Asset Allocator: May2015- Coping with Flucuating Oil Prices

In his latest weekly Asset Allocator post, David Stevenson looks at the oil price crash that begun in late 2014 and has stretched into 2015, examining whether the bulk of the damage lies within developed markets like the US or the cheaper OPEC markets and what even cheaper oil prices could mean for us all.

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes no responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear. 


ASSET ALLOCATOR: MAY 2015

26/05/15- Coping with Fluctuating Oil Prices  

 

In recent months, whenever I give an investment seminar, I prominently feature a slide with the wholly unoriginal title of “Investment Surprises for the next few years: Greyish swans with black spots”. The obvious pun here is on the varieties of swans – black (Nassim Taleb) and grey (Martin Sorrell) – that can be found loitering around the global financial markets, springing surprises on us all. My point is that some of these surprises are essentially unknowable and unpredictable (black), others believable but thought at some stage unlikely (grey), and yet more that seem to exist somewhere in between these two states but are probably bloody obvious to most contrarians.  

Top of my list in the powerpoint is Oil. It reads “Oil at $20. Yes we can!” 

I’m fairly sure the average reader can surmise my general point in making this statement which is that we’ve not seen anything yet in terms of price action and that oil prices could go much, much lower. My own thinking on this subject was summed up in an Investment Week column from back in February (the 13th to be precise – here’s the link: http://www.investmentweek.co.uk/investment-week/opinion/2395088/the-contrarian-investor-is-the-great-oil-crash-really-over). 

It’s worth quoting this article at some length to get the ‘gist of my argument. 

“All eyes are now on the OPEC summit in June, where we can expect trebles all round as the assorted energy ministers congratulate themselves on having taught those pesky Americans a thing or two about markets. In sum, job done. …I believe there is much worse to come in the resources sector, especially as the Saudis realise their little experiment in energy-based creative destruction is not working…..In simple terms, the state-centric oil producers have miscalculated. They passionately believe that, because they have the lowest marginal cost of production, they can sit tight and destroy the higher cost shale producers in the US, thus eliminating the dastardly Yanks as the world’s dominant marginal supply of oil and gas….I am willing to bet they are wrong – the US producers will simply find a clever way around the lower prices, forcing the Saudis onto the back foot. In sum, oil production and supply will barely fall……So, on the capitalist, free market side of the fence, we have a legion of producers having to work out how to produce cheaper oil, day in, day out, helped along by hedged output contracts that let them stay in profit for the time being. This gives the smartest operators the chance to work out how to squeeze costs even further, and push those marginal cost rates below $40 and then $35 a barrel. On the other side of the fence, we have a gaggle of OPEC countries which run their energy sector as a state department, with budgets that require oil prices of at least $90-$100/bbl to balance their fiscal and external budgets. ETFS says, at current prices, Saudi Arabia is losing about S$10bn per month from its foreign currency reserves. 

So maybe the resilience of the US is much greater than the resilience of OPEC? Add in the near certainty OPEC production cuts are unlikely before H2 2015, and we have the makings of a game of chicken, one OPEC may lose. And what happens if it does? What if a sudden production quota cut after the OPEC summit in June 2015 does not deliver on higher prices? Well, my friends, the cat is then well and truly out of the bag. The US emerges as the key global swing producer and prices will plummet, hitting a nadir of perhaps $20 before settling at around $40 a barrel. This will unleash a huge wave of defaults as well as geopolitical mayhem. But the global economy will have received a massive cash injection which should help boost global growth at just the moment when the eurozone is finally beginning its slow escape from deflation. Volatility will no doubt increase, but this could be the makings of a huge risk-on rally.” 

The chart below much more eloquently than any words would allow explains why I’ve been wrong so far. 

It shows the price of Brent oil over the last twelve months, plus a whole legion of indicators including the thick green line (the 20 day moving average), the thin blue line (the 20 day moving average), and trend lines suggesting a steep descent (the solid and dotted blue lines). The important line of course is the one in the middle (red and green) which shows that Brent oil prices have rallied in recent weeks to hit about $65 a barrel, clearing all the trend lines, as well as the 20 day moving average. My own guess is that within the next few weeks that price might even clear the 200 day moving average, at which point many speculators will no doubt start to bet big time on a rally?

 

This short term price action might be underpinned by relatively positive numbers from the oil markets. As last week’s research report from Societe Generale’s own analyst’s note, the oil market stats were “moderately bullish for crude, gasoline, and distillate: stocks drew and demand was solid. Total 4w average product demand growth was strong at 739 kb/d y-o-y (+3.9%) to 19.7 Mb/d. Crude stocks continued to draw seasonally, and we expect crude and product demand to remain supportive as economic activity rebounds following a weak first quarter. Crude production fell by a significant 112 kb/d, but the slide was solely due to field maintenance in Alaska; it is worth noting that supply in Alaska has already returned to normal. Lower 48 output - including shale oil - was flat at 8.87 Mb/d.”

Unfortunately I don’t believe this market consensus is correct.

Oil prices have stabilised but I still struggle to understand why the Saudi government would have unleashed such a tsunami of market moves for such a small net effect. Are oil prices at $65 really going to massively cut oil production, and return the Middle Eastern kingdom to its normal role as price setter? I think not.

A report last week from the oil and gas team at Edison nail two important facts.

The first is that despite the falling price of oil, the cost of producing oil in key North American shale formations has continued to decline. As I said in my Investment Week article in a race between capital intensive US producers and state controlled oil giants I know which side I’d bet on.

The Edison team note that as regards productivity in the US “while the rig count has fallen, rig productivity has increased markedly. Notably, the Permian region has seen a spike in the rates in April and May, with rates increasing from 200bopd in January to 265bopd in May. We will watch the next few data points in coming months to see how this develops. The Permian currently accounts for 2.0mmbd or about 36% of US onshore production so this is not an immaterial data point.”

The chart below demonstrates this argument in hard numbers – US unconventional oil is getting cheaper to produce as productivity gains accelerate.

 

Looking beyond the US, the Edison team observe that “elsewhere, the rate of increase in rig productivity is now normalising with average increases of c.5% (per month) across the regions. It is not hard to appreciate that growth rates of 5% per month have had a significant offsetting effect despite the drastic reduction in rig count since late 2014.”

Next up we have the thorny issue of crude stocks which are now at record highs. 

 

The chart above shows the huge increase in global oil stocks, massively moving out of their normal 5 year trading range.

Another recent note, this time from analysts at Goldman Sachs I think brilliantly sums up the contrarian view.

In a report entitled “Reality of oil market will trump perception and positioning” Damien Courvalin and Jeffrey Currie conclude that “(1) while the US producer response has been large, we believe it remains short of the slowdown required and will reverse at current prices, (2) the reaction of non-OPEC producers remains limited so far and low-cost producers such as Saudi Arabia, Iraq and Russia are on track to grow production sharply, (3) access to equity and debt capital markets is already back to being open. We therefore reiterate our bearish oil price view, as we simply do not find that the amount of pressure that the industry has faced - either through cash flow/oil prices or through access to capital - has been sufficient to ration the forward hydrocarbon and capital surpluses. In addition, we believe that the recent rally will in fact undermine the market rebalancing, especially as we lower our estimated oil marginal costs. Finally, oil net speculative positioning is now as long as when oil traded at $100/bbl last summer”.

To be fair even the Goldman Sachs analysts accept that their predictions of much lower prices might take some time to come through especially as we are approaching seasonally stronger demand and potential China strategic reserves fill. The oil price rally has also coincided with other macro reversals “such as a rising Euro and a surprisingly large intraday inverse correlation between oil and the dollar since early April”. And what of the impending OPEC summit? The GS analysts anticipate a “passive response”, so I suppose the speculative investor might not want to bet on a big downward move in oil prices in June?

Nevertheless despite these bullish short term headwinds I’d stick with my very bearish view about medium term oil prices.

In sum I’d make three very simple arguments that the energy market is very far from a sensible equilibrium: 

1)  Oil production in ‘target’ (for Saudi purposes) unconventional areas has NOT reversed by anywhere near enough. According to the Goldman Sachs analysts “US production will still grow in 2016 at the current rig count given continued efficiency gains, signs of high grading and an elevated well backlog”. 

2)  If one aim of the Saudi’s was to scare the capital markets into withdrawing their funding for new oil fields in the US and beyond, they’ve seemingly failed. According to the GS analysts “apart from January, access to capital has been remarkably smooth with HY energy debt issuance back to accounting for 20% of US issuance and the equity market absorbing $12 bn of equity issuance since February without a glitch”.

3)  The rate of productivity improvement for US producers is accelerating which means they might be able to make profits even if prices remain below $50 a barrel. The GS report observes that “while the recent improvements in shale breakevens have been primarily driven by cost deflation, we expect that the efficiency gains observed since 2009 will accelerate. This reflects both our expectation that shale, as a technology, is still in its early stages of development and that productivity gains are set to pick up as we move into the Exploitation phase of the oil supply cycle, just as they did in the 1980s for offshore production”.

Given these huge structural drivers I think “the job” is very much Not done for the Saudi’s. The deep structural changes needed – the closure of lots of marginally profitable output capacity – has not occurred and we’re now set for a colossal over supply of oil, on a truly mammoth scale in my humble opinion.

Already indications are emerging that the Saudi government has emerged as the KEY supplier of crude to the massive Chinese market, a position they won’t want to lose by US suppliers under cutting them. My sense is that they’ll drive the oil price much lower to defend their strategic position, although this move isn’t likely to come until the second half of 2015.

My bottom line? 

In portfolio terms I would continue to steer clear of energy related stocks, sectors and themes until this big market move makes an appearance. Stick with the buoyant consumer sectors and tech stocks, where the winners will be obvious.  

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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