency gains is probably limited.  Their hedging programs, which have hugely helped them in the past year, will provide less and less benefit as they run out.  The inventory of uncompleted wells have provided cash flow as they reduce capex and kept production level.  At some point these will run out, and production rates will start to decrease.  Finally, and perhaps most importantly, with debt trading at distressed levels, they will have trouble rolling it over, and at the very least will have to accept much higher interest costs as they issue new debt to roll over the old.  A huge number of companies would eventually go bankrupt if oil prices stay at this level.

2) Integrated Companies- Exxon, Shell, Total, Chevron.  These guys have been shielded by the declines in several ways.  Refining margins and chemicals have been terrific in North America, but with the end of the export ban, and regional differentials the lowest they've been in years, many of the drivers of North American refining profits are abating.  they still have low cost natural gas to give them a cost advantage vs Asian and European refiners, but its hard to see how profits in refining don't come down.  Secondly in the upstream sector, the nature of production sharing contracts (typical for oil majors operating overseas) is such that capex gets paid off before the government starts taking their lion's share of the profits, this insulates risk for the majors.  So while the price declines can make a north american tight-oil well a big money-loser, large overseas projects won't necessarily be hemorrhaging money for the majors since the capex costs will still be recovered.  But the majors' core expertise has become doing high cost technically complex projects, often offshore.  These projects simply don't make sense going forward, unless we see a significant price increase.  Its unclear how they will replace declining production, unless they can buy shale assets in bankruptcy, as the E&Ps go bust.  I'm not sure that Exxon trading 20% off its peak levels, and 20x 2015 earnings, truly reflects their change in circumstances since $100/bbl oil.  The big dividend  yields of the European companies like Shell are tempting, but these are payout ratios of well over 100% at this point, and not at all sustainable.  All of these companies are pricing in a significantly higher oil price, a dangerous situation for investors.

3) Offshore drillers- These were always a bit of a suspect business to me.  In the good times, people order new-builds.  In the bad times, all but the newest drill-ships become almost worthless.  And after decades of deepwater experience costs are still very high.  Meanwhile on-shore tight oil costs have come down dramatically in just 6 or 7 short years.  Capex budgets for onshore can be rapidly cut, while offshore they have to plan for many years into the future.  A bad accident offshore can result in a $50b charge (see BP Horizon spill) unlike onshore drilling.  I'm not saying that offshore drilling will die entirely, but it would not be surprising to me if we see an excess supply of rigs for a decade or more in the future, and essentially no new builds.

4) Refining- High North American refining margins were supported by large regional differentials.  These differentials were caused by rapid production growth in certain regions like North Dakota and West Texas.  With supply declining, logistical constrains will ease.  Already the famous WTI-Brent spread, which first blew out in 2010, has now collapsed.  Its hard to see how refining margins don't contract significantly, but I must admit this is not an area that I know a ton about.

5) Pipelines- 2015 was a horrendous year for pipelines and MLPs.  Kinder Morgan, the poster child for MLP related financial engineering, has crashed from a peak of $44 down to $14.   MLPs were billed as being insulated from price changes, but that apparently was not the case.  I wonder if this crash has now been overdone.  I really don't feel qualified to make a recommendation here without doing some extensive work.

Checking in. A look at the supply-demand balance over the past year.

I have not bought any energy stocks since last writing here.  The world has remained grossly oversupplied, to the tune of about 1 million barrels per day.  World inventories are at their highest level in history.  Demand grew at 1.9% (1.8 million barrels per day) for 2015 vs 2014 of which 1.1 million barrels per day of growth was in the Asia/Pacific region.  The remainder of .6 million per day demand growth was spread out fairly evenly across the world.

The biggest driver of Asian growth was China.  Motor gasoline demand grew at .2 million barrels per day as auto sales reached an annual rate of 16.5 million vehicles, or similar to the US rate of sales.  The key difference is that in the US new vehicles are largely replacing scrapped vehicles.  In China only about 1 million vehicles were scrapped in 2015, and the rate of growth for the in-use fleet of passenger vehicles was an incredible 20% annually.    India products demand also grew at about .3 million barrels per day, another strong driver of the Asian demand growth.

 Supply demand balance from IEA December report.

On the supply side, after years of non-opec supply growth driven mainly by the US, non-opec supply growth slowed dramatically over the course of 2015.  US supply growth has finally reversed.   The oil rig count stands at 545 according to the december Baker Hughes report, down by about two thirds since peaking in late 2014. Russian growth, which has been a surprise, is also projected to stop next year by IEA.  Overall, former Soviet Union exports were roughly flat at about 9 million barrels per day.   By the end of the year non-opec supply was probably contracting.    

But this slack was taken up by strong opec supply growth.  Saudi Arabia has often been given the credit for OPECs all-out production, and they certainly are the most influential OPEC member, since they are the only ones who maintain significant spare capacity. But in fact the Saudis have not added much to the glut, since their own increases in supply have largely been soaked up by increasing domestic demand.  Total exports have hovered around 8 million barrels per day of crude and products since 2012.  Iraq, on the other hand has gone from exporting around 2 to 2.5 mbd in early 2014, to exporting about 4 mbd in late 2015.  Iraq remains a potential source of increased supply in the long term, but a stretched budget, political instability, and lack of investment suggest that further production growth may be some years off.  Libya and Iran are the two most likely growers in 2016.  Libya is producing at less than .5 mbd, compared to their levels of 1.7 mbd before Gadhafi’s ouster.  There are some indications that the fighting there may stop. Iran has lots of spare capacity ready to come online if sanctions end.  Both areas are also affected by chronic underinvestment, and good grow supply over the longer term under the right conditions.

IEA projects continued oversupply until late 2016.  Overall, I think there are a lot of reasons to continue to be pessimistic. In the near term, we can expect a contraction of supply in the US, but this may well be offset by continued OPEC growth driven by Libya and Iran in the short term.  In the longer term (3-5 year), these low oil prices will reduce production in expensive deepwater areas like Gulf of Mexico, Canadian Oil Sands, North Sea, Offshore West Africa etc.  It will also reduce exploration budgets, which will reduce very long term supply.  Demand will continue to grow in the short term, driven by Asia.  But in the longer term, unlimited demand growth is not a given.  It is still very hard to say what the equilibrium price would be.  Given that US tight oil can work fairly well at $50-60/bbl, I would view this as the upper end of the likely price range over the next few years. 

Key points:

1. The world is still oversupplied, although the 1 million barrels per day of oversupply is easing.  There is a good chance supply and demand will be in balance at the end of the year (but with unprecedented high inventory levels).
2. Large capex budget cuts will lead to significant declines in US on-shore volumes next year, and will result in longer term declines (or at least will prevent growth) in other high-cost areas like Canadian oil sands and deepwater gulf of mexico, north sea, Brazil, West Africa, etc.
3. There is still a risk for another big leg down in oil price.  One obvious scenario would be Iran exports coming back online with a vengeance.  Another, perhaps less likely, would be running up against physical limitations for storage, a scenario put forward by the Venezuelan oil minister.