Road to Recovery

From January/February 2017 Edition

OIL PRICES FINALLY REBOUND AFTER A DECADE OF DECLINE

Crude oil was the worst performing asset class over the last decade according to John Authers of the Financial Times. In 2007, investing in oil was a top investment strategy. And why not? It had just finished the previous ten-year span as the best-performing global commodity. Prices had climbed well above $100 a barrel, driven by numerous forecasts of oil scarcity and mushrooming demand from economic and population growth.

Forecasts called for oil prices to reach $200 a barrel. However, if you had purchased a crude oil futures contract at the start of 2007 you would have lost money holding it to the end of 2016.

On the other hand, crude oil turned out to be the best performing asset class over the past 12 months. But don’t tell that to people in the oil industry as they will merely shake their head. Last year saw the largest number of oil industry bankruptcies in decades, the loss of tens of thousands of jobs, and significant economic harm to regions dependent on oil and gas.

However, if you were a speculator trading oil futures and you purchased a contract in February when oil prices fell to $26 a barrel, you more than doubled your money by year-end. Even if you weren’t smart enough to catch oil’s absolute bottom, overall for 2016 you would have made 45 percent. But that wasn’t enough to offset the losses from the prior nine years.

The radically different performance for crude oil prices during the two past decades reflects the mistake of assuming the future will be like the past. Last year’s oil price performance highlighted that mistake. That’s what makes projecting this year’s oil price more challenging than usual. Most forecasters rely on models that extrapolate the recent past, depending on how the forecaster expects near-term events to impact oil supply and/or demand.

But it is usually the unforeseen events – called Black Swans – that throw forecasts off-track. Having recently returned from New Zealand where black swans can be seen by the thousands, we wonder just how rare these events are.

Seeking Direction

Oil prices are struggling to find direction as we start 2017. That’s because the earlier rise in prices was driven in anticipation that oil exporters’ actions would alter the global supply and demand balance for the better. Optimism exploded last December following the announcement of the Vienna Accord, in which OPEC members agreed to cut their combined production by 1.2 million barrels a day. That initial wave of optimism is now being tempered by the realization that OPEC has never complied with agreements to limit its output.

OPEC is considered one of the largest groups of cheaters ever assembled in a cartel. One study showed that, over the past three decades, OPEC has only achieved two-thirds of its agreed production cuts. This time, OPEC leaders say they expect 80 percent compliance. However, they believe that even if they only get 50 percent compliance that will still be sufficient to send oil prices substantially higher.

Holding prices back is skepticism about OPEC’s ability to meet its production cut target – despite comments from leading oil exporters that they are already reducing production. The optimistic view is buoyed by the fact that OPEC’s historically leading cheaters – Iran and Venezuela – are struggling to sustain their production, let alone increase it.

Sparse data on shipping volumes and the latest country production estimates are sending mixed signals. Venezuela, one of the most economically distressed members of OPEC, is now suggesting there needs to be a new agreement because global oil prices haven’t climbed as high as it thought they would, or as high as it needs them financially.

Further confusing the picture is Saudi Arabia, where oil officials are claiming their production cut commitment will only last for the first six months of 2017 – conveniently during the country’s winter months when internal oil demand typically falls. While those same Saudi officials are saying that six months of cuts is sufficient to bring the global oil market into balance, they ignore 2017 oil demand estimates marking the slowest projected growth in years.

Dampening the optimism is that oil output in the U.S. is responding to the increased rig activity that commenced last fall as oil prices rose from the low $40s a barrel to the low $50s. U.S. operators are optimistic that their drilling and production efficiency gains of the past few years have made many more prospects highly profitable, and they are being drilled now.

Last fall’s oil price optimism was boosted when several non-OPEC exporters, including leading oil producer Russia, agreed to cut output by a combined 600,000 barrels a day. With prospects for nearly 1.8 million barrels a day of oil production coming out of the global supply chain, many people believe prices should be much higher than their current low $50s a barrel range.

The bearish case for oil prices was recently spelled out by a natural resources-oriented mutual fund manager. In his view, commodities are in a long-term secular bear market driven by waves of new supplies coming to market in response to the long span of super-high prices. He believes the bear market in oil could last another 10-15 years and will become more visible and powerful once we get beyond the oil price “sugar high” from the OPEC production cut announcement. He sees oil prices back below $40 a barrel by 2018.

Short-Term vs. Long-Term Trends

Is this portfolio manager falling into the forecasting trap of extrapolating recent trends? The 2015-2016 oil industry recession in many measures was worse than the one experienced in the early 1980s that needed a decade for the industry to recover. There are many similarities between the recent industry recession and that earlier one.

The extended period of very high oil prices in the late 1970s convinced people that high oil prices would become the norm. Believing the oil and gas industry was in a new era of profitability, drilling surged and oilfield service capacity exploded to satisfy the growing demand. In that earlier period, high oil prices drove the industry to seek new conventional reserves in unexplored areas around the world. This time, high oil prices encouraged the use of improved technology for unlocking new oil supplies like those buried in shale formations.

The net result for both periods was much more oil being available just when high prices eroded demand. Now, oil consumption is also fighting increased environmental pressure to de-carbonize economies, regardless of whether that strategy is appropriate for developing economies where increased use of oil and gas is enabling significant advances in national living standards.

Often it is difficult to separate short-term from long-term issues impacting energy because the differences are merely slight variations in industry trends. The variations often result from the timing of where we are in our economic cycles. For example, when the global economy is recovering from a recession or slow-growth period, prospects for increased energy consumption are high. That generally translates into higher commodity prices. Likewise, as we teeter on the brink of an economic recession, the future for energy demand growth appears less promising, putting downward pressure on oil prices.

Despite differing outlooks, the primary drivers of energy demand remain world population growth and rising living standards. Long-term, those trends mean more energy is needed. That is why, when we examine long-term energy forecasts – those to 2035 or 2040 – prepared by oil companies, government agencies, think tanks or investors, the lines on the charts always appear to be smooth and rising because that is the trend of the primary energy drivers. However, short-term oil industry forecasts often reflect much greater volatility due to the specific timing for economic recoveries or declines.

New Price Floor?

Global economic activity is now projected to be higher than previously anticipated based on the view that new leadership will generate stronger U.S. economic growth that will pull along the rest of the world. If that happens, more oil and gas consumption will follow, which will speed up the timing of the global oil market rebalancing and drive prices higher.

Whether oil prices rise as high as optimists expect may be less of an issue than the increased assurance of a higher oil price floor going forward. Eliminating our portfolio manager’s view that the world will see $40 a barrel oil in 2018 would do wonders for the oil patch and, theoretically, for the overall economy, considering the record of the industry’s contribution to global economic activity in 2010-2014.

While it takes a while for the oil industry to adjust to lower prices, once the adjustment is made it can then operate for many years at that level of activity. An extended period of essentially stable oilfield activity may be just what the doctor ordered. It would enable the industry to piece itself back together again after being torn apart over the last two years. 

 

BY G. Allen Brooks

Allen Brooks is Managing Director of energy services investment firm PPHB in Houston. His fortnightly Musings From the Oil Patch is among the most widely read newsletters in the industry