Bonjour Volatility – Reasons to be Cheerful 1 2 3…

More musings on the oil price, I know, I know – it’s a mug’s game…

Part 1: Short Term

Somehow, oil is holding above $40.   Notwithstanding the details, the US continues adding oil into storage (+3mmbbls yesterday) – and we have several ephemeral events taking production offline and propping up the price (Kuwait strike, Forcados down and now issues at Escravos, Libya, etc)…  But fundamentals are really no different now than they were in February (albeit with even more in storage).  Now, I fully buy into the narrative around the coming rebalancing – and am more and more convinced it will result in a big overshoot in the other direction (hence a recent public utterance of mine of $85-90 in Sept 2017).  But today (and in the next few months) I don’t see that rebalancing happening in this time span… so am back to fundamentals and scratching my head why we are at $45 today…  
That being said, the whole situation is becoming pretty unstable – the outages in Nigeria don’t look like random events.  

How about this for one coming out of left field: Venezuela which produces just under 2.5mmbbls/day produces roughly 70% of its electricity from hydro power.  Their dams have, along with everything else been poorly maintained and managed, and are currently drought affected – the key Guri dam is 3ft above its minimum water level – so pretty soon the lights will start to go off.  Now how many of Venzuela’s 15,000 wells have electrically driven pumps?  I don’t know the number, but I’ll bet it is a huge proportion…   and when the grid fails, Venezuela will resort to generators to power the wells and to power homes and businesses, so we can expect domestic consumption to increase and exports to decrease.  

So as the Kuwait strike fades, it is possible something bigger will take its place and prop prices up… who knows?

So who holds the cards?

Saudi says it has unused excess capacity of 1mmbbs/d – which is a stretch on top of its current near-record 10.5mmbbls – but given the investments over the last few years, reported to be in the $100m range, it is possible.   Does make you wonder about the possible damage being done by over-pulling on some of the older reservoirs…  

Iran – I am definitely in the doubters camp here – the lifting of sanctions has been partial, and whilst there is a lot of call for capital, the equity model doesn’t work well without debt lubricating the wheels – and the banks are likely to be very cautious on the combination of oil and Iran – so yes, but slowly slowly… oh and the fields are complex (compared to say Iraq or Saudi) and the fiscals are not yet attractive….

Russia – as noted below, they just put the brakes on big-time…

US LTO – several points need to be considered:  (1) speed of “shale 2.0” – rigs are available, but hundreds of thousands of seasoned workers have been let go – and many may not be ready to come back at the drop of hat.   Even if they are, there is also the availability and cost of financing to consider.  (2) actual resources volumes that will work at lower break-even costs ( are currently getting down to sweet spots, whilst these appear to be huge in Marcellus and Utica gas plays, their extent is less clear in oil plays – the Baakan is down and out for a while, whilst some bits of the Permian continues…)  – so as GCA put it recently – this is a supertanker that will turn slowly, but turn it will.

Iraq – an outsider – but whilst chaotic is not a player, but has the potential to do 8-10mmbbls/day of cheap unit cost oil (according to some) – which makes it a substantial wildcard – but not one I’d bet on in the window being discussed.

Part 2: Medium Term

You know that feeling on a roller-coaster when you are in a deep dive and you start to feel the G-forces increase as you approach bottom, and you know the run-up is coming…  we’re on the way down screaming our heads off.

Depletion is a basic fact of the oil and gas business.  Any given accumulation of oil and/or gas is finite: you take some out and the accumulation has depleted. the deflating balloon analogy is a good visual reminder, and a good summary read here.

Everyone in the industry knows this, and most commentators in the mainstream get it.  Reserves Replacement Ratios are important metrics of oil companies; why? because if you can’t replace your reserves (which are being produced) you will become the “magical shrinking oil company”.

On a global scale, conventional supply is always forecast with a 2% to 4% annual average decline.  This is historically probably pretty accurate – but without wishing to jinx everything – “this time it is different”.  Why?  Well the key is maintenance capex.   As oil prices fall, you cut unsanctioned project Capex first (pre FID projects, discretionary exploration wells etc.), you squeeze Opex via service companies and G&A, but when it gets really tight, you ease up on maintenance capex.  This is probably the biggest known-unknown in the current downturn.  In the 2013 IEA Energy outlook report it was suggested that whilst the average decline would be 2%, the decline of mature fields (which make up >60% of the world’s production) would be 6.5%; and this would rise to 9% if maintenance investment was cut.

The current downturn is almost unprecedented in the history of boom-bust cycles – and so there is little historical data on the effect of prolonged under-investment in maintenance capex, but there is increasing anecdotal evidence.

Not picking on Venezuela in particular, but helpfully a figure is available –  and guess what? its not happening…

Oil industry experts suggest that PDVSA needs to invest at least $3 billion annually into its existing fields just to maintain current production levels.

Another big one in the news this week  (FT) – Russia has decreed (to fix a rather big hole in its national budget due to, er low oil prices…) that eight SOEs must pay 50% of their distributable profits as dividends (i.e. mainly to the government).  This will impact Gasprom and Rosneft very hard.  Whilst they have benefitted from low local costs over the last 18 months (due to Rouble weakness), they have maintained investments and Russian oil production is at an all time (post soviet) high.  This trend will now invert as capital is diverted away from capex.

So medium term I see a significant drop in both US unconventionals and world-wide (especially non-Opec) production through natural attrition.  The “rebalancing” will overshoot into a supply side crunch.   Sometime…

Part 3: The Longer Term

If  you have rest this far – congrats.  This post is turning out far longer than I expected…. but to avoid repetition – my view on the longer term was published here.  To summarise: demand destruction will lead to a shrinking oil industry.

To add to the argument on demand destruction – I previously focused on oil being used in transport.  Just under half is used in PetChem – and even this could be disrupted by technology in the post Cop21 world.

The last man standing will be the lowest unit-cost production, and we all know where that is.  However, this doesn’t necessarily mean low prices and low volatility – because if/when prices become depressed from lower demand (and to be clear I am talking about lower demand driven by energy transition, rather than global recession), there will be the potential for huge geopolitical instability as 60 year old power balances and alliances shift (Saudi pivot to Russia etc).  Equally there will be local instability – Nigeria has a massively booming population and historically catastrophic mismanagement that has been partly mollified by petrodollars.  The transition to a (better) more diversified economy could be very painful indeed…

 So even in a significantly shrunken industry will not be immune from the familiar boom and bust cycles.   This will make traders happy, but make project planning a nightmare…  So my next post will take a look at the “Death of the Mega-project”.

For those who like the math this is an interesting analysis of oil price history using the signal processing of Fast Fourier Transforms to extract frequency events…

The Futures Curve is always a nice smooth line, typically curving up or down to meet some recent historical average.  It is always wrong.  Obviously there are innumerable permutations, but one thing is for sure – it will be no smooth curve to a stable average.  My guess is down, then up, overshoot and back down again, with significant volatility.  At some point the US shale industry will ‘right-size’ and act as the dampener to this dynamic. But not on this current cycle.