In a year, it may be time to short oil again

In a year, it may be time to short oil again

Second chances in life are a rarity.  But if you missed the opportunity to short oil in 2014, you may have another later next year.  The underlying dynamic that caused the 2014 oil price collapse—fracking--is still in full swing.  But OPEC and Russia, pinned in, are defying gravity for now.  They will not be able to do so forever.  Supply and demand eventually dictate prices.

Supply history:  Fracking changes the equation

Investors were so excited about the company-specific investment opportunities brought about by new drilling technologies like fracking in 2010 that they forgot to keep an eye on the oil market.  Originally viewed for its potential to boost natural gas output, fracking soon came to be employed for boosting more profitable oil extraction.  American crude production, previously stuck at 5m b/d of a 90m b/d market, started to increase dramatically and relentlessly to over 9m b/d by 2014, tipping the world into oversupply. 

The Saudis decided to flood the crude market in 2014 to wash out the Americans from the equation.  But American production, despite rig cutbacks of more than 50%, held stubbornly at 9m b/d.  Just when oil prices bottomed below $30/ barrel, Wall Street investments zoomed.  Prices for Permian basin and other oil-rich lands in the US reached an all-time high.  Concurrently, extraction efficiencies were achieved that brought the cost of Permian oil near that for the Saudis. 

Supply forecast

Unable to endure the pain of $26 per barrel oil in 2014, the Saudis took their foot off the pedal, restoring oil prices to $50 per barrel, where they are today.  But at $26 per barrel, American producers were a spring waiting to be sprung, and the recovery of oil to $50 per barrel has sprung them back into full expansion mode.  American production has recovered to 9.9m b/d, forcing OPEC (i.e., Saudi Arabia) and Russia to cut back production by 2m b/d to sustain pricing, exhibiting a rare unity of purpose.  As long as prices remain at this level, which is likely because of political reasons explored below, American production is likely to reach 11m b/d next year and 13m b/d in 2019, making America the largest producer of crude in the world and forever changing the balance of power in the oil industry.

But will prices remain at $50 per barrel through 2018?  The short answer is yes. First, the Saudis under deputy crown prince Salman must sustain the oil price at $60 per barrel to launch the IPO of Aramco, the state-owned oil company, in 2018.  This IPO is a top priority of the crown prince’s to diversify the economy away from oil.  Aramco is Saudi Arabia.  The Saudis cannot afford to let this IPO fail, and they have the means to pull it off.  That means, however, may be the seed of their own destruction.

Second, Putin is up for re-election in 2018 and wants to sustain oil prices to improve his chances for re-election.  His re-election is not a foregone conclusion.  More than 1 million people protested on Red Square after his 2011 election, a calamity he blames Hillary Clinton for to this day for calling into question the fairness of the results.   

By the end of next year, after Putin is re-elected and the Aramco IPO goes off, the Saudis and Russians are likely to face the choice of continuing to lose market share or coming back full force into the market.  It is unlikely we will see them sit idly by as other producers push them aside.  They may have little choice but to start pumping full force again, sending global oil prices into a tailspin in a repeat of 2014.  Only this time, with productive capacity nearing 100 million barrels per day and demand stagnating at 92 million barrels per day, a price rebound is more problematic. When the world runs out of places to store this excess crude, current production must be sold at whatever price moves the last barrel.  Watch out below.  

Demand forecast

Compounding the problem for oil is electric cars.  Until now, there has been no arbitrage between crude oil and natural gas.  Electric cars, powered by electric utilities run on natural gas which now outnumber coal utilities in output, at last represent that arbitrage.  Natural gas is $3.25 per 1000 cubic feet.  Crude contains 5.85 times the carbon level of 1000 cubic feet of natural gas.  Until Crude sells for $19 per barrel, natural gas is more economical.  First movers pay a premium.  Second movers don’t.  When you have the choice of two identical looking SUVS at the same price but the electric one gets 60 miles per gallon equivalent vs. 20 MPG for the gasoline-powered one, which will you choose? 

Slightly less than 1% of all cars produced in the US in 2016 (134,000 out of 17.5m), the electric car market grew 37%. Sales are likely to reach 1% of total car production globally in 2017, and demand growth could accelerate to the point where electric cars are 2% of the 2019 total given the cost dynamics described above.  Given a global car market that is lucky to grow 2% in a good year, 100% of the incremental growth could come from electric cars in 2019.  In other words, there could be no incremental growth in demand for crude from the largest consumer of the commodity.

At the same time, the trend of younger generations to drive less is leading to a puzzling decline in driving in the US summer months despite a strong economy that would lead one to predict the opposite.

The demand side of the crude equation does not look promising. 

Anchoring may provide time

Most investment managers today are old enough to remember gasoline lines during the oil embargo of 1973.   That event has forever given them a reverence for oil, as if it is somehow exempt from the laws of supply and demand.  It is not.  Anchoring held the price of oil unrealistically high when supply was building in 2012 and 2013.  It is likely to play a part next year as well, bolstering the joint Saudi and Russian efforts to hold the price artificially high.  You have plenty of time to short this commodity. 

Conclusion

New drilling technology like fracking and CO2 injections (reviving old wells) are steadily increasing the amount of available oil in the world beyond anyone’s expectations.   Five billion years worth of life on earth is a lot of oil, and all that life was not limited to the Middle East.   It is only a matter of time before the relentless advance of technology brings down the price of a barrel of oil to $19 per barrel where it is at parity with natural gas carbon pricing against which it will be increasingly arbitraged.  Only this time, the drop will be long-lasting, perhaps permanent.  Five billion years is a long time.  Global fracking potential is vast.  Meanwhile, oil is no longer the only option for powering mobility.  Like our cell phones, our cars will soon be powered by batteries and oil will be phased out of the global energy picture.  Dirty stinking smoking engines will be relegated to the age of the dinosaurs where they belong.

Ancillary investment opportunity:  HFC

The Americans are boosting production as we speak, and OPEC and the Russians are cutting back.  Not all crude is created equal, nor are refineries.  Some are equipped to process WTI, which the Americans produce.  Others are equipped to process Brent, the global oil standard. The growth in American output at the expense of Brent is likely to lead to an abundance of WTI flooding Cushing with no place to go and a shortage of Brent.  This happened in 2012 and 2013 to the enormous benefit of, amongst others, Tepper favorite HFC.  We are likely to see a repeat of that performance starting, oh, right about now.  Who said life does not provide second chances?  History repeats itself.                           

SE Connell 5/30/17  

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