Is there a more dangerous place to explore than the investment markets?
Obviously Afghanistan is a bit dodgy and Johannesburg presents you with a better than average chance of being stabbed or shot. And I hear that there’s a village in Papua New Guinea where, if like me, you’re a pale face, you’ll be chopped up and eaten. But by gosh, they’ve got nothing on what wild swings in the investment markets can do to a man.
I was reminded of this when viewing one James Cordier, the CEO of OptionSellers.com. It so turns out that James lost something like $150 million of his clients’ money, which would be all dandy if he was managing a gazillion dollars. Trouble is that isn’t the case. Far as I can tell, he was managing… ummm, about $150m.
You can watch his disturbing apology here.
This probably won’t be the last time you see something like this.
I’m sure Jim and his buddies are nice blokes, but I’ve a real problem with his “rogue wave” excuse.
You see, his strategy was pretty simple. Sell options and pick up premium.
That’s a bloody good strategy if you’re a farmer with a soybean crop. You go sell some product forward to manage cash flows. Or you’re a pig farmer and you do the same thing.
But herein lies the problem. Jim ain’t any of those things, which means one thing. He never owned the underlying. He was always what we call “naked” — selling pigs he never owned… or soybean… or in this case, natural gas.
The strategy works really well… until it doesn’t. And when it doesn’t, it really doesn’t.
That’s not rogue wave stuff. It’s just probability and risk. Jimbo and his expensive watch-wearing brethren who will so dearly miss their holidays in Marseille and that 800-foot boat should have known this. Otherwise they’re like a pig farmer who thinks he’s farming cotton. It’s a problem feeding them fertilizer expecting fat pigs.
Jimbo was implicitly short volatility and had UNLIMITED risk. Ultimately he’s been carried out on a stretcher. Being short volatility in a world which has had volatility suppressed by central bank shenanigans impresses me as, how do I say this politely, fucking stupid.
That said, the recent move in the markets has dealt us a blow, too. Though we’re a long way from a stretcher. I think it was Sun Tzu who said:
Sometimes we need to lose the small battles in order to win the war.
It is times like these that tend to shake your fundamental view to its core as crude has fallen some 35% in a straight line within just 6 weeks.
It is worth asking ourselves this: is the “bull market” that started in early 2016 over?
And what has pushed the price of crude down as of late?
Well, before I try to answer that take a look at this:
I know I mentioned this in the weekly but stay with me. Crude and natural are moving in a dramatic linear fashion in opposite directions. They rarely move linearly and almost never in opposite directions to what we are currently witnessing.
This behavior suggested someone(s) were caught short natural gas and long crude and had to scramble to unwind those positions. We suspected this because the market moves made no sense. Here we have Mark Fisher explain:
Mark is supported by Macro Tourist’s latest blog.
We could argue that there was a little bit too much bullish sentiment a month or so ago when the US and Iran were rattling sabers at one another, and that crude was due for a normal bull market pull back.
But that wouldn’t normally have resulted in the violence of this recent move. Nope, this was a bunch of whales (yes, it’s more than Jimbo with his $150m levered client money) who got complacent and felt unstoppable like Usain Bolt.
And these whales had a leveraged long oil, short natural spread on. And as it made money, they doubled down probably a few times. And then pop. The hamstring went and the athletes couldn’t even stand up anymore let alone run.
So the burning question is, should we buy, sell, or hold oil stocks?
This is, therefore, an opportune time for me to try my best to answer this question. I will do my best to lay out my arguments in a succinct manner.
Technically Speaking
Good luck on trying to “trend trade” oil and on the back of that oil related stocks. If you want to position for where oil will be in 5 years (my definition of a long-term time frame), you better have something else up your sleeve than a chart.
Does a 20% fall mean the bull market is dead? Not so quick. It is not uncommon to have big pullbacks in a bull market.
On a 30-day basis crude has fallen by some 26%. But in the two previous bullish phases (1999 to 2007 and 2009 to 2014) it wasn’t uncommon for crude to pull back by 20% or more over a 30-day basis.
Although not “statistically significant”, one could conclude that big pull backs, like what we are currently witnessing, are a necessary phenomenon to ensure the bull market remains intact.
From a behavioural finance standpoint, we need this to take place. After all, investment markets are nothing more than the collection of millions of participants, all with emotions.
Perhaps we could also say that “true” bear markets also happen after prolonged bullish phases where there is lots of optimism. The latest bullish phase is some 2.5 years long, and even going back to the start of October I didn’t see much evidence of optimism in oil and gas stocks.
From a technical and sentiment perspective I believe we are probably closer to the start of a bull market in oil rather than closer to the end.
The Fundamental Perspective
I will try and condense my fundamental view down to just one paragraph:
There will be a large demand supply gap open up over the next 5 years.
Demand will continue to grow constantly but supply will not be able to keep up. This is due to the underinvestment in big conventional oil projects over the last 5 years.
There is a reliance on the continued growth and productivity of shale oil in the US, but this is built on very shaky assumptions and within a couple of years supply from shale sources will surprise to the downside. This is going to be significant and the emotional reaction especially by the US Government will be profound.
Conventional oil will not be able to offset the fall in production from Shale sources because there are no big projects coming on line within the next 5yrs.
And that all gives rise to a big supply deficit.
What follows is an elaboration of this view.
Global Demand
Last year oil consumption rose to a new high as did global energy consumption in general.
Let’s take a deeper dive into global oil consumption numbers. Let’s first look at the global picture of the continual growth in demand for oil and energy.
The only decrease in demand was on the back of the 2008 GFC. What we find interesting is the source of that growth in demand.
There are three major demand regions for oil in the world: North America, Europe, and Asia Pacific. These three regions account for two-thirds of global crude oil demand.
US and European demand hasn’t changed much over the last 30 years or so. But it is another story for Asia Pacific, which is the rising “Usain Bolt” of demand.
It is the increase in demand from Asia that is the primary reason for global demand trending steadily higher.
Asia Pacific accounts for most of the world’s population and population growth. Demand is being driven by billions of people who use a lot less oil per capita than the U.S., but whose per capita consumption is rising.
Chinese demand has increased by 5.0 million BPD over the last 10 years, the most of any country.
However, Chinese demand is still only 3.3 barrels per person per year. The US consumes some 22 barrels per person per year. By way of comparison, if China’s per capita demand were as high as the US, it would be nearly as great as the entire current global demand.
The second largest increase in oil demand over the past decade is India, which has seen its demand increase by 1.7 million BPD. Third place will probably be a surprise to many. Saudi Arabia has increased its oil demand by 1.5 million BPD over the past decade.
Is it unreasonable to expect the current trends in oil consumption depicted in the graph above over the last 20 years to change much over the next 10 years?
I certainly don’t think there will be any surprises. Not on the demand side at least!
Supply
We discussed the recent trends in consumption above. Let’s now dive into trends in supply/production.
In early 2008 crude hit $150 a barrel in almost the exact opposite behavior that is now occurring. There was no real fundamental reason to justify that move.
During the previous three years, global crude output increased by just 1.2 million BPD and most of that came from OPEC.
At the time the popular narrative was that OPEC had the world over a barrel. Everyone was concerned and there was talk of this being a repeat of the 1970s oil crisis. And don’t forget the “peak oil” story that was being bandied about at the time. Oil over $200? Sure, of course. Everyone was in.
But the future played out rather differently than the popular narrative (as it usually does). Going unnoticed to most, oil producers were experimenting with a new technology (albeit a technology that was being perfected) called horizontal drilling and hydraulic fracturing and also known as fracking.
The perfection of this technology led to the unlocking of vast oil oil deposits (locked up in shale) that had previously been too expensive to recover. It was boom times and one of the greatest revolutions in oil and gas production. Thanks to the “fracking revolution” oil production increased in 2009 and then rose over the next seven years at the fastest rate in U.S. history.
While OPEC did account for some 43% of the world’s oil in 2017, the majority of new oil production since 2008 has come from the U.S.T
Oil Supply Growth From 2008 to 2017
Of the additional oil produced since 2008, the U.S. accounted for 60 percent of that production. Russian and Saudi production didn’t change by any material amount.
But the big catch is that additional production from the US came more or less entirely from fracking.
So perhaps to understand the global supply outlook for crude is to understand the sustainability of crude from US fracking.
Which brings us to…
The Long Term Sustainability of US Shale Oil Production
To the general populace, the U.S. oil and gas industry is in the midst of a decade-long boom. Fracking has unleashed a torrent of oil and gas production, lifting U.S. output to all-time highs and fueling dreams of American energy being the new Saudi Arabia.
But peek under the covers and it all looks as shaky as Tesla’s finances. We believe that it is essentially one of the greatest delusions and amounts to nothing more than a giant ponzi scheme.
In short, the shale oil industry in the United States is using investor (debt and equity holder) money to subsidize oil consumers and to line the pockets of a minority (namely company executives). There is no long-term sustainable value being created.
This may be a controversial thing to say but it is based on the fact that companies that are most deeply dependent on US shale oil deposits have always burnt cash (free cash flow negative) even before the great crash in oil prices in 2014 and 2015.
“Free cash flow” is operating cash flow (cash generated from operations, in this case the sale of oil and related products) minus capital expenditures. Prolonged periods of negative cash flow (in the good and bad times) indicate that something is amiss within the industry.
The excellent report details the free cash flow issue of shale oil companies:
Only nine of 33 shale oil exploration and production companies reviewed in the report had positive free cash flow for the first half of 2018. Nine! This, even though prices had risen from around $30 in 2016 to the mid-$70 range a few months ago.
Even in the “boom” times when oil was at about $100 these companies couldn’t produce a positive free cash flow!
Capital expenditure (CAPEX) is what a company spends now in order to generate production in the future. With respect to oilers, it is the acquisition of new oil deposits and the drilling and completion of new wells and infrastructure.
With companies not generating enough cash flow to finance the drilling of new wells, additional debt or new shares must be issued to raise funds.
Raising debt increases the risk of bankruptcy. That should be obvious but nobody has been paying attention. Rather everyone is chasing the “production” and so long as production is rising investors have been willing to throw more money at them.
It’s the same old “growth stock” story I see in the venture capital world, which by the way is at serious “holy mother of Mary this is truly madness” juncture as global interest rates rise causing that near free spigot of risk capital to blow away in the wind.
Back to our shale friends.
Raising additional equity dilutes the value of the company for existing shareholders. Again, something investors have been paying no attention to. Either which way, this is just throwing good money after bad.
Look, see, we’re losing money, so we’ll make it up on volume. It’s insanity.
And we haven’t touched on decline rates. You may ask yourself, but why don’t frackers reserve enough money to drill new wells prior to looking for new prospects? Good question.
It is all to do with decline rates of wells once they start pumping. It is generally known that after three years most shale wells are producing about 80% less oil than when they began. Decline rates for conventional oil production after three years comes to between 12 to 15%.
So in order to keep a fracking company’s overall production growing, the company must drill continuously or risk declining production, which would lead to a vicious cycle of declining cash flows needed to drill new wells.
And remember it’s the increased production that’s gotten so many investors giddy with excitement and so to stay alive they do the insane. Ramp production on a loss making venture. What could possibly go wrong? I dunno, you tell me.
In order to keep drilling, companies need extra cash. So every year they find themselves tapping capital markets for new lines of debt or to raise additional equity. So far markets have been accommodating.
But remember this. That which is unsustainable won’t be sustained.
Clearly this is not a long-term sustainable situation. Sooner or later the cost of capital will start rising (rates) and investors will start demanding a return on their capital. This has already started. If I was long any of this stuff, I’d elbow my way to the nearest door knocking grannies and disabled folk out the way. The hell with it. Get me out. NOW!
I’m not long. But others are, and it’s coming. Watch.
Another Catch
Not every shale well is the same. Concentrations of shale oil vary. The core areas, known as sweet spots, typically make up just 20% of a shale field. Once drillers move beyond sweet spots, their productivity declines dramatically. Collapse is not a word to be bandied about lightly as it could be termed sensationalist but it’s fitting.
The dramatic ramp up in production over the past decade has mostly occurred in these sweet spots and was accentuated during great collapse in the oil price in 2014 and 2015.
Please note we don’t discount this amazing technology. And yes, significant improvements in drilling technology and techniques have more than compensated for this depletion.
Shale drillers can now access a greater portion of a reservoir than just a few years ago. While shale wells have always suffered from steep declines in their production profiles, overall output has trended up over the past few years (apart from the big drop off in 2014).
However, technological advancements in shale oil extraction can only go so far and we’d need some really amazing advances right now to have these companies turn a profit.
The long-term outlook raises more questions.
The Post Carbon Institute says that the EIA’s thesis of strong growth in shale production for the next several decades assumes that the industry will produce all proven oil and gas reserves, “plus a high percentage of unproven resources — in some cases over 100% — by 2050.” Shale oil production, according to the EIA’s 2017 Annual Energy Outlook, won’t peak until the 2040s.
That scenario is extremely optimistic to say the least! The report breaks down the major shale plays to explain why.
The Bakken. Well productivity improvements have flat-lined or decreased in all but two counties, indicating available well locations are running out.
Eagle Ford. The EIA is overstating its potential, with high well density and high depletion rates likely to limit the region’s ability to keep production elevated through the 2040s.
The Permian. The EIA’s long-term assumptions for the Wolfcamp, for instance, rest on “vast additional, as-yet-unknown, resources” to be recovered.
We can already see this playing out. Since the great crash of 2014 production has picked up and surpassed the previous peak but it is essentially the result of production at the Permian basin.
And if we get more micro on the Permian, production becomes even more concentrated. It is only a couple of areas on the Permian that account for the majority of the increase in production.
Record levels of production in the US isn’t as broad based as we are led to believe. It is concentrated in just a few areas. These aren’t great gushers like one typically finds in the Middle East but rather wells of the rapid depletion variety.
The report concludes:
- It is highly likely that it will simply be too costly to produce as much oil as the EIA assumes will be produced.
- The very high to extremely optimistic projections impart an unjustified level of comfort for long-term energy sustainability,
- As sweet spots are exhausted, the reality is likely to be much higher costs and higher drilling rates to maintain production and/or stem declines.
I have no good reason to doubt the conclusions of this report.
Conventional Oil? No One Bothered
And one chart to rule them all. Thanks for the fracking “revolution”, the world has essentially turned its back on conventional oil.
What happens if oil produced from fracking sources does come in way under expectations? The world just doesn’t have capacity to make up this shortfall from conventional sources.
This hasn’t gone unnoticed by the IEA:
Granted that was an 18-month old article, but nothing much has changed since then.
From the article:
There’s a risk the world is becoming too reliant on the rapid growth of U.S. shale oil, its foremost energy adviser has warned.
Without a raft of new approvals for non-shale projects, oil production from U.S. shale plays must more than triple by 2025, to an eye-popping 15 million barrels a day, to satisfy global demand, according to the International Energy Agency’s latest World Energy Outlook
The trouble is, it’s unlikely shale can grow to that extent. Even if producers are able to overcome infrastructure bottlenecks that have muted growth this year, they’d need to invest far more and bring in a higher number of rigs than they did when oil prices peaked at $115 a barrel in 2014.
Oil’s crash has meant that cash-strapped companies have been delaying or canceling projects for years, opening up the risk of an oil-supply shortfall in the next few years.
That would be less of a problem if the world followed the IEA’s “sustainable development scenario,” where aggressive policies targeting carbon emissions slice into demand for fossil fuels. Except the world doesn’t look like it’s headed down that path, and it’s likely that developing economies will drive oil consumption higher through to 2040.
The Paris-based agency estimates about 16 billion barrels of new conventional oil resources needs to be discovered and discovered for development each year between now and 2025 to avoid a “mismatch” between supply and demand. That’s double the current rate of approvals, and even a crude price rally this year hasn’t been enough to greatly increase new project investments.
And one last chart to bring everything together:
This from the IEA’s yearly outlook report:
The analysis shows oil consumption growing in coming decades, due to rising petrochemicals, trucking and aviation demand. But meeting this growth in the near term means that approvals of conventional oil projects need to double from their current low levels. Without such a pick-up in investment, US shale production, which has already been expanding at record pace, would have to add more than 10 million barrels a day from today to 2025, the equivalent of adding another Russia to global supply in seven years – which would be an historically unprecedented feat.
What About EVs?
Light passenger vehicles are a smaller part of oil’s consumption than what everyone thinks.
Yes, developed economies will see a fall in demand for oil from light duty vehicles but this will largely be offset by an increase in developing countries. But the big deal is demand from commercial transport and petrochemicals:
There are much bigger issues for the outlook for oil than those relating to EVs!
I think the answer is very clear. If you look through the short-term noise, the long-term fundamentals are very clear. One just has to have the tenacity to hold on to that view for at least 5 years (easier said than done).
A Passing Thought…
Remember this?
My goodness, what a hell of a time!
That was just short of 3 years ago. I think it is still very clear in everyone’s mind, including members of OPEC and the Saudis in particular.
Their experiment to drive frackers in the US out of business backfired and nearly took them out of power. I am quite certain that they will not let this happen again (i.e. they won’t be so slow to cut production).
Not wanting to get involved with politics or political agendas, but if I were the Saudis, I would be rather pissed.
Reminds me of the boy who cried “wolf”. My thinking is that the Saudis won’t be so willing to cooperate with the US after the Iranian sanctions. Who is to say that the 6 month extension to the sanctions won’t be “extended”?
Our Pick: Offshore Oil
Beaten up and bashed. But there is a big light at the end of the tunnel. The dramas over the last 5 years have forced offshore oil to become much more competitive with land based operations.
From the article:
The economics of some projects, which once required high crude prices to be profitable, had seen a “transformation”, with cash generation far surpassing that of US shale. “Deepwater can compete if not demonstrate higher returns because of fundamental cost reduction,” he said. “Break-even prices in deepwater — we are now talking $30 per barrel.”
The economics of some projects, which once required high crude prices to be profitable, had seen a “transformation”, with cash generation far surpassing that of US shale. “Deepwater can compete if not demonstrate higher returns because of fundamental cost reduction,” he said. “Break-even prices in deepwater — we are now talking $30 per barrel.”
Some 30% of the world’s oil and gas consumed comes from offshore sources. We believe that this is the sector that will see significant inflows of capital once it becomes obvious that shale oil won’t be able to produce as expected.
Yet most offshore service companies are still being priced as if there will be little or no oil and gas produced from offshore sources a few years from now. This is after a number of offshore oil service companies have exited bankruptcy with restructured balance sheets and healthy liquidity situations.
We believe there are huge opportunities to investing in offshore oil service companies that have strong balance sheets (so that they can at least survive for another couple of years until capex starts to materially pickup).
What exactly to invest in? That is hard because there is so much value out there. Let’s take a look, though.
From offshore infrastructure operators:
Drilling equipment providers:
Offshore service vessel operators:
ROV operators:
And offshore drillers:
And geophysical operators:
Judge me by my actions, not words.
So much value to choose from. I think the latest weakness we have just witnessed is a great opportunity to pick up many absolute bargains with high payoffs so long as we are patient enough to wait more than a few years.
It’s the waiting that is the hardest part.
But individual investors have that luxury (if you have the temperament for it). Fund managers don’t have this luxury. They can’t stray too far from the pack for fear of losing AUM… and losing business. But this shortcoming of fund managers is one of the big potential competitive advantages of retail investors. Use it to your best advantage!
Lastly, I’m working on a report for you which explains our thinking on the geopolitics globally and what this means for markets, in particular, energy markets. I’ll get it to you before the fat guy comes down the chimney.
Sincerely,
Chris MacIntosh
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Asymmetric Opportunities Fund
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