Could the bears be right? Could oil stay forever in the shale band? It certainly looks that way as we're now almost two years into a thesis with little to show for it. What were healthy gains at year-end have now evaporated, and what looked like divine intervention last year with an OPEC agreement now looks hopeless as even the "oil god" has forsaken the bulls. How low and how long will it go? How low can it go? Those are the questions the market now asks.
Unlike the bears, our questions though are just the opposite. What happens when the headwinds shift? What happens when curtailed OPEC and Non-OPEC exports meets higher summer demand, and OECD inventory draws accelerate? We're going to find out in the next few months, but we believe the drawdown will continue gathering steam, a drawdown that's been masked based on our analysis in Parts 1, 2 and 3. In our last article, let's talk about the shifting winds, and why despite the turbulent weather we continue to defy the market's bearish roar:
Headwinds Become Tailwinds
Sales of crude oil from the SPR likely ended in July. The amount of crude oil coming onto the US commercial market will stop until next year when the next batch is scheduled to be sold. 16M barrels wasn't that material, but it certainly doesn't help perception. That's changed, and right on time as we enter the higher demand seasons.
Unsurprisingly, now that inventory destocking is largely complete, OPEC announced in May that it was focusing on reducing exports. Saudi Arabia plans to reduce exports to the U.S. by 4M barrels in July and 7M in August, as compared to June, effectively removing 11M barrels from U.S. imports. If other countries join in, then the data should reflect the lower imports in a few months. Either way, a tailwind is forming to reduce visible OECD inventories.
Despite the price action, physical spreads are tight. Demand for both crude and products appears to be strong. Refinery margins are also high, which further implies that end-consumer demand is robust, and that the draw on crude oil and products should continue.
Demand in the West (U.S. and Europe) is set to climb as the summer season peaks (and for products even higher demand has yet to arrive). Higher consumption in the latter half of the year means oil inventories should begin to fall significantly. U.S. crude inventories historically fall around 30M barrels during the summer, and given the factors above, could be higher this year. Products also historically fall in the latter half of the year, so draws could potentially accelerate.
Economic deceleration in two of the biggest demand centers (India and China) were large drivers for the first half's perceived demand weakness. In November 2016, the Indian government voided larger denominated rupees in an attempt to curb black market transactions, fight corruption, and raise tax compliance. This surprise announcement tripped up the cash dominated economy in Q1, and GDP and oil consumption declined. After the shock wore off and new bills were circulated, the economy resumed growing in recent months and oil consumption is now on the mend.
For China, what started as a robust year decelerated. Latest figures indicate that recovery is in progress. GDP increased to 6.9% in the second quarter, and China is anticipated to grow 6.5% overall for the year, which should keep demand elevated. Chinese figures showed stronger than anticipated imports in the first half of 2017 (likely elevated because of line-fills for new pipelines and refineries and to fill strategic reserves). Imports might taper off as the one-off demands fade, but year-over-year China demand appears to be strong, and could grow as the One Belt One Road (NYSEARCA:OBOR) strategic plans kick-into high gear. OBOR is China's ambitious foreign policy foray, in which it plans to underwrite billions of dollars of infrastructure investment worldwide and construct a network of railways, ports, roads, pipelines, and utility grids that link China and Europe/Asia in general.
With over 60 countries involved, it's a way for China to foster economic growth and promote trade, one influenced and dominated by China. The OBOR projects also provide a much needed outlet for China's excess manufacturing capacity in steel, cement, etc. As OBOR projects roll-out, we believe China's economy could continue to display high economic growth rate. At its heart, OBOR is financial stimulus coupled with foreign policy prerogatives, and will increasingly become a key factor in driving China's oil consumption.
Growth in U.S. oil production may be slowing as productivity gains have tapered off. At sub-$50/barrel, most of U.S. production is untenable. Sure they can drill, but not profitably on a long-term basis. What they can drill is also focused on the "best of the core plays," which can last only so long. Moreover, as more producers focus on the bests regions (i.e., Permian), the localized demand drives up costs. So as we've said previously, cost inflation will become a limiting factor and break-even points will rise. The recent decline in oil prices won't help, and all of these variables could translate to potentially lower growth in U.S. production for 2017 and 2018 than the market anticipates. Will U.S. production grow? Definitely. Enough to offset declines elsewhere? We doubt it.
International rig counts, the very rigs that drill oil wells outside of the U.S. totaled 955 this time last year. This year? 957. Unless productivity materially rises, and there's no indication that this is occurring, international oil production isn't only capped, but will continue falling as natural decline reduces output.
According to Citibank, geopolitical outages are the lowest they've been these past five years. Even with domestic instability in Nigeria, Libya and Venezuela, Qatar's standoff with the Middle East and tensions between Iran and Saudi Arabia, none of it is priced into oil today.
Regarding OPEC/non-OPEC, looking ahead the market anticipates that inventory could grow again when the OPEC/non-OPEC agreement ends in Q1 2018. We're not so sure about this. We know the main participants of this cut, Russia and Saudi Arabia, have major incentives to see it succeed. We also know that such incentives will continue into 2018 as the Russian elections are in Q1 and Saudi Arabia's IPO of Saudi Aramco, a key tentpole to Crown Prince Mohammed Bin Salman's Vision 2030 initiative is later that year.
As the largest producer in OPEC, we have to ask ourselves, is Saudi Arabia incentivized to go back to pumping oil all out and oversupply the market ahead of its own Aramco IPO? Does it make sense to depress oil prices when you're about to sell a piece of your oil assets? Saudi Arabia agreed to cut 486K bpd and along with its close allies UAE and Kuwait, the three total over 700K bpd, or two-thirds of the OPEC oil cuts. Russia itself agreed to cut 300K bpd. We believe both participants will push through some form of continued cuts, or restrained production even after the expiration of the current Vienna Agreement. For Russia and many other participants, "everyone knows" Saudi Arabia will do the heavy lifting. For Saudi Arabia that may be a small price to pay for a successful IPO.
So there you have it, a quick list of ten reasons why we remain committed to a decidedly painful contrarian investment. For a physical commodity that needs to be replenished, shrinking investments and an outflow of capital means less production, and less production inevitably means a shortage. Economics is unrelenting. We anticipate that by year-end 2017, OECD stocks will be near the five-year average.
We say near because we don't know precisely. What's interesting is that the five-year average is a dynamic moving five-year average. The amount of inventory rises and falls with the season and through time. For example, today we're using a baseline five-year average of 2012-16. In May 2018, will the pundits use a five-year average baseline of 2013-17? If so, the excess inventory automatically falls by 80M barrels (i.e., 20%) because average inventories are higher as we move forward.
So if inventories are balanced at year-end, and the calendar turns to Jan. 1, is there suddenly a shortage by 80M barrels? We wouldn't put it past the market to perceive that, which is why sentiment can change quickly. Perception and fundamentals can drive reality, while we prefer the latter, the former can be a powerful force. In the end, it's about to get interesting as the higher demand season (Q3-Q4) is coming at us, and if elevated demand persists, we may defy expectations and experience the rushing of the bulls.
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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.