Oil's Goldilocks Price Range Summer Comes To An End

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Includes: BNO, DBO, DNO, DTO, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO
by: Albert Goldson

Summary

Prepare for a rapid price increase from this summer’s Goldilocks just below $70/bbl oil average price based on the confluence of independent foreign policy, operational and financial factors.

Factors include the sanctioned reduction of Iranian exports and future production, Venezuelan production collapse, and perhaps a financial reckoning of US shale oil firms.

Surplus Saudi production capacity will be unable to meet strong global demand to offset these scenarios.

Finally there are several on-going economic "Mexican standoff" sanctions between multiple oil producers that will complicate OPEC’s ability to craft a mutually acceptable agreement in the December 2018 meeting.

The present Goldilocks oil price range this summer is averaging just under $70/bbl and has served most oil producers and consumers quite well. However, changes in the following variables may alter this balance considerably and feature a period of high volatility and possibly a sudden oil price surge that could destroy demand and subsequently asphyxiate global growth.

The three major insidious trends occurring almost simultaneously that could catapult oil prices out of their summer Goldilocks price range well into 2019 are as follows:

  1. Iran: Draconian US sanctions that could completely restrict Iran to selling oil.
  2. Venezuela: Its oil production is scrapping the barrel whose figures by year-end 2018 will be barely enough to meet minimum domestic requirements.
  3. US Shale: An industry shakeout through gradual Fed tightening that would cut off financing in an industry where the vast majority of firms are hemorrhaging money and even the profitable ones are producing lower than expected returns on investment.

If global oil demand was weak or tepid, these potential scenarios would not be as alarming. However, global oil demand remains robust and any disruption, even short term, would push oil prices dramatically higher.

The Saudis have historically boasted that they can ramp up production as much as 2 million bbls/day to meet global demand and/or production shortfalls. However, increased production over the medium to long term is unsustainable and with it raises the issue with respect to the quality of the additional production.

Iran

Politically, Iran cannot afford to lose face by deciding to return to renegotiate the nuclear agreement in the short term. They’ve successfully survived US sanctions for decades and will probably simply wait out the current administration and gamble on a US leadership change in 2 years.

If a Democratic candidate won the 2020 presidency combined with a strong Democratic control in the House and Senate via the upcoming mid-term elections, Iran would feel they could negotiate a face-saving compromise on the nuclear agreement’s terms and conditions. Interestingly US sanctions take effect on 4 November 2018 just two days before the US mid-term elections.

Whether these will be hard draconian sanctions to cut Iran completely from the world economy or selective sanctions has not yet been publicly announced. Such selective sanctions could include waivers to export limited oil to their major clients such as the European Union, China, India, Japan and South Korea.

On the other hand, should the GOP win or even come close to taking the House and Senate in the mid-term elections, this may indicate to the Iranians a stronger possibility that Trump could get re-elected in 2020. For this reason, Iran’s Plan B may pose a serious security risk to the US at some level because such a result poses an existential threat to the current Iranian government with respect to its political survival due to long-term economic hardship.

Venezuela

Venezuela’s economic collapse and unprecedented humanitarian disaster is unfolding at such a slow-motion rate that they often seem to drop off the media radar for extended periods of time. President Maduro’s voluntary or involuntary departure would only raise more questions as to how Venezuela would recover even under a unified military junta.

Oil production will continue to fall unabated even after a leadership change and, under the very best of circumstances, an immediate infusion of economic aid. Any meaningful increase in oil production will take several years at best.

Despite Venezuela’s qualification yet refusal to apply for IMF aid, IMF funding may not be readily available to meet a disaster of this magnitude. This consideration comes particularly after the IMF’s record-breaking $50 billion bailout agreement and subsequent ongoing renegotiation of terms with Argentina whose currency and economy continue to falter even with strict adherence to IMF-recommended economic policies.

US Shale Oil Shakeout

One of the most insidious trends has been the continued Wall Street financing of US shale oil companies despite their inability to provide any return of investment. I discussed at length under US Shale Oil section in my SA 1 June 2018 article Revised OPEC Production Quotas Won’t Derail Higher Oil Prices why most US shale oil firms are a losing proposition and the reasons why they are unable to capture profits despite higher oil prices. This aforementioned section with respect to financing challenges is as follows:

“Financially, US shale oil firms are still struggling to turn a profit in 2018 despite higher oil prices. According to the Wall Street Journal article 17 May 2018, Oil Is Above $70, But Frackers Still Struggle to Make Money, only 5 of the top 20 US oil companies have managed to turn a profit in the 1Q2018. The major factors for this inability to turn a profit even with higher oil prices are as follows:

  • Hedging strategies through derivatives were locked in when oil prices were in the range of $50-$55 bbl. For this reason, these firms are unable to capture higher revenue from higher oil prices.

  • Considerably higher oil-field service costs such as drilling contractors and the purchase of required sand and water, which have become more expensive.

These factors may result in lack of additional investments including from private equity firms as well as the exasperation of shareholders who may sell their shares for lack of better management acumen in cost control. So even when the three new pipelines are operational, the financial tap may be turned off for many shale oil firms that would ironically result in lower production despite the removal of infrastructure constraints.”

The trend was discussed in explicit detail recently in the 2 September 2018 NY Times article The Next Financial Crisis Lurks Underground. To quote the journalist Bethany McLean, “The 60 biggest US shale oil firms are not generating enough cash from their operations to cover their operating and capital expenses.” And as mentioned in my earlier mentioned article, only 5 of the top 20 US shale oil companies made more money than they spent in 1Q2018.

Ms. McLean furthered explained that a key reason for this profit shortfall is because fracked oil wells have a steep year-on-year decline rate as experienced in North Dakota 69% the first year and 85% overall the 2nd and 3rd years vs. a conventional well which declines about 10% annually. For this reason, huge investments are required annually to offset the declines. The cycle continues as Wall Street has obliged with more financing because of continued record-low interest rates.

US shale oil production continues unabated because of low interest rates, a scenario which is changing as the Fed progressively increases interest rates while operational fixed costs such as oil-field service firms and the purchase of water, sand and the related transportation costs increase.

US shale oil firms are far more adept at operational prowess than financial acumen. Interestingly the operational and financial disciplines are polar opposites. The US shale oil firms have optimized operations considerably year after year to extract more oil at lower costs yet have failed to arrest the hemorrhaging of expenditures.

There are two scenarios that could curtail or even halt additionally financing and subsequently shale oil production:

  1. The first is the halt of Wall Street financing as a result of the Fed’s progressive tightening of the rate reaching a tipping point. Even an announcement or rumor of such a possibility will rattle the US shale oil industry and probably the global oil market.
  2. The second is a market correction in general, even a minor one, in which Wall Street will take a hard assessment of their overall investment portfolio.

In the midst of potentially volatile changes are the winners, those who would profit handsomely with a sharp rise in oil prices while maintaining unencumbered production capacities.

Saudis

American sanctions against Iran will permit the Saudis to not only capture greater market share at Iran’s expense but with it, higher oil prices as a chunk of Iranian oil is removed from the market.

This has allowed the convenient official announcement of Aramco's IPO delay that was specifically discussed, stated and projected almost a year ago in my 13 November 2017 SA article Aramco IPO: The Right Company at the Wrong Time. This same contrarian projection was reiterated several months later when I was quoted in the article in on-line publication Middle East Eye 27 March 2018 entitled Bin Salman in New York Eyes on Aramco.

Higher oil prices will allow the Saudis greater comfort in financing their ambitious Vision 2030 mega-projects through other means through international loans without the risk of a highly complicated and potentially underwhelming IPO.

Russia

They are in an excellent win-win position with potentially higher oil prices offsetting to a large extent US sanctions through which they’ve performed rather well under the circumstances.

These factors serve as a backdrop leading to the 3 December 2018 OPEC meeting. There are multiple sanctions against many OPEC producers akin to a petro-Mexican stand-off which means that the agenda will be, as they say, “complicated.” This situation would be laughable if not for the seriousness affecting each one. It’s a toxic brew that could provoke extreme oil price volatility. The sanction situations are as follows:

  • The US sanctions against Iran officially take place 4 November 2018. Already the announcement is impacting the energy market as global players from operations to finance are disengaging from Iranian businesses to avoid US penalties.
  • The US has selective sanctions on Russia.
  • The US has selective sanctions on Venezuela.
  • Saudi Arabia and UAE continue to embargo Qatar, which has received economic relief from Turkey with respect to trade, which in turn the US has selectively sanctioned particular high-ranking officials and applied considerably higher tariffs on particular products.

Other variables that could exacerbate the market include Libya and Nigeria. Because militants are holding Libyan and Nigeria oil producers as de facto economic hostages with attacks, projected oil production from those countries is nothing more than a best guess.

Libya is a quasi-failed state that is ruled by multiple factions in which agreements for elections or even an official power-sharing agreement are still remote.

With respect to Nigeria, presidential and national assembly elections are scheduled to take place 19 February 2019. Militants continue to disrupt oil production, Boko Haram is still a threat and the economy remains weak, none of which the president Buhari, a former military general, has been able to resolve.

Recommendation

This is a period of tremendous opportunity for two types of energy investors: (1) the nimble, adventurous risk-takers who revel in volatile markets and (2) long-term investors who can afford to ride out whatever level of volatility might present itself.

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.