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Leonard Brecken

Leonard Brecken

Leonard is a former portfolio manager and principal at Brecken Capital LLC, a hedge fund focused on domestic equities. You can reach Leonard on Twitter.

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Saudi Price War Strategy May Blow Up In Their Face

This morning markets woke to rising Middle East tensions which cause upward pressure on prices offset by headlines via Reuters “Naimi says Saudi oil production near record high in April”. OPEC output is up 810,000 barrels from the previous month while Saudi Arabia has seen output eclipse 10.4M/D, up from 10.3M/D the previous month, setting a new record. What Reuters fails to report is that demand is also soaring and that is why OPEC is increasing production. After all, the Saudi Oil Minister stated that the uptick was in response to what their customers (mostly in Asia and in particular China) are demanding. In other words the media once again construes the fact that higher supply is bad for prices as it fails to mention that it’s a response to much better than expected demand.

According to Cornerstone Analytics, demand is up some 1.7M/D in 1Q15 vs. initial estimates from others of less than 1M/D average rise for the year. So the price drop is clearly seeing a demand response. The recent monetary easing in rates and reserves by China will only help to increase demand further from here. Remember the cries that the oil “glut” was because of weak Asian demand (another in a long series of deceptions)? Cornerstone Analytics goes on to say this morning, that OPEC can’t meet its call and that will become self-evident as prices rise to $85 for Brent by years end. Personally, I think $75-80 is more conservative and realistic into 2016. Related: Wall Street Bets On Oil Price Rally

The Saudis are clearly trying to crowd out the marginal high cost players and by doing so incrementally recapture their market share. This was their strategy all along and increasing output is consistent with that strategy. It does render a June OPEC moot and an output cut also unlikely. Russian agreement appears unlikely and the Saudis have repeatedly said they won’t cut unless non-OPEC follows. If this turns out to be the case, seeing an $85 Brent price seems unlikely even into 2016, especially in light of all the other forces against such a rise. Some of which include: the relentless producer hedging that is flattening the price curve at present which will act to maintain production; or the reduced buying by non-commercial investors either as a result of media bias or as an attempt to keep prices low to boost economic growth. Related: Is This Where Investors Should Be Looking When Oil Recovers?

Valuations in the E&P space as measured on an EV/EBITDA basis aren’t cheap either, granting a lifeline to restructure as well. The question is does the Saudi math work on these assumptions? If Saudis produced 9.5M/D @ $85/B that’s $807M/D vs. the current output of 10.4M/D assuming a more reasonable $75 in 2016 they are making $780M/D! So the Saudis rant that they have no agenda and act based on rational economics but when you look at it this isn’t rational at all. The cost reductions occurring in US production, which the Saudis probably underestimated, are running near 20% so this strategy of crowding out really isn’t working very well and other OPEC members probably agree. Related: OPEC Says US Oil Boom Will End This Year

One final comment: Morgan Stanley this morning, in their weekly energy review, had a full page of explanation of how markets shouldn’t get too excited by EIA estimates of production declines. Thump as once again one falls off their chair. Now MS has probably been the most level headed and unbiased of all the brokers. But it is self-evident that the EIA flip flopped and has clearly been over-estimating production while understating demand and so now we should dismiss it? MS goes on explaining how weekly estimates get revised on a monthly basis and that EIA tends to use extrapolation in estimation, tending to underestimate in times of rising production only to overestimate when the trend reverses which, by the way, has been the point here all along. We are, within the next 4-6 weeks, ready to witness the reversal of the production increases in 2H14 and the EIA is clearly not equipped to capture it.

By Leonard Brecken for Oilprice.com

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