When the wheels fall off

In a previous post I wrote about how I thought geopolitics was being ignored and ought to come back into the oil price equation – it looks like that is starting to happen, the threat by Turkey of shutting of Kurdish exports made a strong point, not ignored by the market. At the same time, surprise, surprise, demand is picking up “more than expected”

The wisdom of the crowds is a nice idea, can result in some surprisingly accurate results. However, we all know about the myriad cognitive biases that afflict us poor humans, and as Ben Horowitz notes in “The Hard Thing about Hard Things”, group think can be very efficient at reaching the wrong conclusion. We have seen this (in my opinion) spectacularly in the past couple of years with the “Lower for Longer” mantra becoming “Lower Forever” as the demise of the ICE is gleefully forecast.  Perhaps that’s a bit harsh, as even those of us in the industry recognize that 100 year old technology is perhaps neither the most efficient form of transport nor the best use of a precious resource like oil.

Murmurations from the Permian

If you have ever watched a large flock of birds swirling and diving in majestic, artistic patterns at dusk, known as murmurations, you will have been amazed at the synchronization of so many individuals – a marvel of collective communication. It turns out this behaviour can be modelled very simply – using just a few rules, the collective can be seen as complex emergent behaviour. Simply put, any given bird is watching just one or two birds on its immediate wing tips, reacting to their movement to follow and avoid collisions.  Minor errors in synchronization provide the randomness and results in the beautiful patterns…

Mainstream media seems to work in much the same way – don’t bother with analysis or thinking, but react to the current zeitgeist; collectively building symphonic crescendos of “thought” patterns. Peak Oil was one such… Peak Demand is another (as per my premature blog post). As much as I am a fan of EVs, the transition to EVs and the death of oil is an example of this kind of feedback loop, boosted by the powerful steroid of wishful thinking.

“The problem with the oil market right now is that while it seems to want to trade the next decade’s potential slowdown in demand, it is ignoring the fundamental reality that exists today,” said London-based consultancy Energy Aspects“Investors remain transfixed by an as-yet unrealised energy revolution.”

The murmuration of oil stories is now wheeling around, and the there are an increasing number picking up on the idea that we may not be able to sit back in the luxury of having a lake of cheap oil over-supplying the market until we all drive Teslas. Ironically it is a form of Peak Oil swinging back into view. Not the 2009 Peak Oil, whereby we will run out, but the 2017 Peak Oil where it is actually expensive to get at.

Peak Cheap Oil

We are well past the era of cheap oil. This is wonderfully captured by Art Berman,

When you hear “unconventional oil”, think “expensive oil”

Back in February 2016 I wrote about how Shale 2.0 was going to be much more expensive. A post again, somewhat premature. But that flock of starlings is coming home to roost (now just making up my metaphors). The words to watch out for are “capital discipline”. These are creeping into company statements as well as equity and debt conversations. Roughly translated, and in common use in most places apart from Silicon Valley and the Permian Basin, this means don’t spend more than you can earn. A noble objective, and one that is easier said than done.

Gunning for growth has been an objective – driven by two factors. Firstly, the unusual “hold-by-production” land rights – if you don’t drill you have to give up the lease, so drill baby drill. Secondly, if you have enough producing wells, all of them mature, with the decline rate as modest as the production rate, the ensemble can actually make good money – especially if you forget about all the sunk costs it took to build that portfolio. The gas plays of the Barnett are actually making quite good money for the incumbents.

The problem is that living within your means, with Revenues minus Costs leaving a bit left over for Capex, doesn’t leave much, if any, room for debt repayments let alone equity returns.. oh and your production is stagnating, if not out-right falling off a cliff….

By some reckonings, the main shale players have a collective $200bn of debt. In the linked article, there is a questionable assumption or two – it assumes that all this debt is only on the shale plays (which it probably isn’t) and it assumes that you can repay debt with wellhead revenues (you can’t, as above, you have Opex and G&A).

Notwithstanding this, if we assume only half that debt is backed by shale (say $100bn) and has no interest payable, and you guess a generous netback – say $20/bbl.. you would need to produce c. 5 billion bbls just to repay the debt. Equity take a back seat. Oh and at the same time, your financial firemen are turning off the taps, repeating in your ear “Capital Discipline, Capital Discipline”… How many new wells would be needed to produce 5bn bbls from a shale play? at what cost?

  • By some estimates (RBC) the US will need to invest $50bn per year, just to keep production at today’s levels.
  • Storage is fast reducing to pre-glut levels, which has been a damper to supply side questions.
  • When capital dries up for the shale, it will decline at 35% per annum… so the current 5mmbbls/day will reduce by 1.75mmbbls/d in a year – with nothing obviously available to replace it.
  • The latest estimate is that demand has increased 1.7mmbbls/day in the last year – despite the headlines about the end of oil.

There are still several big projects, sanctioned in the 2010-2014 period (or earlier) yet to come on-stream, so there is no obvious “cliff-edge”, but the potential to swap rapidly into supply-side issues is clearly real.

Einhorn’s “The MotherFrackers” hasn’t happened as he suggested… yet, that doesn’t mean its wrong – he may yet be proven right – If the numbers are to be believed, it’s just a question of time. Without wanting to labour the point – there were people who were right about the sub-prime bubble, but acted too early, some rode their belief and made fortunes, as described in The Big Short, others who rang the alarm bell were simply cast aside. 

The heroes of The Big Short knew the trigger (variable rate mortgages switching from low teaser-rates to higher variable rates), and still almost got burned on timing… we have no such obvious trigger…. So timing is a huge unknown, but the indications are there.

The markets have been so focused on the feel-good story of “shale will provide limitless oil until we all transition to EVs by 20[25]” that it has taken a while for the murmuration to start to swing around. This narrative is so wrong that it is creating a dangerous complacency around supply, and indeed even affecting US foreign policy, with the US leaving a void gleefully being filled by Russia… but I digress.

A question to end with, and don’t be shy, use the comments box. How many barrels of oil per day are removed from the demand side by replacing 1 million ICE vehicles with 1 million EVs ?