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An Oil Market Refresher; And Why WTI Is Poised To Snap Higher (Again)

|Includes: OIL, The United States Oil ETF, LP (USO), XOM
  • Hopefully this can used as a brief primer that covers the modern day oil-supply dynamics
  • Stability in the Middle East is predicated on the strength of its oil revenues
  • US Shale is consolidating but is still very fragmented
  • Saudi has multiple reasons to want the price of crude higher

Following the crude oil market can make for a painful existence. The current dynamics at play could make for a classic HBS case study. On one side, we have a host of unsavory characters trying to influence the market with bloated verbiage. Sometimes this chatter is meant to obfuscate; sometimes it is meant to outright deceive. Making matters complicated, this side of the equation is comprised of an official cartel and random rogue nations. Needles to say, the various 24 players are not always aligned in theory or in practice. The other side of the would-be case study is a group of old-school wildcatters turned technology mavens. This group goes about their business mostly in silence...simply pumping when it makes economic sense. And this is only on the supply side of the bigger equation.

OPEC has had much to say during its 2017 production cutting program - its first since 2008. With the usual lead from Saudi Arabia, the cartel explains that compliance has run over 100% (they are cutting more than promised). However, what is left to the small print is that only 10 of the 13 OPEC members are held to any commitment. Iran, Libya, and Nigeria are free to produce as much oil as they see fit (not to mention Indonesia which decided to drop out of OPEC entirely rather than commit to a 5% production cut). This mighty triumvirate accounts for about 18% of all OPEC production. Moreover, of the 10 cutters, the wording is quite explicit in terms of each member's commitment: production. The agreement does not limit the exporting of spare capacity. And these specifics matter. The agreement aims to cut about 2% of daily global production. There is no doubt this is a significant number. But it also doesn't leave much room for error.

Inside of OPEC, there is constant grappling about the proper balance between market share and price. Saudi has the luxury of pushing for price as it is not only the largest producer, but it also has the lowest production cost of around $10. Meanwhile, other producers are struggling to stay in the black. Iraq, namely its Kurdistan region, has a production cost of around $60. Needless to say, their incentives are not aligned.

The one consistent concern across the cartel's members is the correlation between oil profits and government stability. Pointing to Iraq again, it is politically still a mess (no political commentary here...). The various regions are battling over ownership of the oil revenues. Assuming this battling remains political and not actual, it is a quality problem. After all, they are trying to divvy up "new found" money. The point here is that the disagreements could (and do) turn much worse when the government coffers are not being filled with oil money (Syria is a prime example of this, but clearly it happens all over the Middle East). The same holds true for Saudi. The stability of the kingdom's rulers is essentially based on government largesse. 45% of the national budget is spent on public sector employees. Simply put, these are handouts meant to appease the people while the rulers live in luxury (ok, there was a little political commentary there, but I'll move on...). Saudi finally realized they could no longer keep spending in the same fashion with the price of oil being cut in half basically. The government instituted a Vision 2030 plan which was to cut public sector spending down to 40%. This has not been a popular move. The seeds of unrest among the commoners have been planted.

Another wildcard for Saudi is the potential listing of its state-owned oil giant, Saudi Aramco. The original numbers floated targeted a market capitalization of $2T...yes trillion. Analysts at firms not vying for a cut of the deal seem to be valuing Aramco around $400mm with $70 oil. The WSJ reported today that bankers working on the deal are having a hard time coming up with a $1.5T valuation. And this still-boosted price is based on a 50% tax rate which would be very generous (nor permanent). And the original hope was the deal would come in 2017. I think the likely target date has been pushed back to late the earliest.

Outside of the cartel, we have what I referred to as the rogue nations. This is certainly an unfair label across the spectrum, but with Russia as its leader, the wording seems to fit. This group of 11 promised about 1/3 of the total 1.8mm in daily production cuts. It's compliance has been lackluster, to say the least. March compliance was running around 66%. While this is pretty feeble, it does compare nicely to the 44% in February. But as I like to say, how do we know the cheaters are not cheating about the reporting of their cheating?

Finally, we get to the other side of the equation...the US shale producers. This group is typically thought to be small-scale drillers that get punished by sharp oil drops. This was certainly true for the $100 -> $30 drop. But this drop also changed the ownership profile. Just this year, we had some of the oldest-school West Texas oil families sell out to global firms. The Bass family sold its Permian land to Exxon for $6.6b. And Clayton Williams sold his Permian assets to Noble Energy for $3.2. Other than being nice paydays for the already super-rich, it shows the faith in shale by some of the majors (Exxon's XTO subsidiary will manage the new assets).

Despite this recent consolidation, the shale business is still very fragmented. With fields shaped like gerrymandered voting districts (or to go with a Permain reference, like the drawing of school districts around star football players' homes back in the 1980's…see Friday Night Lights), technology and nuance are more important than ever. Marginal costs are different across fields and drillers. Local governments can have a large say in the matter. And competition is fierce. We've all seen that drillers are coming back in droves evidenced by the weekly Baker Hughes Rig Count. The US oil rig count now stands at 688. This is up from a measly low of 316 early last year. But it still pales in comparison to the over 1600 rigs back in 2014. All this boils down to my original summation for the shale drillers...they pump whenever it makes sense for their shareholders.

So where does this leave us? Well, some very quiet but yet very important news hit yesterday. Saudi Arabia announced that it will roll back some of the public sector spending cuts. That is, they are going to revert back to spending to appease the aforementioned masses. I haven't seen any detail, but the news can only really be read in one way...Saudi wants a higher oil price. In the past few weeks, Saudi indicated that $60 was a fair oil price (Saudi refers to the Brent price not WTI. Right now there is about a $2 spread with Brent trading at a premium). But if they are going to make promises to the people, they will need to better than this.

But as this is the oil market, there is always a "however." In this case, it comes back to the US shale guys. But given the recent mgmt. changes in some large swaths of prime land in West Texas, the lag time to ramp up production might be delayed more than usual. Speculators are still running heavy longs in the futures market, but this might not mean as much as it does on the surface when adjusted for increases in open interest and decreases in price.

So, if Saudi needs higher prices (for spending on the home front and the eventual Aramco IPO), non-OPEC compliance is on the rise, US Shale drilling acceleration might be delayed, and if US speculators are ripe to dust off their recent wounds after having piled in up to $53, oil could be posed for another run to recent highs.

I know I have skipped the demand side of this complex macro puzzle. But this essentially boils down to the strength of the global economy which typically boils down to the US economy. And this requires a whole different set of analyses. Kind of a cop-out, I know, but the reality is that everyone will have their own view (ie opinion) of the economy and the current political backdrop. For what it is worth, I believe this administration will be able to pass some pro-growth legislation, but it will take some time (not just to implement, but to pass). And last week's Flash PMI showed another slowing of growth across both Services and Manufacturing, so the road to a Trumpian Eutopia might be longer than can be reasonably expected (the PMI does still read a positive 52.7, but it has dropped steadily since the January high). On the flip side, US earnings have been generally strong with upbeat forecasts.

In terms of trading, I know USO is a common vehicle. But this should only be used for short term trading. Given its roll structure, you can get eaten alive with costs and by the shape of the curve. I would suggest trading the actual future so as to avoid complacency and to force yourself to know the calendar. I would also recommend using stop-losses. The speculators are mostly institutional macro traders, and they are very aggressive in this realm. They deploy massive amounts of leverage. They push winners exhaustingly and cut losers on a dime. And CTA performance has been poor as of late, so they are likely to take their tactical trading to extremes. Needless to say, trading the oil market is not for the faint at heart.

I am personally long WTI via royalty and working interest streams of shale drillers across the US but mostly located in West Texas. I have owned Kurdistan E&P's in the past (painful), and maybe I will again some day (no time soon).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.