"The human understanding when it has once adopted an opinion... draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects or despises, or else by some distinction sets aside or rejects." - Francis Bacon
Please note: This series is the result of a number of group discussions held in the TNRH Chat Room. I should point out, the series, in essence, has many co-authors in the TNRH Members, I am only the midwife. Since certain TNRH Members are to be credited for conceiving and exploring some of the important concepts presented here, I dedicate this series to the great Chat Room of TNRH.
1. A history of recent consensuses on oil price
The human mind seems not to be intuitively capable to tell apart the fleeting from the permanent, especially when it comes to things that take a long time to play out. Oftentimes, we think the transient, be it as tangible as a fortune or as impalpable as an opinion, will last forever just because it has been experienced by us in the recent past. Psychologists came up with fancy names like confirmation bias to describe such a less-than-rational human characteristic.
Back in March 2008, following the oil price (OIL)(USO) had incessantly risen for seven years, Goldman Sachs predicted that oil was heading for $200 per barrel (see here). That forecast was ruined by an oil crash down to $33/bo induced by the Great Recession. However, a quick rebound of oil prices lent new optimism; e.g., Charles Maxwell famously projected the oil price being destined for $300/bo in February 2011 (see here), although the consensus seems to have gravitated toward $100/bo forever as so eloquently quipped by T. Boone Pickens (see here).
But almost at the same time as the oilman was pontificating, crude oil price started to fall precipitously and did not take a respite until seven months later, at which point, WTI had fallen to $42/bo. Nobody foresaw this sharp drop in oil price; in disbelief and attempting to cling to their entrenched belief, many prophesied a V-shaped rebound to the $100/bo equilibrium (see here), including well-respected industry insiders from Harold Hamm of Continental Resources (CLR) to David Demshur of CoreLab (CLB), who said in January 2015 "As was the case in 2009, Core sees a V-shaped recovery starting to occur in late 2015, and that echoes comments from Harold Hamm most recently" (see here).
By late 2015, when a quick reversal was clearly not materializing, pessimism finally took hold. CNN Money rejoined, "Forget $40 a barrel oil. Prices could plummet to $20 as a massive supply glut persists until the end of next year," citing a Goldman Sachs report of September 2015 (see here).
Trying to make sense of a changing oil industry, the bank came up with the “New Oil Order" (see here). Governed by the "New Oil Order," oil prices will stay "lower for longer," a new consensus the industry came to accept (see here and here). As time went by, "lower for longer" was so well rubbed in and, almost "retrodictably," evolved into "lower forever." By July 2017, when another episode of oil price swoon happened, "lower forever" began to be taken as the received wisdom by the multitude including such industry behemoth as Shell (NYSE:RDS.A) (NYSE:RDS.B) (see here) (Fig. 1).
Fig. 1. A history of conventional wisdom regarding the oil price, modified after an oil price chart sourced from barchart.com.
Just like Nassim Nicholas Taleb's proverbial Thanksgiving turkey (Fig. 2), which is fed by the butcher for 1,000 days, each of which passed confirms to the turkey that the butcher loves it, until the 1,001st day when a rude surprise befalls it (see here), we human beings come to believe things, complacently settle on them and assume them to be permanently true.
If the afore-reviewed track record of our consensus building tells us anything, it has to be we consistently reach wrong consensuses. What a distressing reality for us to face! This brings us to the outlook of oil prices.
2. What was wrong with 'Lower Forever'?
The problem with our cognitive process lies in that it appears to be beyond our natural ken to figure out how the overly-complex systems operate, so in the end, we resort to (over-)simplification of complexity and make-do assumptions to hash out a theory. Then, various theories were let to compete in the market of ideas to decide which one wins out and end up being the consensus; such a social process works well in some cases, but it can turn out to be terribly wrong in others.
The consensus opinions regarding complex matters may work up to a point until it doesn't, e.g., the flat earth theory. Likewise, the "lower forever" theory seems to have caved in, with loud cracking noises heard from its supporting pillars, as I describe below.
2.1. The lost mojo of a hyped swing producer
The U.S. shale oil producers were collectively designated as the swing producer as in the "New Oil Order," which has been marketed as the new paradigm of the oil price in the age of the shale oil revolution. However, these producers turn out to be less powerful than previously assumed.
A swing producer is defined as a supplier or a close oligopolistic group of suppliers of a commodity, which is able to increase or decrease commodity supply at minimal additional internal cost, and thus able to influence prices and balance the markets, providing downside protection in the short to middle term, because it controls large spare production capacity. Quintessential swing producers include Russia in potash fertilizer and, historically, the De Beers Company (OTCQX:AAUKF) in diamonds.
According to such a definition, the U.S. shale oil producers clearly do not qualify to be a force of swing production. These companies do not have sufficient spare production that can be turned on or off at minimal additional internal cost. Tight oil is capital intensive to develop and, once in production, declines fast. The tight oil producers need to keep spending to maintain a flat production; many tight oil producers lose money to grow production. Producers are under increasing pressure to abandon the practice of growing production at any costs and to pursue the new policy of profitable growth.
Fig. 3. A map showing major shale plays in the U.S., source: here.
The real problem with the U.S. shale being the swing producer is low-cost shale plays are few and far between. The Eagle Ford and Bakken, once touted as the most promising unconventional plays by Mark Papa then at EOG (EOG) (see here), are downgraded by the same person now at Centennial Resource Development (CDEV), citing the exhaustion of Tier-1 drilling locations in these plays (see here). Eagle Ford's problem to grow production is well summarized here. The SCOOP/STACK, OK, and the DJ Basin, CO, though emerging, do not move the needle on the total U.S. production. Even the Permian play, the elephant in the room, can only barely manage to keep the total U.S. oil production flat (Fig. 4).
Fig. 4. The U.S. crude oil production (upper left), with contributions from Eagle Ford (upper right), North Dakota (the main Bakken producing state, lower left), and Oklahoma and Colorado (lower right), modified after here.
2.2. The rising costs to find, develop and produce oil in hindsight
As Papa pointed out (see here), the overall quality of the yet-to-develop U.S. unconventional oil properties has dropped. Elsewhere in the world, the three years of exploration Capex cutback led to insufficient reserve additions and deterioration of producing asset quality. Even in Saudi Arabia, primary oil recovery seems to have come to an end, judging from her reported need for enhanced oil recovery or EOR oilfield service (see here and here). Consequently, falling asset quality will result in an increase in the all-in finding and development costs, i.e., F&D costs, of oil.
Drilling and completion technological advancement certainly led to a permanent decrease in oil production costs but a large part of the cost reduction as recorded by the tight oil producers are actually attributable to the temporary drop of oilfield service costs. These oilfield service costs are bound to appreciate along with rising oil prices. What are costs to the oil producers are revenue to the oilfield service firms, such as Halliburton (HAL), Schlumberger (SLB), Baker Hughes (BHGE) and CoreLab.
- The revenue of Halliburton grew YoY at 1.9%, 29.5%, and 42.0% in 1Q, 2Q, and 3Q, respectively.
- That of Schlumberger increased YoY by -14%, 4%, and 13% in 1Q, 2Q, and 3Q, respectively.
- That of CoreLab expanded YoY by 2.7%, 10.7%, and 15.9% in 1Q, 2Q, and 3Q, respectively.
Therefore, revenue growth seems to have picked up speed at these oilfield service providers, which can only mean one thing: the operators are paying more to get work done. The amount of work certainly increased but according to these service companies, the day rates were rising too, as evidenced by the expansion of their profit margins.
The continued interest rate escalation by the Fed increases the capital costs of the oil companies. This interest raising comes at a time when a slew of junior debt issued between 2013 and 2014 comes due around 2020 and needs to be refinanced.
The global environmentalist movement seems to be hampering the installation of pipelines everywhere, from Canada, via the U.S., to Colombia. The existence of pipeline bottlenecks will only increase transportation costs for the oil producers.
2.3. Geopolitical instability is rearing its ugly head again
The period of relative geopolitical tranquility appears to have come to an end. Back in late September 2017, the Iraqi Kurds declared independence, ruffling so many feathers in the neighboring countries. This reminded the world that the Middle East was the new powder keg (see here).
The cold war between Saudi Arabia and Iran used to be fought through proxies across the region. But it suddenly turned hot after Iran-backed Yemeni rebels fired a missile at Saudi capital Riyadh on November 4 (see here). Senior Saudi officials threatened to respond to aggression against the nation, followed by a statement from the Arab League in support of the Saudi stance.
Carl von Clausewitz said, "War is the continuation of politics by other means." Saudi Arabia is in a domestic turmoil; it desperately needs higher oil prices to plug its leaking treasury coffer. Chris Martenson describes a rather intense future, involving a destabilizing Saudi Arabia, regionally hegemonic Iran, an ambitious China, a conspiring Russia, and a U.S. that has been much weakened in recent years (see here). He prophesies,
"Unless something very dramatically changes in either the supply or demand equation for oil, and soon, we can now put a timeline in place for when the great unraveling begins. Somewhere between the second half of 2018 and the end of 2019 oil will dramatically increase in price and that will shake the foundations of the global mountain of debt and its related underfunded liabilities. Think 9.0 on the financial Richter scale."
Across the globe, OPEC member country Venezuela is already officially in default (see here); the oil production from that country had been in a sharp decline since 2014 and the default will only accelerate the fall of production.
2.4. Oil demand growth stronger than expected
The market has been trading under an assumption of a weakening demand going forward. OPEC World Oil Outlook of 2016 forecast the global oil demand to grow 0.93 MMbo/d from 2014 to 2020 (see here). The IEA expects global oil demand to grow on average by 1.2 MMbo/d each year to 2022 (see here). Amrita Sen, Chief Oil Analyst at consultancy Energy Aspects, thinks these demand forecasts, built "on a dated premise of ever more efficient oil use" in the aftermath of nearly a decade of high oil prices, may have failed to take into consideration that low oil prices are conducive to less efficient oil consumption, just as high oil prices promote oil use efficiency (see here).
In contrast to the predicted approximately 1.0 MMbo/d annual growth, oil demand grew by 2.0 MMbo/d in 2015 and 1.6 MMbo/d in 2016. According to BP Statistical Review of World Energy, "Global oil consumption growth averaged 1.6 million b/d, above the 10-year average of 1 million b/d for the second successive year as a result of stronger than usual growth in the OECD. However, China (+400,000 b/d) and India (+330,000 b/d) still provided the largest contributions to growth" (see here).
According to Sen, car buyers warmed up to gas-guzzling SUVs as oil prices plummeted since late 2014. This is confirmed by data released by Edmunds. As fuel prices fell from 2015 to 2016, consumers preferred SUVs and trucks over hybrid or electric vehicles (Table 1). The consumers sent an unequivocal signal that a $45-55/bo oil was too cheap, but the so-called shale band still gained currency on Wall Street.
Table 1. Consumers traded in EVs for SUVs and trucks in 2016, source: Edmunds (see here).
In summary, the "lower forever" theory of oil prices already crumbled. The robust demand growth, in conspiration with rising costs, lackluster growth outlook of the U.S. tight oil production and geopolitical tension, has started to drive the oil price higher. This is not a hypothetical, projected event of the future. The Great Oil Upswing is already underway. "A multi-year bull trend" has been declared by some Seeking Alpha contributors (see here).
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