In his March 1, 2016 letter to investors, crude oil trading "god," Andrew J. Hall (AH), called the bottom in oil prices. I (RB) had come to the same conclusion in my article dated March 9th, though I had hedged my bet. The International Energy Agency (IEA) and Goldman both published similar conclusions two days later but cited different reasons.
Mr. Hall gives four reasons in this Letter for supporting his call: production declines, Saudi Arabia, smaller glut than believed, exaggerated macroeconomic headwinds. I comment on each of these below.
AH: "Indirect data suggest that production declines in the U.S. are occurring more rapidly even than these forecasts predict. Reliable direct data on U.S. oil production is not available in a timely fashion. The data published weekly by the EIA (and ballyhooed by the press and analysts who ought to know better) is actually derived from a model. It is superseded by actual monthly data published two months in arrears…The average for the past four weeks is now 863 kbpd below year ago levels. This compares to a year over year decline in the EIA's model of U.S. crude production - which the media perseverates over - of only 83 kbpd."
RB: Looking at the EIA's weekly statistics, production for the four weeks ending February 19, 2016 were 83 kbpd above the year-ago level. But Mr. Hall argues that production is 863 kbpd below last year's levels, which would put production at 8.296 million barrels per day (mmbd).
The "reliable data" he refers to that is published two months in arrears is the Petroleum Supply Monthly. For December 2015, it reported production at 9.262 mmbd. For his estimate to be correct, production would have had to fall by 966 kbpd in less than a 2-month period.
Mr. Hall provides no source of the "indirect data" that would account for such a massive drop in production. On the contrary, U.S. crude oil stocks have been rising much faster than the EIA had projected in its December outlook.
AH: "The mooted freeze in OPEC (plus Russian) production is moreover not a totally meaningless development. It signals that Saudi Arabia is not hell bent on flooding markets and will not raise its production toward its theoretical maximum in order to grow its market share."
RB: I agree that the change in Saudi Arabia's posture is an important new development, probably the most significant. However, my reasoning is different. It is not because Saudi Arabia will not raise its production, which we can safely assume was already at capacity.
Instead, the "freeze talk" spooked short-sellers. If producers can cause markets to rally, almost at will at any random time, that effectively reduce probabilities of very low prices since sellers do not want to be subject to such price risks. This effect has its limits but I think it accounts for the rise in prices since it was announced mid-February.
AH: "We think the current inventory excess is actually about 260 million barrels, all of which is in the OECD countries and with most of that in the U.S. This excess inventory amounts to about 5 percent of global commercial inventories. This does not seem so elevated at a time when spare production capacity is essentially zero and geopolitical risks in many oil exporting countries are on the rise."
RB: According to the Energy Information Administration (NYSEMKT:EIA), total OECD petroleum inventories had risen by 385 million barrels since November 2014, when Saudi Arabia decided started its market share war. Furthermore, the EIA projects that it will take until August 2017 for the supply-demand to balance, after adding another 229 million barrels. At that point, the surplus will be about 615 million barrels. If that surplus is drawn down over the course of the year beginning September 2017, it will add 1.7 million barrels per day to world supplies, enough to meet another year's world demand growth.
People use percentages to make the oversupply sound small to support their view. But it has to be translated into supply and demand terms to get a better perspective of what it means.
AH: "We think the chances of the U.S. economy slipping into recession are very low. To be sure Q4 2015 GDP growth was lackluster but data are already being revised higher. As regards oil specifically, year over year demand comparisons for gasoline are phenomenal: apparent demand has been running 5.2 percent above year ago levels on average for the past four weeks."
"We also think worries about China are overblown. Certainly GDP growth there continues to slow but we believe the authorities - despite recent missteps - have enough policy tools available to avoid a hard landing."
"A strong dollar has also been cited as a negative for oil prices. However, we think further dollar appreciation is likely to be limited - all the more as the Fed is likely to proceed with caution with further rate increases."
RB: U.S. petroleum product demand growth in the year-to-date is up 0.5 % v. the same weeks in 2015, even with strong gasoline demand.
Conclusion to March Letter to Investors
AH: "For the reasons set out above, we believe the global oil market is already close to being balanced yet prices are at a level that will continue to destroy supply. The longer they stay at current levels the greater the risk that the world will face a significant supply shortfall in 2017. At a minimum, prices need to rise to a level that stops further supply destruction - that is probably close to $50. Later this year prices will need to rise further to create supply. We believe that level to be $60 rising over the next 12 months to $80. There is a reasonable risk that the supply response will be insufficient in which case prices will need to rise to levels that destroy demand. That would imply prices above $100."
RB: As noted above, the EIA supply/demand projections do not show a supply-demand balance until August 2017, at which point there is a year's supply of excess inventories to work down. I think the $50-$60 price per barrel is realistic on the upside, but then a significant amount of hedging by producers will begin to take place, limiting further price increases.
History of Calling the Bottom
The fact is that this is not the first time Andy Hall has been calling for higher oil prices. With the exception of the end of 2014 and the start of 2015, he has been calling for higher oil prices since March 2014, even when oil prices were around $100 per barrel.
His original thesis two years ago was that "producers have already drilled in many of the best areas, or sweet spots. Hall predicts that growth in shale output will begin to moderate this year (2014) and U.S. production will peak as soon as 2016. 'Once those areas have been drilled out, operators will have to move to more-marginal locations and well productivity will fall…Far from continuing to grow, production will start to decline.'" Hall predicted Brent crude prices were likely to rise to as much as $150 a barrel in five years or less.
I debated the reasons in Mr. Hall's July 2015 letter here. And I explained what I thought were the behavioral reasons behind sticking with a losing position here, resulting in a $3 billion loss over the past 4 years. I have since found a quote that supports my belief that Hall is blinded by confirmation bias. "When you believe something, facts become inconvenient obstacles," Hall wrote in April (2014) according to Bloomberg's Bradley Olsen.
In early 2015, Mr. Hall proclaimed that $40 is an "absolute price floor for crude."
"Greatest Modern Day Sage"
For a fair and balanced article, I am including written statements by a former employee of Mr. Hall's about 20-26 years ago.
January 12, 2015: "An Oil Icon Calls the Bottom: Last week, perhaps the greatest modern day sage in the crude oil market said enough is enough."
He stated: "Mr. Hall knows the oil markets better than almost anyone on earth does, and he is offering sage advice from many decades of experience."
"I worked directly for Hall from 1991 through 1997. Hall understands crude oil in a way that almost no one else does. He sits in a unique position that gives him a bird's eye view of all aspects of the oil market - that position allows the trader to truly "feel the pulse" of the international market for crude oil."
"Andy Hall's trading prowess is unprecedented, and the root of his talent is that he understands the multivariate calculus of trading."
I'm not sure the international oil market had much of a pulse to feel in 2015.
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.