Wednesday, January 13, 2016

Oil: don't manufacture reasons to be bearish

I'm an oil tourist, so you're welcome to use this article as a contrary indicator if you want, but I think that the oil selloff is overdone and that some of the bearish arguments are wrong.

The most common bear argument I hear is (paraphrasing) "The price of oil has crashed, but US shale production has barely fallen. Until it falls, oil will only crash further. Next stop $20!"

I disagree with this line of thought for a couple of reasons:

First, oil capex is down significantly from the peak. I've seen one estimate that 2015 had the biggest-ever year-over-year decline. There's a lag between capex and output changes, but I don't see how capex can fall so far as it has without an eventual corresponding decline in output. Many oil companies that hedged a significant part of their 2015 production are unhedged or much less hedged for 2016, giving them an incentive to reduce production.

Second, US shale isn't the entire market. Andrew Hall argues that the global oil glut is much smaller than the U.S. glut:

Hall points out that there has been a significant decline in total oil inventories during the past few months. Combined data for commercial inventories in the U.S. and Japan, in leased storage in Rotterdam and Singapore plus oil in floating storage, showed a decline of over 1.5 million bpd in November – the first monthly decline this year. Commercial oil inventories in China fell by over 600,000 bpd in October and now stand at the same level as a year ago.

Demand is rising in both the U.S. and the rest of the world: the IEA estimates that global demand growth reached a five-year high last year. It's expected to rise again, at a somewhat lower rate, this year.

A comparison with the 1980s

In the early 1980s, Saudis Arabia steadily cut its oil production to keep prices stable, but this backfired by encouraging producers in the U.S. and elsewhere to fill the gap by increasing their own production. In late 1985 the Saudis switched their policy from maintaining prices to maintaining market share, and the price of oil responded by falling 2/3rds in less than a year.

Something similar has happened in this decline, with OPEC maintaining production as prices fall in order to flush out the shale drillers. There's one big difference between then and now, however: in the '80s, Saudi Arabia's production cuts left it with years of excess capacity, which depressed prices for the rest of the decade; the same kind of excess capacity doesn't exist today. Despite that, oil has fallen more this time around.

I think oil supply/demand is less awful than it looks, and within the next few months we should see signs that the market is stabilizing. "Next few months" may seem like an eternity when oil is falling 3-5% every day, but it will happen before we know it.


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  2. Agreed on supply.

    The issue is demand; where real time data is not matching forecasts for demand growth.

    Distillate consumption in US is 3.4 mm bbl/day for 1st 2 weeks of Jan-16 compared to 3.9 mmbbl/day last year. That's down 8-9%

    Gasoline/petroleum consumption in US is 8.8 mmbbl/day for first 2 weeks in Jan-2016 vs 9.2 mmbbl/day for first 2 weeks in Jan-2015. Decrease of 4.3%

    1. I assumed that previous weak reports were a fluke, but obviously I was wrong, and it was dumb for me to publish that piece a couple hours before the EIA report. Oh well- I deserve it for trying to call the bottom.

  3. Question is how to play an eventual rebound? Petrochemical currencies? What are equities pricing in?

    1. My sense is that E&P stocks are pricing in a higher strip and that E&P debt is as well, although to a lesser extent. With the E&Ps, there's also the issue that many of these companies are run for production growth rather than total return; I prefer petro-currencies because agent-principal problems aren't an issue for them. On the other hand, Canada and Norway both have big housing bubbles which should become a problem at some point; oil isn't the only thing that affects their exchange rates.


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