We recently updated our oil thesis for 2018 and wanted to share some of our conclusions and thoughts as we begin the year. In this second of two articles (Part 1 is here), we'll provide more excerpts of our findings and some additional insights on incentives. Needless to say... we think we're going higher.
Tragedy of the Common Goal
We’re now past the point of no return, that finite period in time when the world could have, but failed to, reinvest in energy development to arrest declines. There was no appetite to do so, for political reasons (Saudi Arabia and Russia) and economic reasons (producers worldwide), and why would there be when everyone is losing money? In Barclays mid-year Upstream Spend Survey (conducted in August 2017), we see this tepid desire play out. This survey of 200 major oil producers indicates that in 2015/2016 oil companies globally halved their spending.
While 2017 spending appears to increase by 8%, we see on the right side that most of this increase was absorbed by service cost inflation. With numerous oil service providers having consolidated or liquidated in the downturn, the survivors now have pricing power. As we look to 2018, the Barclays survey indicates another year of anemic growth, which again factoring in inflation is largely flat. Three years of underinvestment, and now likely a fourth.
If you think that’s bad, wait there’s more. Remember outside of shale, oil projects take years to develop and bring online. If oil companies fail to make such long-lead investments, decline rates will increase. Yet, what little spending that remained was redirected from long-lead projects to short-life shale projects in North America, which increased by 31% (dark blue portions of the graph above).
We already know that shale wells decline dramatically in their first year of operation, which means E&P companies will have to devote more of their future capital to such short-life projects just to maintain production levels. It’s akin to running on a treadmill that tilts higher and runs faster the longer you’re on it. You’ll have to expend more capital and energy just to stay in place. Moreover, it siphons resources from large-scale projects with lower decline rates, projects that can form a bedrock on which to grow future production.
Even the US shale has limits though. Many analysts on Wall Street continue to claim that US production will keep rising, eclipse demand and lead to inventory rebuilding in 2018. Nonsense. In the past three years as oil producers pulled back, demand has raced ahead. Today, increasing demand is almost wholly being met by US production increases. As we showed in our last letter, by the end of 2018, demand will have increased by 6.2M bpd in the last three years, which means the world will need as much oil as US shale producers can pump.
In fact, any shortfall in US production will exacerbate the shortage. 2018 US production growth still looks aggressive to us because we think well productivity declines will begin to matter when the core sweet spots are drilled and secondary/tertiary drilling spots are brought online. Moreover, we think the recent push towards capital discipline could further slow US growth.
Value Over Volume
After years of spending beyond cash flows, E&P companies have lately faced a chorus of criticism from institutional investors. Tired of the unrestrained and largely unprofitable growth, shareholders have demanded that management teams focus on generating free cash flow, return capital, and peg management compensation to such metrics. Wall Street analysts dubbed the strategic shift “value over volume.”
In Q3/Q4, “value over volume” became the rallying cry, and management teams began addressing the issues. The new mandate will only truly take hold when management compensation metrics are revised, but it appears that process has begun. In a prior article we stated:
“As companies gain scale and shale operators consolidate, further discipline will set-in, and shale production growth may become even more tempered. The Wild West of today eventually matures into the well-managed oil fields of tomorrow, and production growth inevitably falls.”
That discipline may come faster than even we anticipated as companies pivot from unrestrained growth to a workmanlike manufacturing process. According to consulting firm Wood Mackenzie, 30 companies account for 70% of US shale production, and if only a few commit to spending within cash flows, US production growth may slow from its blistering pace. Just like lenders, shareholders provide capital, and this is a prime example of shareholders telling management teams that the terms for their capital are tightening and the cost is rising.
No Will and No Way
Yet hyper-focusing on US production growth is akin to admiring the furniture on a sinking ship. The dearth of international investment and flat rig count tells you that production outside of North America will likely disappoint. Absent an increase in well productivity, international production will continue to stagnate, which means offsetting decline rates become even more difficult. Internationally, producers either lack the wherewithal or the will to increase production.
In 2018, the International Energy Agency (“IEA”) projects that global oil supply and demand will be perfectly balanced at 1.3M bpd apiece. Much of the supply depends on US, Canada and Brazil growing. Growth in the first two countries are likely, but a 200K bpd growth from Brazil? Not so much, given that analysts had forecasted Brazil to also grow by 200K bpd in 2017, but it managed to eke out barely half that.
What’s more likely to happen in 2018 is what happened in 2017. Demand growth outpaced supply growth because various Non-OPEC countries underperformed and acted as a drag on US/Canada production growth. Hence the deficit. 2017’s deficit won’t disappear just because the calendar turned, and any shortfall in 2018 will be accretive to the overall deficit we’ve been experiencing and erode inventories faster.
It’s clear that US shale didn’t simply displace more expensive foreign produced oil, it’s threatening the very existence of some producers. By depressing prices for so long, maintenance capital has not kept pace to stem the decline rates. Worse, in some countries, prolific US production has politically and economically destabilized economies that depend on oil revenues to support their social programs.
The prime example is Venezuela whose oil industry is crumbling in real time as the political and economic structure implodes. Consequently, we’ve seen Venezuela’s production output spiral downwards. While other countries such as Mexico or Brazil haven’t experienced such political turmoil, production has stagnated, and in Mexico’s case is declining, which means rebuilding these supply channels won’t be easy, as it takes time to arrest the decline and even more time to increase production. More time than the world has, which brings us to our last point . . . no one cares.
In a previous article, my son Mason introduced us to the concept of liquidity and why that adds to volatility, but in a recent conversation I had with him, he wanted to impart on us the power of incentives.
Mason: I like mommy and Addy the best.
Me: Wait... what about daddy?
Me: Want some candy?
Me: How ‘bout now?
Mason: I like daddy the best.
Me: That’s the spirit.
Incentives work just as well in questionable parenting practices as it does in geopolitics, except you replace “candy” with money. As you may recall, OPEC and Non-OPEC countries, a collection of 24 countries representing more than 50% of the world’s total oil output, agreed in November 2016 to cap oil production and rebalance the oil market (“Vienna Agreement”). OPEC and Non-OPEC members met again in November 2017 and agreed to extend their accord for the entirety of 2018.
Frankly, we anticipated this outcome because the participants all had mutually aligned interests. When Saudi Arabia’s King Salman visited Russia in October we knew the deal was done because shortly thereafter, the two countries announced that Saudi Arabia would invest in various Russian led energy projects and acquire Russian made weaponry (i.e., “candy”).
The economic inducements were undoubtedly a means to solidify Russia’s continuing support... Mason would be proud. This was critical for Saudi Arabia because the oil market is still rebalancing, and given its plan to list Saudi Aramco in an initial public offering (“IPO”) in 2018, it needed further certainty that oil prices were headed higher.
Saudi Arabia, along with its Gulf Coast partners, carries the major burden of the cuts. So as the largest OPEC producers there’s a high likelihood that OPEC compliance will remain high. For Russia, which carries half of the Non-OPEC production cuts, their sacrifice is and has been significantly smaller. Russia’s 300K bpd production cut is small relative to OPEC’s entire commitment, and given the other economic inducements, it’s essentially a free rider at this point.
By the time the Vienna Agreement ends in 2018, it will have blunted the impact of increasing US shale production. If you doubt that, just look at Russia’s Minister of Energy Alexander Novak’s recent testy comments on CNBC about US shale production:
“I am asked this question every interview and I have already answered it many times. This is not news for us. For some reason when people ask this question they seem to believe that we didn't think that shale oil would grow... Either you underestimate us or you think we lack professionalism. I think that if you think we are professional you need to understand that we are including all this in our calculations.”
Now many commentators have discounted the Vienna Agreement as a mirage, a production cut in name only because prior to the 2016 agreement OPEC had intentionally overproduced and then set the ceiling at the higher production level. We agree to some extent, but in the midst of a shortage, any foregone production becomes meaningful. In addition, the restraint and high compliance rate reveals much about the commitment level of these producers. The consistency bias is even stronger now that oil inventories have declined materially; success begets success and there’s momentum to see the cuts through. We believe the market underestimated the group’s resolve, and when producers accounting for over half of the world’s oil production collude to constrain an already tight market, their unadulterated self-interest will become our tailwind.
For all the tumult, disappointment, and capitulation around us, we’re still confident because this is “lower for longer” paying out on Wall Street at the end of 2017.
As we write, Brent is hovering around $67/barrel, exceeding even the highest analyst forecast made a few weeks ago. If inventory trends hold, the analysts who’ve perennially called for “lower for longer” will revise their forecasts under the guise of new information, but the results will be the same. They will all chase oil prices higher.
Oil inventory declines haven’t been small, they haven’t been immaterial, and they haven’t been slight. The drawdown was larger and faster than anyone, outside of a few outlier contrarians, predicted, and it will accelerate. Our oil thesis is very much intact for 2018, and as you’ve likely gathered... we’re optimistic. Happy New Year everyone.
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Disclosure: I am/we are long CRC, WLL. 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.