The last two weeks have been a wild ride for oil. In writing the articles for this week, what interested me most was the technical shift that occurred on February 21, 2017, but didn’t seem to result in a major market shift until the last few weeks. When viewed historically, as I discuss in this week’s article about price volatility, every bench mark indicator peaked on February 21, 2017, and then began a steady decline. Obviously, until we view historical data after the event, we can’t see that. But I nevertheless remain fascinated that on that particular day, the overall impression of the media was that oil remained headed for positive territory.
In the last edition of The Five Star Standard, we presented a view held by many that we may be looking at this all wrong: the world is about to enter into supply deficit and unless there is a rush of capital expenditure, oil could be headed up dramatically in the coming years.
In this edition, we present the contrarian view held by Goldman Sachs, amongst others. Goldman in effect argues that the perfect storm is brewing: CAPEX invested seven years ago in mega-projects will come online IN 2018-2019. When combined with the relatively short 6-7 month lead time for a shale project, this will create the perfect storm that could crash the price of oil.
The problem may be more fundamental though. I remember when I was a young lawyer, I attended a State Bar of Texas annual meeting where the guest speaker was Karen Hughes. Some of you might remember Ms. Hughes who directed George W. Bush’s first campaign for Texas governor and later served as a counselor from 2001 to 2002 when he was President. At the time of the conference, then candidate Obama was running against John McCain. Speaking about the upcoming election, Ms. Hughes stated that Mr. Obama was running on a platform of rhetoric and ideals rather than actual policy, while Mr. McCain was running on a strong policy platform without the feel good rhetoric of Mr. Obama. She pondered who would win. Fast forward to this election cycle and a similar event occurred. Mrs. Clinton offered excruciatingly detailed policy proposals on her website, while Mr. Trump ran on a platform of change that articulated ideals – but not necessarily clear policy on how to achieve them. We see in both instances which candidate won the election.
And a similar situation has arisen in oil markets. Were oil markets trading on hype or on fundamentals? Fundamentally, the data is not positive. Inventories remain near five year highs, output cuts seem to not have had the desired affect despite high compliance rates, and some indications exist that world oil demand will not increase at projected rates to soak up excess supply. Yet, OPEC and others continue to talk-up the supply cuts while having to admit that they are not having the desired effect – at least not yet.
I would posit to you that what we are seeing is a change for money managers and others who are looking at fundamentals and becoming increasingly concerned as the actual data begins to slap them in the face in a sobering way. Fundamentally, inventories are high, production from the U.S. is booming and will likely continue to do so. Currently, some four million barrels per day of spare supply is either voluntarily or involuntarily offline, and nothing seems to be changing. Add that to the fact that OPEC has been wishy-washy at best and there appears to be cause for concern.
And then there is the politics of OPEC that makes the organization inherently unstable. There is no doubt that Saudi Arabia has sacrificed and lead the way. In contrast, Iran has largely gotten a free ride and has repeatedly boasted about their increased production and their plans to increase production next year. Effectively slapping the Saudis in the face. The Saudis are already hinting that they will not agree to extend cuts unless Iran agrees to cuts. And Iran is already saying that cuts are a non-starter. While many seem to view an OPEC extension in May as a given, I think that is a dangerous assumption given the current geopolitical situation.
Nevertheless, I remain, for now, in the optimistic camp. There are reports that U.S. gasoline demand growth has been sluggish, but this is somewhat to be anticipated. Americans have demanded more fuel-efficient cars over the years, and generationally, there has been a shift in consumer practices as younger consumers demand more “green” products. And many consumers remember getting burned before: buying that large SUV right before oil prices skyrocketed. They might be hesitant to do so again.
But I believe world growth will continue and eventually supply side dynamics will result in reduced inventories. Yes. You will see increased U.S. production – and that production will be substantially more than previously anticipated. But OPEC has every incentive to continue regulating market price, even to the extent that they lose some market share. As the premium between light/sweet and heavy/sour narrows, some of the economies of refining and production may serve as the invisible hand to realign worldwide production/consumption in a more favorable manner for OPEC.
Moreover, while the U.S. appears to be booming, the rest of the world is not, and it won’t be long before they begin hitting structural barriers to increased production. Everything from an insufficient number of workers to delays in bringing new rigs online as a result of the tremendous loss of production capacity that has occurred over the past two years, the U.S. will hit the proverbial wall. More importantly, beginning next month, U.S. Banks will begin their reassessment of oil companies’ credit lines. Banks are not known to be risk takers, and they may put the brakes on some of the radical expansion plans.
I still believe OPEC has a choice: extend the cuts for another six months – i.e. grin and bear it, or don’t. But if they don’t they risk throwing the market into disarray for several more years and ultimately sacrificing market share anyway. No one knows how truly productive U.S. shale can be or what their true cost per barrel will be given the substantial technological advances OPEC forced them to make. Do they really want to gamble that U.S. producers can’t get their cost of production down further and keep drilling? Hopefully, they learned from their experience over the past two years that letting the market go without any intervention will simply lead to other producers becoming more competitive.
Until next time my friends.
By: Ty Chapman
Five Star Metals, Inc.
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