This weeks Ty’s Take is going to be a bit of a hodge podge – so let me begin by apologizing for any stream-of-conscience style writing. I promise I will do my best to keep it organized and relevant.
Like a lot of business owners, I spend a tremendous amount of time planning for the future. And this is particularly true for us at Five Star in month of December each year as we finalize budgets and forecasts for the next year. We project business levels, profit margins, costs, hiring requirements, and a host of other factors knowing all the time that we will be wrong – the question is how close can we get.
I say all of that to say this. At no point during the rest of the year as in December do I spend as much time thinking, analyzing, and trying to predict what next year will hold. And while I am always attune to market conditions for oil and steel pricing, I am hyper-focused on it right now as it consumes days and days of my time.
That having been said, I truly believe we are in for recovery in 2017. Forgetting the fact that people smarter than me have called bottom, I see every indication that recovery is imminent.
Why I Believe Markets Will Recover in 2017.
First, as I mentioned before, OPEC has real incentive to comply with its output cut. Saudi Arabia is particularly incentivized which is why they have point blank said they will go further than 500,000 barrels a day if need be as they have said they will do (See the other articles this week). As I mentioned before the Aramco deal is looming and they need high reserve values.
But here is the thing. Theoretically, assuming that other producers cannot just flip a switch and turn on the faucet, according to analysts at Goldman Sachs, Saudi Arabia can cut as much as 1.1 million barrels a day – more than double its target, and make more money than they are making now. I fully believe that the Saudis have finally accepted that the American shale industry is substantially more resilient than they believed and have conceded that they simply cannot win the war – so Plan B is in order.
And this makes sense. I have traveled extensively and read a great many articles, and one thing that has always interested me is how people in many other countries cannot grasp the American free market system, our ability to be creative and adaptive. This is particularly true in more totalitarian states. For example, the most popular movie in China at one point was Kung Fu Panda (made in the USA!). The Chinese cultural minister expressed frustration in an interview about why China couldn’t produce that movie. Culturally, he just could not grasp American ingenuity and spirit or why his people don’t have the same ability to innovate and create. And I think the same was true with the Saudis. They cannot grasp that an American business won’t just fold, we will fight, we will move to Plan B, and if that doesn’t work to Plan C. We will create. We will innovate. We will survive until you knock every breath of life out of us. Until we have exhausted ourselves, our resources, and combed the earth for the person that may have a better idea than we do so we can survive.
That’s why we invented new technology, got more efficient, and have driven down the cost of production so much so that our breakeven price on a barrel is less than half of what it was before they declared economic war on us – they put our backs into the proverbial corner and we just built a new door. Patriotism aside, I truly think the Saudis thought two years ago they would crush us. When it didn’t work they had to switch course.
So at that point, they had to come to terms with the problem. They have fought an expensive proxy war in Yemen, their reserves are shrinking, they can’t fund their economic improvement projects, and they have tacitly acknowledged they can’t go on like this. Moreover, while they like to say they can produce 12 million barrels a day – the truth is that to do so they have to invest a substantial amount in new fields which the current price of oil doesn’t justify – so they have a problem if they want to keep the war going. Even their current production practices are negative in the long run as they are bad reserve management and will ultimately lead to quicker depletion of their existing fields. Viola! New OPEC deal!
And as we reported this week and last week. We have every indication that American drilling is picking up. The rig count continues to rise, rig rental rates and sand are getting more expensive, and the U.S. added 100,000 bpd of production since May.
Three additional factors emanating from the U.S. indicate that we are on the brink of recovery. First, is the Fed Rate hike. The Fed needed to raise rates. And while the rate hike was not very much, it was hugely significant as it shows confidence by the Fed in the U.S. economy’s growth which obviously bodes will for continued demand growth of oil. Initially, rate hikes are bad for oil as they strengthen the American dollar which is negative overall for oil pricing. And markets reacted accordingly. However, at least in my mind, the confidence the Fed clearly has in the U.S. economy on a go forward basis outweighs the negative impact of a stronger U.S. dollar.
As many of you have probably noticed, its cold outside. Maybe not as cold in Houston as the rest of the country, but it is very cold in the rest of the country. As Natural Gas becomes more and more prevalent for power generation, shifting climate patterns become more and more significant. Colder weather is now expected to dominate the U.S. winter raising demand for natural gas which should increase price and encourage development.
And as we mentioned in an earlier article, oil prices have changed enough to now allow U.S. producers to lock in hedged prices at over $50 a barrel. That is hugely significant, as it will insure some profit margin even at a $40.00 a barrel break even and is probably a sufficient enough gain to encourage production.
What Concerns Me.
But there is some disconcerting news that I mentioned in an earlier article. Forgive me while I geek out on you for the next few paragraphs. So far, oil traders seem to be trading as though they believe the oil market will move into deficit, but not until the second half of 2017.
The way trader’s view the market can be seen in the futures curve. If supply is forecast to exceed demand (i.e. – there is more oil building in stock piles than is being pulled), future prices will trade in a structure called contango – that is where prices for short term delivery dates are below those for later delivery dates. Another way of thinking about this is, I will be buying it in the future, because me waiting is better than me buying it now and storing it because I will have storage costs so there is less demand to buy it now and I’m better off waiting for the future to buy it so you have to give me an incentive to buy it now.
The opposite situation is called backwardation. This occurs when demand is expected to exceed supply. In that case, near term prices are higher than prices for later delivery. In that case, I think I can buy it now and store it cheaper than I will be able to buy it in say, six months, so when everyone does this, the near term price gets driven up as opposed to the long-term price. In effect the premium for short-term delivery helps keep consumption lower and preserve future stock.
At first this seems counter intuitive. But spot price and futures price always converge at the closing of the contract on the futures market. Therefore, we are not dealing with the actual value of the barrel at the closing of the contract on the futures market, but rather, what is the demand for that contract today.
The reason I explain this concept is to tell you that periods of oversupply have been associated with contango, whereas periods of stock rebalancing and draws have been associated with backwardation.
Currently, a contango market exists through 2018, but the spread is narrowing. The contango for the second half of 2017 has shrunk to less than 80 cents per barrel, while the contango for the first half of 2018 is down to 25 cents and the second half to just 1 cent. Thus, traders seem to believe it will be second half of 2017 before we rebalance. Of course, they have been wrong in the past.
My Final Analysis.
I truly believe we are at bottom and that OPEC will adhere to its production quotas (ok, some Nations are going to cheat). I also feel the market shifting. Whether that occurs in the first half of next year is anybody’s guess. I’m personally preparing for a Q1 2017 that largely looks like this quarter, with an uptick in February and March. I think sustained recovery will occur when markets see OPEC adhering to its commitments to the World, and confidence amongst investors increasing.
If you listen to the oil Ministers and the big oil execs, we will recover sooner rather than later. The U.S. is already producing 100,000 bpd more than it did in May – a sign that drillers are confident. That confidence will increase as they are better able to lock in hedged oil prices to give them downside protection.
What remains to be seen is whether the proverbial floodgates will open or we will see a trickle up in business. I reviewed our prior years and tried to find the effect of bottom. In the past, we have seen slow uptick, followed by a bit more of an uptick, and then a month over month floodgates open and we regained a huge portion of our business. I feel like we are through the slow uptick now, and hopefully, will continue on an upward trajectory.
So what am I planning on? I’m planning on it slowly picking up in first quarter, and then accelerating in Second and Third Quarter. But that is just my opinion. And as I said in the opening statement. I know I will be wrong. The question is by how much. It’s a lot harder when you try and predict the months rather than the years.
I’m curious to hear from you all. What has been your downturn experiences? How quickly did you rebound from bottom? When do you think we will be back to normal?
By: Ty Chapman
Five Star Metals, Inc.
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