'Lower Costs, Borrow Cash Or Liquidate': Any Questions?

by: The Heisenberg


Here we go again.

Another week, another string of headlines suggesting that David (US shale) is going to slay Goliath (OPEC).

I don't want to explain this again, but apparently I need to.

Here's an update on the simplest market in the world to understand.

Frankly, I don't know why I bother to talk about this anymore.

In fact, when I see headlines about it, my knee-jerk reaction is "please, just stop."

But no one is going to "just stop," which means that by extension, I have to keep making the same point or risk readers interpreting my silence as some kind of implicit sign that my opinion has changed.

Some time ago, when introducing a piece on tight credit spreads, I suggested I was uniquely qualified to discuss asymmetric risk/reward scenarios because outside of markets, I have at various times demonstrated a tendency to get myself into situations where the upside is capped but the downside is virtually unlimited.

Along those same lines, I'm also uniquely qualified to discuss delusions of grandeur. As more than a few readers have pointed out, I seem to exhibit a kind of God complex indicative of a deeply ingrained belief in my own abilities. Those readers would be correct.

So given that, you can trust me when I tell you that US shale and US operators in general are suffering from delusions of grandeur of late. The entire sector seems to think that because oil (NYSEARCA:USO) is trading above $50/bbl, they are going to take down OPEC.

Analysts, journalists, and market observers are contributing to this absurd fantasy.

Bloomberg ran an article on Friday entitled, "A Fit US Shale Industry Challenges OPEC Once Again." So a couple of things there. First of all, "no", the US shale industry is not "challenging" OPEC today, and in fact, they weren't "challenging" OPEC yesterday either. That's like me saying "an increasingly popular Heisenberg Report challenges Bloomberg."

But let's just say, for argument's sake, that the headline there is accurate. The question then becomes: okay, so what happened the last time a "fit US shale industry challenged OPEC"? Oh that's right, OPEC put them clean out of business. Or at least they would have were it not for the insatiable, central bank-inspired hunt for yield that kept capital markets wide open for otherwise insolvent US operators.

I probably don't need to tell you about the numbers, but this week's EIA data showed yet another new record for US inventories. The following chart is hilarious and it's perhaps the purest expression of why I contend that all you need is common sense to analyze the oil market:

(Chart: Bloomberg)

Yes, OPEC production is down, but look at where it is versus recent history and then look at US stockpiles. That's the very definition of bearish and it reinforces a point I made last month about the levels from which OPEC cut.

When you ramp up production going into a production cut and use those ramped levels as a baseline, you haven't really "cut" anything. Here's how Citi explains it:

The OPEC cut ironically added a million barrels a day of oil to the market because producers ramped up before the deal took effect. One of the ironic aspects of that two-month period when they all over-produced is that it means the supply deal probably needs to be extended.

So they need to extend the deal to make up for the overproduction that occurred precisely because everyone was expecting an imminent production cut agreement. That's absurd, but predictable. What would you do if you were producing something and you thought that in two months' time you were going to be forced to lower your output? Well, you'd produce more in the two months you had left under the prevailing regime, right? Right.

Just to drive the point home about record US stockpiles, have a look at this chart which gives you some historical context:

(Chart: Citi)

We got a barrage of crude headlines from Reuters on Tuesday which included the results of a survey that apparently shows compliance with the cuts at 94% and, more interesting, a story suggesting that the Saudis want $60/bbl because that's the level "the OPEC heavyweight and its Gulf allies - the United Arab Emirates, Kuwait and Qatar - believe would encourage investment in new fields but not lead to a jump in U.S. shale output."

A couple of things on that. First, it doesn't appear to be quite accurate. As Didier Casimiro, a senior executive at Moscow-based Rosneft, told Bloomberg this week "with $55 a barrel, we see everyone very happy in the U.S." Indeed, the following chart seems to suggest that $60/bbl is more than adequate for some US production:

(Chart: BofAML)

But it's not like the Saudis don't know this. I mean, I'm pretty confident Riyadh has done the same math Wall Street has done with regard to breakevens in the US.

Given that, it doesn't require a leap of logic to come to the conclusion that the Saudis believe once everything is taken into account, current prices aren't going to cut it over the long term for US operators.

And really it doesn't matter. Because for the umpteenth time, the problem in the US is that when it comes right down to it, a lot of these operations aren't really viable given the vagaries that oil prices are subject to.

This is another one of those times when I want readers to try and abstract themselves from the specifics and think about it on a common sense level. I'm not an expert on US oil plays. I don't know the first thing about extraction or why one field is more viable than another. But what I do know is that the juxtaposition between certain passages I read makes no sense. For example, read this from the same Bloomberg article linked above:

While more than 100 [US shale drillers] have gone bankrupt since the start of 2015, the companies that survived have reshaped themselves into fitter, leaner and faster versions that can thrive with oil at $50 a barrel.

Okay, well then explain that in the context of the following passage that appears later in the very same article:

So far this year, U.S. energy companies have raised $10.5 billion in fresh equity, with shale and oil service groups drawing the most investment, the best start of the year since at least 1999 and equal to a third of what the sector raised in the whole of 2015.

Why are you raising equity if you've been "reshaped into a fitter, leaner, faster version [of yourself] that can thrive with oil at $50 a barrel"?

Now, I know what someone will say: obviously they're raising capital to fund ramped up capex.

But see that won't work. As I explained in "Return Of The Living Dead", you can't just keep diluting people with debt and equity only to fund the very same production that's going to put you right back in the very same spot you were in before. Here's what Wells Fargo said last month:

Operators seem to have short memories when it comes to capital discipline which is why it's no surprise to us that we're already starting to see signs of a meaningful ramp in spending emerge. Poor capital discipline has consequences as enterprise values are expanded through either net debt or equity increases. In all cases, existing common stockholders' share of total EV is diluted, all else equal. Therefore, production and cash flow forecasts are less impactful than headline figures suggest after making an adjustment for associated dilution.

This is so readily apparent to anyone who understands corporate finance that I'm not sure why anyone is still confused. But people are - still confused that is. Here's proof:

(Chart: Goldman)

And you know what? Nothing said here will matter because they'll be someone (probably a few someones) who will say that in fact it's Heisenberg that doesn't understand things.

I guess the most direct way I can challenge that (since common sense seems to be inadequate) is to quote Ali al-Naimi who, as it turns out, knows a thing or two about oil markets.

Here's the advice he had for US shale last year:

Lower costs, borrow cash or liquidate.

Assuming US shale has reached a near-term limit in terms of exploring option number one, and assuming option number two is only viable until capital markets get sick of funding this ridiculous charade, then option three is probably where this is headed. And ironically, the more US operators produce, the quicker they'll get there.

Any questions?

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.