The Big Petro-Short - Bracing For The Price Abyss

by: Albert Goldson

OPEC’s extended agreement on production quotas through March 2018 to reduce excess inventory is failing miserably due to weakening compliance.

OPEC members are under extreme pressure to produce flat-out for cash flow purposes because world oil prices are far below their budget breakeven costs.

The looming global recession will destroy oil demand despite the reduction of global inventories.

China’ssupply diversification with considerably higher purchases of cheaper US oil in2017 has triggered a de facto price war between Saudi Arabia and US shale oil.

Sellor short oil and oil-related firms before the ground moves beneath your feet.

Global oil inventories are being reduced but it’s having minimal impact on OPEC’s objective to raise prices which have stubbornly remained below $50 barrel. Part of the problem has been weakening compliance because OPEC members are desperate.

Despite Energy Information Administration (EIA) reports of diminishing global oil inventories, OPEC countries continue to suffer economically because powerful market dynamics continue to keep oil prices below $50/bbl. Let’s examine the components of this dynamic:

US Shale Oil Continues Its Blistering Production Pace

According to the US Energy Department in the Wall Street Journal article 8 June 2017, “Surging US Exports Reshape Oil Market” the US exported 1 million bbls/day in early 2017 doubling that amount during the same period in 2016. This can be described through “backhaul economics” in which previously tankers carrying crude from the Middle East to Texas, unloaded and returned empty. Today after unloading their US deliveries, tankers load up in the US and go to Europe.

Additionally several new large projects undertaken prior to the oil price collapse of 2014 are coming on-line.

The Demand Driver: The Chinese Market

According to the 7 July 2017 Wall Street Journal article “China Sucks Up US Oil Exports”, China purchased 100,000 barrels/day from the US in first 5 months of 2017, 10 times the average in 2016. The purchase amount from the US during these 5 months in 2017 has been $1 billion in 2017 vs. only $150 million for the entire 2016. Major factors for this shift is pricing and political stability in the US.

Saudi Arabia’s finances are taking a beating. On July 6, desperate to maintain market share, Saudi Arabia increased discounts on exports to China probably in response to China’s dramatic shift in purchasing more crude oil from the US which is $2.50/bbl cheaper than Brent. This trend of US purchases can continue as long as US prices remain below those of Middle East suppliers, primarily Saudi Arabia, including the greater transportation costs and longer delivery time (6 vs. 3 weeks).

Global oil demand rests squarely with China whose strong purchases, particularly through low prices, are for the purposes of achieving their objective of establishing robust strategic petroleum reserves (SPR). According to the 18 August 2017 Financial Times article entitled, “Traders nervously eye China’s strategic oil imports”, China has already topped off all its government facilities and has resorted to commercial third party commercial storage facilities while additional government facilities are under construction.

Eventually China’s purchasing frenzy will end which means considerably less demand from the world’s most robust markets. Additionally because China deliberately shrouds its classification of oil purchases, it will be difficult to ascertain the timing of the reduction of Chinese purchases.

Saudi Economic Dilemma

According to the Al-Monitor 10 July 2017 on-line article entitled “Saudi King Shows No Sign of Slowing Aggressive Foreign Policy”, Saudi expenditures in Yemen were $5 billion in the first 9 months of their intervention in 2015. Currently the Saudi’ expenditures are $700 million monthly which doesn’t include payments to Sudan for supplying troops.

In the Middle East Eye on-line publication dated 14 August 2017 entitled, “Saudi Crown Prince Wants Out of Yemen War, email Leak Reveals”, Saudi crown prince Mohammed bin-Salman is quietly attempting a face-saving disengagement from the Yemen conflict which would save considerable amount of money. The Saudis now realize that, in a brave new world, neither checkbook diplomacy nor direct military action can achieve desired results. Their only cost-effective foreign policy action has been sanctions against Qatar which has resulted in a stalemate.

OPEC Members’ Economic Challenges and Political Instability

As explained in the Wall Street Journal article dated 31 July 2017, “OPEC Has A Crippling Problem: It’s Members Can’t Stop Pumping”, in order to maintain cash flow, many OPEC members have exceeded their quotas to meet their financial obligations and avoid civil unrest so the current regimes can remain in power. Nigeria is the most vulnerable because they have the highest required oil price at $139/bbl.

OPEC member compliance has fallen to 75% (non-OPEC producers under this agreement 64%) per the mid-August International Energy Agency (NASDAQ:IEA) report. Compliance is fraying and may soon collapse well before the March 2018 expiration date. For this reason OPEC is arranging special meetings in November to address this compliance failure and may revert to utilizing export quotas instead of production quotas which are more economically realistic and easier to monitor.

Complicating OPEC's efforts to reduce production and raise prices are the OPEC members Libya and Nigeria who are exempt from the original and extended quota agreements. In October 2016 Libya was producing 400,000 bbls/day. Today it’s now producing about 1 million bbls/day. With respect to Nigeria, their October 2016 production was 400,000 bbls/day but now produces about 1.6 million bbls/day. For both Libya and Nigeria, the reason for the quantum production jump is unexpected political and operational stability which have significantly reduced production disruptions. This collective increase of 1.8 million bbls/day merely reduces OPEC’s objective of cutting 2.2 million bbls/day to an adjusted 400,000 bbls/day assuming 100% compliance.

Additionally there seems to be a perverse irony in the fact that the late 2016 OPEC agreement called for a total cut of 2.2 million barrels/day which matched Venezuela’s daily oil production at that time. My SA article “Venezuela - OPEC’s Sacrificial Lamb for High Oil Prices” published in February 2016, well before the OPEC October quota agreement, could be interpreted as OPEC’s anticipation of severe production disruptions in Venezuela which never materialized during the increasingly violent protests.

The market criticized OPEC for extending the current production quotas rather than taking a more aggressive position. However according to OPEC protocol any production change decisions must be agreed upon unanimously. This requirement complicates matters because OPEC members are a highly diverse group with conflicting interests.

What the media and energy observers failed to mention that the extension of production quotas was the best that could be politically achieved at the time. OPEC was well aware of the consequences but any kind of deal was required to prevent an oil price collapse so the extension with unchanged quotas represented the best option.

The bull market is quietly losing steam with all economic indicators at all time highs just begging for a market correction. It’s just a question of when, how deep and how long the correction and eventual recession will negatively impact demand and oil prices.

My analysis of the changing fundamentals and trends lead me to the conclusion that it’s only a matter of time before oil prices suddenly plunge. This is going to get brutal and messy and no one in the energy industry is immune.

For this reason, my recommendation for investors for the short-term is to sell or short oil and related oil services. As a long-term energy stock investor, I intend to hold onto my investments as part of my long-term investment strategy.

Disclosure: I am/we are long VDE, FSNGX. 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.

Additional disclosure: As an energy stock investor, I intend to hold onto my investments as part of my long-term personal investment strategy.