31 Dec Oiling Up (Q4-18)

The biggest surprise in 2018 that caught nearly every energy investor and trader off-guard was the steep 30% decline in oil prices at the beginning of the fourth quarter. Not surprisingly, this large pullback has resulted in a surge of bearish calls for a collapse in oil prices similar to those in 2001, following the 9/11 terrorist attacks that caused oil prices to fall more than 40%. Back then, everyone assumed that oil demand would fall after the attacks. Instead, oil demand exceeded expectations and non-OPEC oil supply was a huge disappointment. The same setup looks likely to occur today. Given our existing energy-related investments and continuous access to upstream, midstream and oilfield services lending opportunities, we examine current oil markets.

Many analysts blame a combination of weak global demand and surging shale production in the U.S. for the rise in oil inventories and price weakness. The facts do not support this assessment. In April 2018, OPEC states and Russia (together known as “OPEC2”) were producing 43.3 million barrels per day (“bpd”). By November 2018, OPEC2 increased production 1.4 million bpd adding approximately 175 million barrels to global oil markets over seven months. However, global inventories grew by only 25 million barrels relative to long-term averages so without the OPEC2 production increase inventories would have drawn massively by 150 million barrels even accounting for the stronger than expected production from U.S. shale basins.

The short-cycle nature of shale production and the intensity of activity in basins like the Permian, Bakken and Eagle Ford is resulting in drillers being forced into less desirable locations. Production from Tier 1 well locations (i.e., those with the best pay and optimum pressure) is starting to shift to Tier 2 wells that do not have the same rates of productivity. Production per new well in 2018 from U.S. shale grew by less than 1% even though average drilling lengths and proppant (solid materials like sand used to keep well fractures open) loads increased. Standard Chartered Bank believes producers have gone from drilling 100% Tier 1 wells in both the Eagle Ford and Bakken to 50% and 30% Tier 2 wells in each basin, respectively. If this trend continues then productivity per well will decline and U.S. shale will see production rollover sometime in 2019. In a recent earnings conference call, oilfield services giant Schlumberger alluded to disappointing results in so-called “child wells” in the Permian, “Parent” wells refer to the first well drilled on a pad in a virgin section of land, while “child” wells simply refer to the subsequent wells drilled. When child wells are experiencing performance degradation of as much as 30% compared with parent wells, then it is a sign that a field is already in the middle-phase of its development. This confirms that shales are showing signs of exhaustion. There is also anecdotal evidence that many shale producers are overstating well projections in their corporate presentations1, further highlighting the steep decline rates of shale basins.

It is clear that the largest oil exporting countries are keen to drain global inventories. A coalition (the “Oil Coalition”) of OPEC states, led by the Kingdom of Saudi Arabia (“KSA”), and non-OPEC states led by Russia, recently agreed to cut production by approximately 1.2 million bpd to reduce oil inventories and re-balance supply globally. KSA alone cut nearly 450,000 bpd of production in December 2018 and has indicated plans to drop production further by March 2019. Russia’s production quota in the Oil Coalition is 11.2 million bpd in 2019, which is 200,000 bpd less than October 2018 reference levels. While there is some disagreement among top ranking Russian officials over production cuts, to the extent that participation in the Oil Coalition satisfies Russia’s economic and geopolitical interests, primarily higher revenues and deeper ties with KSA, then Russia should continue to honour its quota.

Non-OPEC oil supply outside of the U.S. and Russia has been in secular decline. Over the past decade, conventional non-OPEC discoveries totaled just 110 billion barrels while consumption equaled 360 billion barrels. We believe most market participants are underestimating the intense deterioration of oil production in the rest of the world. The supply estimates of the International Energy Agency (“IEA”), which form the basis of most energy analysts’ models, called for non-OPEC supply ex U.S. and Russia to grow by 600,000 bpd in 2018; that figure has now been revised down to 200,000 bpd, a massive 65% reduction. The IEA expects non-OPEC production outside the U.S. and Russia will grow by 125,000 bpd in 2019, which seems too high when considering the December oil curtailments in Alberta and chronic underinvestment in the North Sea and Mexico over the past decade.

The IEA’s projections on demand have also not fared well. Over the past eight years, the IEA has underestimated oil demand seven times by an average of 1.2 million bpd on average. According to official IEA statistics, 2018 oil demand averaged 99.3 million bpd, which was an increase of 1.3 million bpd over 2017. However, the IEA also reports a “miscellaneous to balance item” account of 1 million bpd, which are essentially “missing” oil barrels that are unreported and have gone into commercial storage away from official inventory counts (for example, in ocean tankers or cargo trains owned by private trading firms). According to Reuters, these missing barrels represent underestimated non-OECD demand. These missing barrels have been accelerating in recent months and will further narrow global oil balances in 2019.

The biggest headwind to oil prices is the global economy and more specifically the world’s demand for oil. Emerging market commodity demand growth, the engine for global growth, has been slowly trending down since the beginning of 2018. BCA Research recently developed a proprietary index, the Global Industrial Activity (“GIA”) index that measures the strength of the underlying global demand for commodities (Figure 4). The GIA, according to BCA Research, is close to or in a bottoming phase and ready to turn up within the first half of 2019. The GIA captures more than 80% of the variation in the movement in oil prices The biggest headwind to oil prices is the global economy and more specifically the world’s demand for oil. Emerging market commodity demand growth, the engine for global growth, has been slowly trending down since the beginning of 2018. BCA Research recently developed a proprietary index, the Global Industrial Activity (“GIA”) index that measures the strength of the underlying global demand for commodities (Figure 4). The GIA, according to BCA Research, is close to or in a bottoming phase and ready to turn up within the first half of 2019. The GIA captures more than 80% of the variation in the movement in oil prices and lagged the synchronized global upturn of 2017 by only a couple months. The long-term energy demand story for emerging markets remains in place. According to Energy Intelligence Group, oil demand outside the OECD is at the highest levels in two decades and exceeds OECD oil demand by more than 4 million bpd.

The production discipline of OPEC2 and the Oil Coalition, slowing shale-oil output, and rising industrial commodity demand from emerging market countries have setup oil markets for another surprise – this time, to the upside.

The biggest headwind to oil prices is the global economy and more specifically the world’s demand for oil. Emerging market commodity demand growth, the engine for global growth, has been slowly trending down since the beginning of 2018. BCA Research recently developed a proprietary index, the Global Industrial Activity (“GIA”) index that measures the strength of the underlying global demand for commodities (Figure 4). The GIA, according to BCA Research, is close to or in a bottoming phase and ready to turn up within the first half of 2019. The GIA captures more than 80% of the variation in the movement in oil prices and lagged the synchronized global upturn of 2017 by only a couple months. The long-term energy demand story for emerging markets remains in place. According to Energy Intelligence Group, oil demand outside the OECD is at the highest levels in two decades and exceeds OECD oil demand by more than 4 million bpd.

The production discipline of OPEC2 and the Oil Coalition, slowing shale-oil output, and rising industrial commodity demand from emerging market countries have setup oil markets for another surprise – this time, to the upside.

Excerpted from Third Eye Capital Management Inc.’s Q4 2018 Investor Letter.