Many Money Managers Have Failed Clients By Wrongly Assessing Oil Market

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Gary Bourgeault

Summary

Fear growing among money managers who believed oil had bottomed.

The one thing most money managers still aren't getting about oil - they may be in denial.

Now they're scrambling, trying to offer reasons oil will rebound to significant levels, even though it's highly unlikely.

Why suggested positive oil price catalysts shouldn't be considered believable - at least in the short term.

For a long time oil companies and their dividends have been a favorite target of institutional money managers and retail investors, who could count on a steady upward move in the stock price and a nice, consistent pay out for years from the dividends. That model is now under extreme stress, as even the bigger companies are struggling to retain their dividends in order to remain a viable vehicle to invest in.

While retail investors had to pay the price for their own decisions, investors relying on money managers have to pay the price for any major gaffes they make, which in the case of oil and finding a bottom, has been a big one.

With a lot of money at stake, especially from politically-connected pension funds, its puts more pressure on financial planners than they may have ever been under, and it's going to get worse.

The major issue has been in thinking what has been happening in the oil market is another historical supply cycle, rather than the permanent disruption of the industry it is, because of the emergence and growth of the U.S. shale industry. This is why even if some of the major producers lowered supply it would make no difference over the long term. All that would happen was higher-cost producers would immediately add supply to the market, limiting the upside of the price of oil.

(click to enlarge) source: CNBC Click to enlarge

Miscalculating the oil bottom

In the past when a supply cycle returned, the response would be for OPEC to lower or raise supply to levels the market would rebalance at. Even though members of the cartel didn't adhere to the quotas agreed to, it was enough, in general, to move the price of oil back to the desired range. That isn't going to happen this time around. OPEC, or even Russia, didn't have to deal with an entirely new market player in shale oil, and specifically U.S. shale oil production. U.S. companies aren't going to cut back on production unless the price of oil forces them to.

That means even if production were to be slashed to support prices, the U.S. companies with significant shale exposure would be the main beneficiaries of that move.

For that reason money managers and many analysts have been wrong about a bottom for oil, as they're working from the same model they did in the past, while the model has completely changed. The new model includes not only the U.S. shale industry in the short term, but the global shale industry in the long term, which represent together about 419 billion barrels of recoverable shale oil.

The factor that has been the main catalyst disrupting the outlook for an oil bottom has been the need for OPEC and Russia to maintain production levels in order to keep the revenue flowing to keep at least a decent portion of their fiscal budgets intact. That has kept the price of oil lower than most anticipated, as it was believed the major producers would have to ease up on production to support oil.

What wasn't included in analysis was the specific strengths of U.S. shale producers, which not only improved efficiencies and thus costs, but also have been able to strike the best oil pockets and develop drilled but uncompleted wells in anticipation of a upward move in price. All of this has made the shale industry very resilient and somewhat resistant to ongoing supply levels from competitors.

It's also why supply from shale companies has remained high with more than 1,000 less rigs in play, and why U.S. oil inventory continues to grow at the same time.

Not including shale oil supply strength has resulted in missing the key factors related to an oil bottom.

What about catalysts for an upward move in price of oil?

We've already talked about the reason cutting production won't be effective over the long term. Let's look at other catalysts suggested as potential catalysts to support oil.

The major one is the slashing of capital expenditure which will result in lower production. Where I see the problem with that is in it being put forth as something that will have an impact in the near term. I don't agree with that. How could it? If capital expenditures have been cut back, it wouldn't have an impact for several years, especially if we're talking the launch of new projects from scratch. It takes time to bring wells into production, and cutting spending now isn't going to impact production and supply anytime soon. I agree that over time it could have an impact, but not in the time frame of a year or so that I'm thinking about.

Spending will be less, but don't think it's not still formidable. For example, in North America, 44 exploration and production companies estimate they'll spend a combined $78 billion on projects in 2016, according to IHS Inc. It's far below the approximate $101 billion spent last year, but still not an abandonment of growth initiatives.

Another scenario being implied as a support for the price of oil is the drying up of existing wells. Again, there is some substance to that, but when talking about shale, which is the most important player at this time as it relates to an oil bottom, it isn't much of an issue. Even if a number wells were slowing down, as of April 2015, there were approximately 4,000 drilled but uncompleted wells in the U.S. ready to be quickly brought into production. The upfront costs have already been paid, and all that remains is for these to start supplying the market. At this stage of development they can be launched very quickly.

The one viable catalyst I see for oil is the growth of demand. I have no problem with that being the long-term outcome, but it will take longer than most believe. With the global economy slowing down downward revisions in oil demand have been consistent, and that won't allow the rebalancing some had hoped for by the end of 2016 or early 2017.

There is some legitimacy for the price support for oil, but the catalysts being proffered, at best, will be several years down the road. Even then it'll be a long time, if ever, we see $100 per barrel again, barring a geopolitical event.

Oil supply, inventory continue to grow

As oil inventory levels continue to rise, the outlook for global supply continues to be upwardly revised. According to the International Energy Agency, in the first half of 2016 supply will grow by another 250,000 barrels per day. This is even with the high probability U.S. production will be reduced.

The Saudis and Russians continue to produce at very high levels, and Iran is just getting started on it increase in production and oil exports after sanctions were removed.

If the price of oil does experience some support, as mentioned earlier, shale producers will quickly enter the market to generate some profits, which will put downward pressure on the price range. Depending on if that support results in the price of oil climbing to higher levels than expected, even non-shale producers may bring more supply to the market. They're reaching desperation stages and any opening will be quickly taken advantage of.

This is why there will continue to be a high level of volatility, as these various factors come into play.

Conclusion

I don't blame money managers in the early stages of the disruption of the oil market; all of us were taking time to absorb and understand what it all meant. But now that it has been around for a while, it should have been understood by now that this wasn't simply another supply cycle, but a real disruption that has long-term consequences for the industry.

Even so, I'm still seeing a lot of analysis based upon the old oil model, which no longer exists. Even the ongoing idea of a meeting between OPEC and Russia to reduce supply is considered a meaningful endeavor, even though that would still be based upon the market as it was before the emergence of U.S. shale producers.

There has already been a massive failure by many financial advisors in regard to oil, and there could be more pain ahead if shale oil continues to put a ceiling on the price of oil. Even now institutional investors are again flooding into the market, making bets on the price of oil sustainably going higher; deciding we have in fact reached a bottom.

But even if we have reached a bottom, there is no way of knowing it, based upon the volatility of the market and uncertainty surrounding what shale companies will do if there is some short-term support for oil prices. That means this is more of a shake of the dice than a highly probable outcome.

From what I've been hearing, it's the same old story the price of oil isn't sustainable at this level. Until there is an increase in demand to offset the oversupply, that isn't relevant to anything. I've seen markets continue higher for much longer than expected, as well as lower longer than expected. This is happening in other commodity sectors like iron ore, where the same argument is being made. Yet companies continue to produce at levels far exceeding demand. It is argued there it isn't sustainable as well. The answer from the actions of these companies so far is this: so what?

Now we'll have to wait and see if that's the way the oil sector will respond as well. The difference is oil now has a brand new player that can produce as much as the two major competitors in the past. This is what money managers need to take into account as they make decisions on behalf of a clientele that counts on them to not only protect, but grow their capital.

The question on everyone's mind is whether or not the oil bottom and outlook is being miscalculated once again.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.