I have spilled a fair amount of ink trying to explain the drivers behind short / medium term moves in oil prices over the last couple of years. Links to some of the recent write ups below:
https://palebluedot284.wordpress.com/2019/01/10/what-went-wrong-in-2018-and-the-path-to-recovery/
https://palebluedot284.wordpress.com/2018/11/12/c-rude-awakening-part-ii/
https://palebluedot284.wordpress.com/2018/08/19/c-rude-awakening/
In most of these blog posts, I have also tried to highlight the longer-term supply/ demand factors that have kept me bullish on my E&P investments in Gear and CRC. However, this has not prevented people from doubting my longer-term road map. How can one continue to believe in the long-term bull thesis for oil after the kind of sell-off we experienced in Q4? Both Gear and CRC lost 50-60% of their market capitalizations in a matter of weeks. As I have admitted in the past, I have been wrong about several things: OPEC spare capacity and desire to bring new supplies to the market, a rotation from growth to value stocks, a slowdown in US shale growth, a bear market cycle for USD… the list goes on and on. From an outsiders perspective, holding concentrated positions in the these stocks despite being wrong on so many variables can appear reckless.
This multi-part series is an attempt to address these concerns and provide some snap shots of my thought process. What am I seeing that prevents me from giving up on this thesis (and in fact deploying more capital towards it)? Is it simply a combination of stubbornness and confirmation bias? Or is there really a rational, long-term argument to be made?
I thought it would be worthwhile to write a focus piece that digs deep into the longer-term issues facing the oil market, and lay out a road map for what to expect over the next few years. I hope to demonstrate that some of the variables I have been wrong about are simply a matter of timing (e.g. Shale slowdown is a matter of when, not if) and others (macro factors like a weaker USD, or a rotation out of growth stocks) will be overshadowed by stronger underlying forces currently at play.
I continue to think that putting an exact expiration date on this thesis is impossible, and the correct approach is to buy and hold good quality E&Ps while while keeping a close eye on the key data points that validate the long-term thesis.
I think there are four major pillars holding up the long-term thesis:
- Under-investment in conventional oil production
- Over-reliance on Shale growth to meet the world’s oil demand growth, and associated problems (sustainability of shale business model and crude quality issues)
- Oil demand outlook
- Fiscal situation of the largest oil exporting nations
But first, some historical context on oil price sell offs from Goehring & Rozencwajg (http://gorozen.com/):
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Since the oil price crash of 2016 investments in conventional oil production have dropped dramatically and are inadequate to meet long-term demand growth. I’ve mentioned this several times on the blog, but let’s go through the details once again as a refresher.
Based on modeling done by HSBC with the help of data from Rystad Energy, ~50% of the world’s oil supply is post-peak and in decline (remember that unlike other commodities, oil production curve is not flat, but roughly like a bell curve with both an incline and decline). The remaining ~50% includes US shale wells / tight oil growth, new conventional projects in ramp up phase, natural gas liquids and biofuels. The implications of this can be illustrated through the following chart:
If decline rates on this post-peak production continue to average 4-6% as currently observed, the world is going to lose 28-35mb/d in oil supply over the next ~20 years. This implies production decline equivalent to 2-3x Saudi Arabia’s current production. On an annual basis it’s a production losses of 1.8-2.6mm b/d.
Of the 20+ major oil producing countries HSBC looked at for this analysis, decline rates accelerated in the vast majority (18). This is largely due to the drop off in capex deployed towards mitigating decline rates / maintenance activities.
Generally speaking, the sources of oil supply growth are dwindling to a few ‘haves’ vs. an increasing list of ‘have-nots’ (i.e. countries that are not capable of increasing production due to lack of investment and other structural factors). Significant production growth capacity today lies with the U.S., Saudi Arabia, Brazil, Venezuela and Iran (post-sanction).
Brazil production growth estimates by the IEA have been consistently overoptimistic, with both 2017 and 2018 ending with close to zero growth (see chart below). However, this hasn’t stopped the IEA from continuing to publish optimistic forecasts. 2019 data so far shows that production is declining with 2,489 kb/d production during February, down -142kb/d from January and 2018 average of 2,587 kb/d. As the past few years have shown, there are clearly some structural / engineering issues that need to resolved and more capital investment needed to generate consistent production growth.
Iranian sanctions are going to be in place until at least 2020 (i.e. the next U.S. presidential elections) based on the Trump administration’s hawkish stance towards the country. Increasing production back to pre-sanction levels will take at least 6-12 months (based on what was observed during the last round of sanctions) and significant amounts of foreign capital investment will be needed to grow Iranian production past pre-sanction levels. Such a capital infusion is unlikely given the political instability in the region and Iran’s volatile relationship with Western powers.
Venezuela has very significant oil reserves, but the recent political and economic climate has led to severe structural damage to oil facilities and brain drain. It will take several years of political stability and influx of capital and engineering talent to recover lost supplies.
In summary, there will be no significant production increase from these three countries for at least the next 1-2 years. In fact, there is an increasing possibility of further production declines from Venezuela as the situation there seems to have approached a stalemate and a prolonged crisis is likely (see light green line in the chart below).
In 2018 Rystad Energy estimated that the global oil and gas industry will spend only $440 bn in the 2015-2020 period on new investments, nearly 50% below the $875 billion the industry spent between 2010 and 2015. So far, legacy conventional projects with long lead times that were approved during the 2010 – 2015 era are still being delivered (3-4 year lead time), and are keeping the conventional oil production base relatively stable (e.g. Guyana and Johan Sverdrup recently). However, in 2021+, the supply contribution from conventional projects in most countries drops off dramatically.
In their 2017 Q4 letter, Goehring & Rozencwajg estimated that since the start of the shale oil revolution in 2007, discoveries of conventional oil (not including shale) have totaled approximately 110 bn barrels while consumption has totaled 360 bn barrels. Meaning that consumption has outstripped new discoveries by a whopping 250 bn.
The data above point to an inescapable and disconcerting conclusion: the world is relying primarily on only two sources of supply growth, the U.S. and Saudi Arabia, to avoid a long-term energy crisis. The key question oil investors is: will this dwindling list of ‘haves’ be able to overcome a) natural declines AND b) demand growth over the next 5-10 years? We will explore the answer to this question further in Parts II, III and IV.
The Pale Blue Dot 