Over-supplied markets like the oil market take prices in only one direction, down. We are seeing indications of a historically over-supplied market right now, so we expect continued weakness on the commodity front. The impact of this reality will be felt across the value stream for crude and refined products until demand begins to pick up. If you're a driver of a giant pickup truck, you're in for some of the happiest times of your life over the next few months.
Over the short run crude will follow the law of diminishing marginal utility where early consumption is advantaged over later consumption of a good. Here is an example-
On a hot summer day, a glass of lemonade from your neighbor's kid’s lemonade stand is just the ticket. The second glass is good, but already your stomach is telling you...slow down. Forget about a third class...even if it’s free. There is a point where no matter how cute your neighbor's kids are or how cheap the lemonade gets, you just can't take anymore. Over time this situation rights itself and you're ready for more at whatever the market price is at that time.
That's kind of the situation that appears to be developing post-Vienna for oil.
“Storage facilities around the world are brimming with cheap oil and could run out of space within months, traders and analysts say, a predicament that could drive down crude prices to unprecedented single-digit dollar amounts.”
Demand destruction This edition of the EIA-STEO gives us a first look at the effect of the coronavirus on global oil demand. This report was delayed for a day to take into account the events of March 9th where crude dropped 30 percent in a single day.
This analysis shouldn't come as a great surprise to anyone, and actually it may be a little optimistic (forecasts usually hit one extreme or another depending on the bias of the forecaster). Daily we see some the major consumers of refined products, airlines-down 50-70 percent, cruise ships-down nearly 100 percent, automobile traffic-no metrics available but we're using less gas, etc., taking down their forecasts of activity for the next few months. This will begin to have an impact.
The graphics that precede suggest strongly we have farther to fall in terms of the crude price.
It hasn't made a lot of news, but tankers started being booked up a couple of weeks ago. The Saudis put the ball in play with the almost immediate chartering of 31 VLCCs, each with a capacity of 2-mm bbl, following the breakdown of the Vienna talks. About a dozen of these will be headed toward the U.S. Folks that's about 24 mm bbl of oil arriving in about 6-weeks. Shell, (RDS.A), (RDS.B) has also taken this step, chartering several VLCCs to store oil at sea.
It should be noted that this is an expensive step with tanker chartering rates increasing 10-fold this month.
Storage is available in refineries now with current utilization of capacity at ~63 percent. Concerns abound going forward though as to spare capacity being rapidly filled with cheap oil as demand suffers.
“We believe we have not seen the worst of the price rout yet, as the market will soon come to realize that it may be facing one of the largest supply surpluses in modern oil market history in April,” said Rystad Energy’s Head of Oil Markets Bjornar Tonhaguen.”
Remember what I said about the last marginal barrel. It's worth far less than earlier barrels, meaning the price could continue to drop.
The air begins to come out of the shale balloon
One of the puzzlements of our major oil producing competitors-OPEC, and Russia, is the lack of discipline in North American shale producers. Why will they continue to produce when they are losing money, confounds them. The oligarchies involved simply cannot fathom the “Wild West” market that reigns in the U.S.
A market with hundreds of producers, all looking to pump out as much oil as they can as fast as they can. By comparison two people have the power to control the flow of about 20 percent of global oil production in Russia and Saudi Arabia. If Vladimir Putin and MbS say close the tap, the tap gets closed jolly-quick. Of course, with the current state of affairs between them, where they’ve said...open the tap, oil floods the market. Things are so much simpler when decisions come down to just a couple of people. Please note-I am not making a case that these are best case outcome scenarios for oil markets, by any stretch. Decision making is just easier.
In an OilPrice article last week I discussed the near-giddy optimism that shale producers had used as their planning basis for Q-1, of 2020. I was attempting to look ahead to how deep the curtailments might become as reality settled onto the Permian producers, that the long-awaited recovery into the $60’s for WTI was still well into the future.
We didn’t have long to wait for the chips to begin to fall. I was a little more pessimistic for the first week’s drop in the rig count, than what was reported by Baker Hughes on Friday, the 20th of March. I’d projected 50, it turned out to be 20, with 11 of those coming in the Permian.
Still more ominous was the drop in FSs’-Frac Spreads (Frac spreads are pumps and associated equipment that provide pressure to frac the subsurface rock.), registered for the same week in the Primary Vision count, down 18 from 298 to 280. We have a lot farther to fall if the 158 count for the second quarter of 2016 is any guide. For reference WTI is currently 60 percent lower than it was when the FS count was 158.
There will be another edition of the Dallas Fed Energy Survey out March 25th, and I will include updates from it in my next article.
Do shale producers need government intervention?
The shale producers in Texas, unable to self-regulate, have taken the unprecedented step of asking the state to do it for them. If you needed any further proof that these folks understand that the Saudi oil-bazooka is aimed directly at them, now you have it. It is also a sign of desperation on their part as the economics of their enterprises declines into the red, West Texas dust.
TNSTAAFL, (There's No Such Thing As A Free Lunch). This is one of my favorite acronyms and up to this point, I would have thought my oilfield brothers and sisters understood it well. We used to. What it means in this case, help- of this sort, will leave them worse off than they perceive themselves being now. The sad thing is…all they need to do is crack a history book, or talk to one of us older oilies. It’s been tried before with disastrous consequences.
Production controls are the inverse of price controls, last time tried with oil in the early 1970's, ironically in response to actions by Saudi Arabia to bolster prices of crude oil. Anybody remember how that worked? I do. It was a train-wreck that threw monster distortions into the market, from which it took the better part of decade to recover.
Note the direction of the curve between the years, 1970-80, and you have your answer. Incentives to drill and produce here in the U.S. were largely destroyed. This idea is probably only topped in absurdity by the one that came after it.
The Windfall Profits Tax of the 1980's. As an ex-crude oil buyer for an independent refinery in the early 1980's, I could tell you stories about the corruption and chicanery this act of federal idiocy engendered. Come to think of it…the statute of limitations has passed and I just may pass along a few stories in future articles.
A final thought on the topic of government intervention, whether at the state or federal level. It won’t go well. It never does. I hope Texas oil producers stop short of actively pursuing it.
Collaboration with OPEC, is it feasible?
Wrapping up this section with a final gem that made the news last week, we need to chat about collaboration between OPEC and Shale producers. To be honest, this is a little hard to take seriously. The idea is simply too absurd, and I think calmer heads will prevail before any serious discussions begin.
The Texas Railroad Commissioner, Ryan Sitton has been in touch with the Secretary General of OPEC, Mohammed Barkindo about curtailing production to shore up prices.
“Just got off the phone with OPEC SG Mohammed Barkindo. Great conversation on global supply and demand,” Mr. Sitton said on Twitter. “We all agree an international deal must get done to ensure economic stability as we recover from COVID-19.“ The Texan official said the OPEC chief had invited him to the next meeting of the organization in June.”
Bottom-line, these two parties have nothing in common save for the desire for a higher oil price. That is not a basis to form a cartel, which would be illegal in this country anyway.
OPEC and U.S. Shale compete for many of the same customers and the thought that under U.S. laws they could "work" together toward the common goal of raising prices or restricting production is just not feasible.
The future of shale
I am convinced it has a future, but the days of boundless expansion are behind it. There will be a period of consolidation as stronger companies take over assets of those who weren’t prepared for the Black Swan event we are living through now. Failure is a part of the Free Enterprise system. It’s part of what made it great.
I can best quote my own words from a prior OilPrice article to close out this section.
“The future of shale belongs to big companies with; Great rock, naturally advantaged oil-prone reservoirs, Superior technology, the ability to frac in 4D as an example, Logistical advantages, raw material supply chain in basin, Low cost of production, relates to naturally advantaged reservoirs, but includes the ability to drill more wells with less money than competitors, Economy of scale, massive acreage positions that enable multi-well pads for efficient draining of the reservoir.”
If you’ve got a strong heart, some investing ideas
Grab your nitro tabs and pop an 80 mg aspirin (with your doctor’s coordination of course!), we’re going to talk about throwing more capital at the oilfield. It has been so long since the oilfield had a winning day, I’m a little out of practice. But, I think we’ve seen a bottom and it’s time to make some money.
Let’s start with Big Red, Halliburton, (NYSE: HAL). They bit the bullet last fall and began writing down their shale fracking equipment. There will be more of that this quarter, I predict.
Last week the company announced the furloughing of 3,500 employees. This is a positive sign as it conserves cash and maintains a core of key employees. The only reason to do this is the company expects to need their skills in the not too distant future.
Liquidity is the key here in making an investing decision. Generally improving international markets had allowed the company to build a $2.3 bn cash position by year end in 2019. Additionally it has $3.5 bn on a credit line available. For 2019 Cash flow covered capex, dividends and stock buybacks. Look for capex, dividends and stock buybacks to be eliminated this quarter, providing the company with ample liquidity over the next year. In 2021 it has a big debt maturity-$697 mm, followed by a year of no debt coming due. In short, I don't think the company faces a solvency crisis as revenues crash this quarter.
This makes the stock as current prices an outstanding buy. I will be looking to add HAL at these levels, ~$5.00/share.
Shell (NYSE: RDS.A, RDS.B) is a buy in the low $20s as well. I've quit using words like "steal," as the price of a stock seems to go down every time I do. That said, I think the company is ridiculously underpriced where it is now, and a rebound back into the $40's will come rapidly when oil crests $30 again. Shell, RDS.B is one of my largest holdings.
You will note that the company's dividend is above 15 percent at current prices. Let's put some risk on the table of a dividend cut or suspension, so we are not looking at Shell for the dividend. (Although, given its almost unmatched dividend record since WW-2 the company has some "prestige," incentive to maintain it.) It could choose to restore the scrip dividend that was cancelled a couple of years ago. This is dilutive but it saves cash, making it my guess as being the way they would go.
Liquidity is always on the table at this juncture in the market. Shell has a combination of cash and credit lines of about $18 bn of liquidity and free cash flow of about $20 bn. Shell has no immediate liquidity concerns. Capex and stock buybacks will be slashed and suspended. Some of this was already in the works as of the Q-4 call.
As a Dutch company, should the need arise, the government of the Netherlands, would surely step in to maintain the company's viability as well.
I am not buying on Monday though. The shares have rebounded 20 percent from absurdly low levels. We will have a rout or two the coming week, and those days will be the ones to watch to maximize eventual returns.
Note- Shell has two classes of stock A, and B. I buy only the B as it is not subject to the 15 percent Dutch withholding tax. Taxes on the A can possibly be reclaimed on your U.S. return, but why add complexity, buy the B.
Governments around the world are adapting to the new viral-reality. Trade is impacted, reducing demand. This won't last forever and as things begin to return to normal demand for oil will pick up. Given the huge storage problem we are about to have, it will take some time before inventory levels come down though, enabling prices to rise to more sustainable levels.
The basic thesis for hydrocarbons remains intact despite the current fall-off in demand. They supply an irreplaceable amount of energy for many key uses, transportation and power generation key among them. Nothing on the horizon changes that equation for decades.
As the global economy recovers, this energy will be needed. It will likely come at higher prices that will enable producers to make a profit, which will of course then result in over production and a future price crash. It’s not called a “cyclic industry” for no reason.
By David Messler for Oilprice.com
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