The fourth quarter brought about a precipitous drop in the price of oil. Brent Crude fell 41% in three months. Steep downward price action is not unprecedented in oil markets1. However the decline over the first thirty days of the quarter was historic with oil losing more than a quarter of its value while futures tallied up the longest consecutive streak of down days ever.
We find a great deal of variance among pundits and headlines and a surprising dichotomy between the near-term price action of oil and the long-term supply-demand economics. We want to review both in detail and perhaps steer our readers towards a more diverse perspective. We should note that the Massif Capital portfolio is long term bullish on the price of oil and the necessary re-emergence, and health, of the offshore oil industry. While we recognize we are biased towards the upside, we hope this commentary presents a strictly empirical review of our findings and will allow our audience the ability to ask better questions as they conduct their independent assessments.
Demand fears, present
Crude demand will be the largest source of uncertainty in 2019. Headwinds from trade tensions and tighter financial conditions are not a healthy backdrop in the late innings of a credit cycle. The interaction between major downside risks may weaken global output and trade substantially. While labor market conditions are improving2, incoming new orders have weakened, particularly in manufacturing. Wage and price pressures are projected to rise in the major advanced economies and space capacity now appears limited.
Both the U.S. and Chinese PMI manufacturing surveys3 suggest a pause in the pace of growth. China has been an important source of growth since 2009, in part driven by shadow banking and speculative lending. Exiting 2018, shadow banking was down 84% year-to-date. December 2018 saw Chinese industrial profits fall 1.8%, their first monthly decline since 2015. Chinese crude oil import quotas for 2019 were notably lower than the same time last year. As manufacturers destock, Asian petrochemical margins have come under heavy pressure. Concerning macroeconomic headlines aside, it’s important to recognize that growth is expected to slow, not contract. Indeed, the OECD calls for a ‘gradual easing’ of growth in 2019, knocking off just 20 basis points from 2018 actuals. Oil demand forecasts4 are directionally consistent with OECD growth estimates with an increase of approximately 1 million b/d globally5. Non-OECD countries are expected to lead that growth with a 2.5% projected increase in oil consumption while OECD countries expect a contraction of 0.6%.
The ambiguity surrounding geopolitics, however, remains a staunch concern. Much of the geopolitical risk, concerning demand, is frontloaded in the first half of 2019. Iran waivers are set to be re-evaluated in May, OPEC will meet in April and the U.S.- China 90-day trade deadline occurs in early March. Absent clarity on these issues, the market is not likely to form a consensus view on even the near-term demand outlook. We expect demand to continue to drive oil price volatility in the first half of the year.
Oversupply? Not so fast…
Following the U.S. administrations announcement of Iranian sanctions in May, Saudi Arabia stepped in as a swing producer, increasing production from 9.9 million b/d to 10.68 million b/d. In total, OPEC production increased roughly 1.5 million b/d between May and November 2018, roughly the equivalent of Mexico’s daily consumption. In a somewhat unexpected turn of events shortly before the sanctions were enforced, waivers were granted to eight countries importing Iranian crude, accounting for roughly 75% of Iran’s exports6. In parallel with a historic quarter of U.S. shale growth, supply concerns began to weigh heavily on the market7. The market is mispricing both stories considerably.
Iran Waivers: In 2017, Iranian crude and condensate exports averaged 2.6 million b/d. Eight months later in September 2018, crude exports totaled 1.8 million b/d, a 30% decrease. By November 2018, Iran was exporting .92 million b/d, a 64% drop from their average the year prior. Higher than expected sanction waivers had a far more significant impact on market sentiment than actual supply volumes. While the waivers may be renewed, they are currently set to expire in early May. While it should not be underestimated that Iran is working around the clock to break the sanctions (satellite data from Cargo Metrics suggest that Iran’s ‘un-official exports’ are notably higher than actuals) it appears unlikely that the world can expect more than 50% of Iranian supply enjoyed just twelve months ago. To put this into perspective, the International Energy Agency (IEA) oil-demand growth forecast that was revised lower in the fall due to ‘global growth concerns’ was 1/10th the magnitude of the Iranian supply decrease.
U.S. Shale: Over the last several years, there has been a collapse in conventional oil discovers in the non-OPEC world. Negligible upstream capital spending over the last five years suggests this paradigm may not change in the near-term. IEA growth rates for Brazil have been revised down 90% since the beginning of 2018; the North Sea is on track to have their second consecutive year of production declines and Canada’s 2019 new capacity additions are expected to be less than 25% of their 2018 capacity growth. The supply story, both today and moving forward, rests with U.S. shale.
U.S shale producers had a remarkably strong 2018. As we examine the third and preliminary fourth-quarter data closely, the number of wells is increasing, but net production growth is declining. The Eagle Ford grew 15% Y/Y, yet net production has slowed by 50%. The Bakken grew 54% as measured by total wells, with net production only growing at 26%. The deterioration of well quality appears to be a growing concern. The key question to us seems whether technology has materially improved such that Q3 2018 growth rates can be extrapolated into the future. The current US Shale narrative attributes the application of new technology to expanding new reservoirs of inventory that can be drilled profitably at low prices, extending the belief that the region can grow by 1 million b/d in perpetuity.
Medium-term US shale forecasts suggest otherwise with supply growth easing from 1 million b/d in 2019 to 0.5 million b/d in 20238.It is important that this forecast also assumes that the current pipeline bottleneck plaguing the region will also subside with additional export capacity expected to hit the market in 2H 2019. In an environment of historically low OPEC spare capacity and a faltering backlog of non-OPEC projects, relying on short term cycle supply from the US seems awfully tenuous. A healthy and growing shale resource base is critical to the oversupply narrative. Examining remaining inventory in key basins, our research suggests it has not as healthy as it may appear. The Permian basin we believe has a likely efficient reserve life of four to seven years. While technology has significantly increased the lateral length of hydraulic fracturing which has boosted near-term output, this activity comes at the expense of steeper declines in total reservoir capacity. Furthermore, an increase in lateral length has likely deteriorated well productivity as it limits the number of future drillable locations9.
While 2018 exit production rates were higher than expected, strongly supporting the bearish oil price narrative, operational data has shown signs of a slowdown as far back as October, well before the significant price collapse. Looking ahead, it appears likely that few operators will be able to generate the free cash flow at current forward curves following the recent price selloff. Either activity levels must be reduced, or operators may face an increasingly bleak financial health check that will not be overlooked by investors10. Additionally, it would appear that creating a strong hedging strategy has become increasingly difficult given the recent price swings. If it is more difficult to hedge, it is more difficult to raise capital. The rapidly depleting nature of shale reserves is a concern. Operators must constantly raise capital to replace assets11. Higher interest rates, increased oil service costs and dwindling prime drilling locations are going to prove a formidable environment.
Finally, we believe an important outstanding question that gets little attention is whether the world can handle more U.S. light crude. The composition of global supply is perhaps more important to consider than total supply. Sour crude is in short supply with the loss of Iranian and Venezuelan oil supplies and new refineries expected to bring two million b/d of additional capacity to the market are designed to run on sour crude12.
The world is however awash with light crude, thanks to the growth, and export, of U.S. production. Pipeline constraints from the prominent shale regions into the gulf coast dominate the headlines today, and while this is a concern over the next calendar year, we believe export capacity in the U.S. will be able to handle even aggressive production estimates within two years. For global inventory stocks to remain flat in 2019 however, the expectations are that U.S. exports will need to average 2.9 million b/d. If the world is currently struggling to absorb 2 million b/d of US light crude, it seems highly unreasonable to expect that it can handle ~3 million b/d. The balancing market in 2019 and beyond will be more dependent on quality than volume. Absent new basin discoveries13, the U.S. shale story may eventually turn a global oversupply narrative into a global deficit narrative.
OPEC: OPEC cuts are beginning to show up in lower loading programs. OPEC loadings fell month over month by 0.32 million b/d in December due to decreased exports in Saudi Arabia, Venezuela and the UAE. Expectations are high for further declines in January as Saudi Arabia, Kuwait and the UAE look to cut production to comply with the new OPEC+ agreement. In addition, Libya’s exports are also expected to fall as recent bad weather in December forced the closure of Es Sider, a major export terminal. Due to the political, legal and operational challenges of resuming imports from Iran, only China, India and Turkey have thus far received cargoes from the sanctioned nation. With respect to the OPEC+ deal that occurred in December, we expect that every OPEC member will cut output by 2.5% from October 2018 levels. We believe OPEC crude output will fall approximately 1 million b/d to ~31 million b/d in the first quarter of 2019. It’s possible we see a gradual increase in production entering into the second half of 2019 as the member countries will adjust their stance based on evolved market fundamentals, principally looking at Iranian exports and global demand. Should OPEC raise production, we do not expect it to exceed 2018 rates of 32.5 million b/d. At this level, spare capacity remains at extremely low levels of ~0.5-0.6 million b/d.
Current concerns regarding global demand are overstated. Global growth will likely taper in 2019, but we do not forecast a contraction. Demand however remains the principal risk entering the year and oil market volatility will likely rest squarely on several key political events over the course of the first six months. Oversupply concerns are often misguided and, in some cases, empirically inaccurate. No OPEC country outside of Iran and Venezuela have spare capacity greater than 0.4 million b/d. We have low expectations either country can utilize that spare capacity over the next year. It’s worth noting that the 2019 Saudi Arabia federal budget assumes a $80 per barrel price of oil for their books to balance14.
Bloomberg economist Ziad Daoud notes that Brent crude would need to rise another $15 to $95 a barrel for the Kingdom to balance their budget. We now appear to be on the 6th consecutive budget deficit in a row, estimated to hit $35 billion in 2019. The King has noted that the country will continue paying for public sector cost of living allowances for citizens and will boost spending to stimulate growth, even as they try and close their deficit. To fund these programs, Saudi Arabia needs oil prices materially higher15. The challenge for the Kingdom is that their ability to influence U.S. inventory is greatly diminished. Saudi exports roughly 1 million b/d to the U.S. A cut in exports by even 50% would be a drop in the bucket compared to the 2 million b/d production growth the U.S. has seen over the last 24 months. It would seem that the only way OPEC can address the light crude supply overhang is by cutting Arab Extra Light (AXL) shipments going east to Asia – a move that remains untested.
While we are not in the business of forecasting prices, we are firm in our belief that the next few years have the structural undertones to support an appreciating oil price. The lack of conventional oil field discoveries is problematic in the medium term as the current supply narrative rests on the perceived strength and extrapolated growth of U.S. shale. Should global demand creep forward even modestly, conventional oil field exploration and production appears necessary.
 The middle of 2014 saw a 60% drop over six months while the fourth quarter of 2015 saw Brent drop 44% over the course of roughly six weeks.
 OECD wide unemployment is at the lowest rate right now since 1980
 The China Caixin PMI Survey and the U.S. Institute of Supply Management PMI Survey.
 Largely consistent across multiple data sources such as IEA, OPEC, Energy Aspects and Jodi.
 Global crude oil demand estimates for 2019 are approximately 100.48 million b/d, an increase of 1.04 million b/d over expected 2018 consumption.
 It would appear that waivers were granted, and the market reacted in kind, partly due to the administrations fondness over lowering domestic gas prices leading into the 2018 U.S. midterm elections. Ironically, as the U.S. is now the largest global exporter, it’s not clear whether low gas prices actually help the economy when netting out the effect of domestic oil and gas industry. For oil importing countries, an oil price increase and economic growth are negatively correlated while all things being equal, the relationship is positively correlated for oil exporter countries. (The Interaction between Oil Price and Economic Growth, Ghalayini, L. 2011).
 The role of hedging should not be understated in the fall, 2018 trading environment. At the end of September, U.S. producers had swaps or puts on ~500 million barrels of production, the equivalent of 16 days of OPEC production. Most hedges were priced between $50 and $60 per barrel. As the oil price collapsed, producers needed to begin selling futures to cover their losses which may have added roughly 5 million barrels a day, synthetically, to the world supply for the quarter.
 Energy Aspects, 2018.
 Pressure is critical for material extraction.
 Diamondback, Parsley and Centennial offer evidence: Diamondback reduced CAPEX by 10% and plans to immediately drop three rigs, PE planned to reduced rig count by 25% going into Q4 2018 and Centennial has put a pause on previous plans to add 2-3 rigs in 2019.
 The depletion rate is somewhere between 5-8 years.
 Energy Aspects, Amrita Sen, 2019.
 Which we acknowledge as a legitimate outcome but have no basis to assign a probability to the event.
 According to the Kingdom, the government expects oil revenues will grow by nearly 10% from 607 billion ryals in 2018 to 662 billion in 2019. To hit 662 billion ryals in oil revenue, they must produce 10.2 milllion b/d sold at an average price of $80 per barrel.
 If the budget is not balanced, concerns of taking on further debt, spending their petrol-dollar reserves and theoretically, at some point, introducing austerity measures may become a reality they will likely try to desperately avoid.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Opinions expressed herein by Massif Capital, LLC (Massif Capital) are not an investment recommendation and are not meant to be relied upon in investment decisions. Massif Capital’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is limited in scope, based on an incomplete set of information, and has limitations to its accuracy. Massif Capital recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' regulatory filings, public statements and competitors. Consulting a qualified investment adviser may be prudent. The information upon which this material is based and was obtained from sources believed to be reliable, but has not been independently verified. Therefore, Massif Capital cannot guarantee its accuracy. Any opinions or estimates constitute Massif Capital’s best judgment as of the date of publication, and are subject to change without notice. Massif Capital explicitly disclaims any liability that may arise from the use of this material; reliance upon information in this publication is at the sole discretion of the reader. Furthermore, under no circumstances is this publication an offer to sell or a solicitation to buy securities or services discussed herein.
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