M.C. Escher And Oil Prices

by: The Heisenberg


Everyday I read someone else's attempt to explain the forces at play in crude markets as if there's some way out of the self-defeating dynamic keeping prices range bound.

It makes no sense to be an oil bull, but there sure are a lot of them out there judging by positioning data.

Have you ever seen M.C. Escher's "Ascending And Descending"?

By now you've probably heard the news: the OPEC production cuts are going great.

(Chart: Bloomberg)

You've probably also heard the other news: it makes not one shred of difference.

On Wednesday I chronicled this week's version of the absurd dynamic that plays out every Tuesday and Wednesday when first, API data points to huge inventory builds leading to a selloff across the crude complex and then, exactly 18 hours later, EIA data confirms the very same huge inventory builds leading directly to frantic dip buying.

As one reader remarked, the competing narratives make it difficult to assess who's right and who's wrong. That is, are the bulls correct to presage a (sort of) imminent return to a balanced market thanks to the OPEC cuts? Or are the bears correct to point out that no matter how you try to break down and slice the numbers, massive inventory builds are massive inventory builds and therefore, no move higher from here will ultimately prove sustainable?

Clearly, I'm in the latter camp.

Every day it's the same story with crude (NYSEARCA:USO) and we're left to watch, incredulous, as commentators try and find new ways to explain yesterday's narrative in a way that sounds fresh.

"Oil declining despite a weaker dollar might signal a delayed reaction to Wednesday's EIA inventory report," Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas SA in London, told Bloomberg "by message" (whatever that means).

For those interested in a snapshot of the effect years of lower prices have had on global market share, here's a 30,000 foot view:

(Charts: BofAML)

As regular readers are no doubt acutely aware, I'm not a huge fan over overanalyzing this market.

Well, I guess that's not entirely true. If you want to have a long discussion about how the sectarian divide will ultimately influence Riyadh and Tehran's respective reaction functions, and/or how the three Sunni/Shiite proxy wars currently raging in the region play into the crude market dynamic, then fine. We can overanalyze things all you want. Because that's interesting.

What's also interesting is the extent to which the Saudis have the luxury of weighing prices against voracious appetite for the kingdom's debt. That appetite was readily apparent in last October's hugely oversubscribed $17.5 billion bond offering.

We can also talk all you want about how the Saudis have to consider the societal implications of cutting subsidies to plug yawning budget gaps and how SAMA reserves and the riyal peg factor into the equation.

All of that is interesting.

But do you know what's not so interesting? US production, that's what. Which is why I have little patience for in depth analysis on the subject.

It's pretty simple. And indeed I created a fun numbered list early on Thursday to which I can refer in the future discussions. Here's the dynamic for US operators:

  1. prices rise
  2. capex and production ramps up as plays become economic again
  3. market becomes oversupplied
  4. prices plunge
  5. outspend (i.e. funding gaps) are plugged with debt, revolvers, and equity offerings
  6. producers live to pump another day thanks to wide open capital markets (i.e. investors' hunt for yield)
  7. prices rise
  8. rinse and repeat

In other words, it's like walking up the down escalator (for a fun visualization, see here).

Let's look at some new charts that reinforce this idea that the dynamic at play in the US is self-defeating. Here's a set of visuals out today from Bloomberg (I combined them all for the sake of space):

(Charts: Bloomberg)

So basically, as the Bloomberg piece explains, you've got a range bound market (thanks to the push-pull dynamic between US production and OPEC), a market in contango, massive US stockpiles, and, hilariously, a giant spec long position against a market that's going nowhere fast. Good stuff.

Now what I want to know, is how anyone justified that record long position given the outlook for US shale and what I also would like to know is how the outlook for shale is sustainable given the fact that, as noted above, if that outlook does indeed materialize it will in effect short circuit itself. That is, if production continues to rise thanks to lower breakeven costs, will that extra production not drive prices lower, effectively sowing the seeds of its own demise? Hint: that's a rhetorical question.

Let's go to BofAML for some color and projections (my highlights):

In the US shale industry maintaining steady spending now seems equivalent to increasing output. In October, we warned that US shale output was about to reverse its declining trend. Looking at the latest numbers from the EIA Drilling Productivity Report, shale output from the main basins bottomed out in January, and we should see a 40 thousand b/d sequential increase this month, driven almost entirely by the Permian basin (Chart 9). The recent pick-up in active oil rigs is partly behind the impending rebound in output. Yet, productivity gains are another major factor. The easiest way to measure this on the rig level is by looking at oil production per rig in new wells. Results are astonishing, with steep increases every month in all the major shale basins, although the Permian is starting to look relatively more mature on this measure.

This current productivity revolution, if it persists at this rate, will have meaningful and long-lasting consequences for non-OPEC production and thus long-term oil prices.

To estimate US shale production growth over the next five years, we conducted a price sensitivity analysis based on break-evens, drilling potential, annual decline rates and productivity gains. We estimate that US shale production will decline annually by 270 thousand b/d, on average, until 2022 in a $40/bbl WTI environment. At $50/bbl, growth returns, though only at a small average of 240 thousand b/d. Should WTI trade at $60 for the next five years, growth reaches 700 thousand b/d, and at $70/bbl it reaches 950 thousand b/d (Chart 15). It goes without saying that the level of US shale output in 2022 will highly depend on the average price of WTI in the next five years (Chart 16).

Ok so a couple of things there. First of all, the last highlighted passage above is hilarious. That is, yes BofAML, it does "go without saying" that the level of output five years from now will "depend on" the price of oil. Do you know why that goes without saying? Because as mentioned above, some of this production will go out of business by then if prices don't stay elevated.

Second of all, I guess I fail to understand how those projections can possibly play out. That is, this is a bit of a mind bender. We're projecting output growth at $70/bbl as if that very same output growth won't prevent prices from ever reaching $70/bbl.

See what I mean when I use the "walking up the down escalator" analogy? This is why I'm bearish on crude.

Let me leave you with an exceedingly apt visual:

(Credit: M.C. Escher's "Ascending and Descending")

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.