- The oil markets have hit multi-year lows on unsubstantiated theories about a supply glut and fears of cooling demand.
- Meanwhile, the geopolitical risks around the world have oddly disappeared in H2 2015.
- Nevertheless, the facts prove that the real thing is way too far from evaporating geopolitical risks or a material deterioration of the global supply-demand fundamentals that can justify a slump.
- The unprecedented downward pressure on oil prices is a headline-driven and sentiment-driven event.
- The oil price will definitely rise significantly in 2015.
The stock market will always give the investors a chance to make a blunder, especially for those who allow emotions to overrule facts and factual thinking. The emotional blunders are part of the game in the stock market. And if you run your portfolio based on lame-thinking and emotion, you will most likely follow the herd mentality and sell at the wrong time, because lame-thinking and emotion will always cloud your judgment.
Things get worse for your portfolio when you allow the analysts and the opinion makers who show up daily on CNBC and Bloomberg, to tell you what is really going on with a sector. To me, many of these guys are not just incompetent. To me, they are dangerous because their advice can ruin your wealth in a record time. It is easy to throw out statements without backing them up with any math, and it is easy to make overly simplistic interpretations of the global supply/demand dynamics. “So easy even a caveman can do it,” as GEICO’s commercial states.
And as clearly illustrated by the following charts, insanity and panic are currently hovering over the oil markets, due to the fact that many incompetent oil prognosticators have flooded the media with their lame opinions over the last months. For instance, the charts for the bullish ETFs (NYSEARCA:USO), (NYSEARCA:DBO) and (NYSEARCA:OIL) that track WTI are below:
This is the chart for the bullish ETF (NYSEARCA:BNO) that tracks Brent:
All these bullish ETFs have returned back to their 2010 levels amid irrational fears for oversupply. But, these fears are completely unsubstantiated and they do not justify at all the sentiment-driven slump in the oil price over the last 4 months.
Andre Kostolany and The Oil Price
Obviously, all these sellers ignore Andre Kostolany who has said that:
“Imagine a man walking, one step at a time, on a country lane for a mile or so. He is accompanied by his dog, which follows the man like a dog follows his master: one step forward, one step backward. While the man is walking slowly, his dog is jumping around back and forth. There will be times when the man is ahead; he will wait for the dog and then there will be times when the dog is ahead and the dog will wait. In this example, the man represents the economy, and the dog the stock market.”
And for those who do not know Andre Kostolany, Kostolany is a stock market legend. Kostolany’s great quote describes what is going on with the oil price these days. The dog (oil price) currently is behind the man (oil supply/demand dynamics) and will catch him sooner rather than later.
In other words, I am a strong believer that Brent is not going to stay below $75/barrel for long, and the dubious Thomas are welcome to read the facts that will propel Brent higher than its current levels by early 2015.
What They Were Telling You In 2013 And H1 2014
Back in 2013 and H1 2014, when Brent was trading around $110/bbl, the analysts and several other opinion makers were calling for oil to hit $150 per barrel. Let’s see some more details and the reasons behind these calls:
1) In H1 2013, the U.S. Department of Energy reported that China overtook the U.S. as the world’s largest net oil importer. That was the time when a report from the Paris-based OECD (Organization for Economic Co-Operation and Development) came out and noted:
“Based on plausible demand and supply equations, there is a risk that prices could go up to anywhere between $150 and $270 per barrel in real terms by 2020, depending on the responsiveness of oil demand and supply and on the size of the temporary risk premium embedded in current prices due to fears about future supply shortages.”
OECD also noted in that report:
“There is a strong price increase needed despite this new oil production coming on stream.”
2) In H1 2013, Energy Aspects, an energy research consultancy, noted as linked above “All estimates point to Asian demand propelling growth.” It also said that the implications of the U.S. shale-oil boom could be overstated for the rest of the world if demand from Asia keeps up.
3) In H1 2013, some analysts from Goldman Sachs wrote that Brent crude oil prices could rise to $150 per barrel in H2 2013 because:
“Despite the boom in U.S. shale gas, the oil price remains high, which he attributed primarily to sanction-related supply disruptions in Iran. Trying to compensate for this, Saudi Arabia has already increased its oil production to a 30-year high this year.”
Mr. Currie added that:
“While global oil demand has increased at a slower pace, it is still higher than the production increases in non-OPEC countries. Upside risks for oil prices include low inventory levels, limited OPEC spare capacity, and geopolitical risks which are likely near an all-time high with production in a very large number of countries at risk, including Egypt, Iran, Iraq, Libya, Nigeria, Sudan, Syria and Venezuela. Europe still faces economic and policy headwinds, China just experienced a significant food inflation surprise (and the livestock impacts from last year’s agriculture price spike will only be felt this year) and the US still faces risks from the debt ceiling debate, the automatic spending cuts (or “sequestration”) and impending tax increases.”
4) In H2 2013, when Brent was still around $115/bbl, the French bank Societe Generale said:
“Brent crude is likely to rise towards $125 a barrel if the West launches airstrikes against Syria, and could go even higher if the conflict spills over into the rest of the Middle East.”
5) As linked above, another report from JBC Energy in Vienna said in H2 2013:
“Current developments such as low spare capacity in Saudi Arabia, stockpiles falling in the U.S., disappointing supply developments around the world and signs of an improving global economy are pointing to tighter markets.”
6) In late 2013, the analysts at the National Bank of Abu Dhabi in UAE noted:
“Average oil price was $112 per barrel in 2012. The average price of crude oil is forecast at $105 per barrel in 2013, $101 per barrel in 2014 and $100 per barrel in 2015. The base case is for oil prices to soften mildly, but remain close to $100 per barrel through 2018. Thereafter, prices rise by a few dollars each year in this scenario.”
7) Even a few months ago in June 2014, the analysts were telling you:
A) This is from Nordea Bank (OTCPK:NRBAY):
“If Iraq, accounting for 3.7% of the world’s total oil production, suffers a serious disruption to its oil supplies, we will see a sharp upswing in oil prices as the OPEC effective spare capacity buffer is low, making the global oil market highly sensitive to further supply disturbances. If Iraqi oil production would fall back to the low levels seen during the invasion of Iraq in 2003, oil prices could easily rise by up to $30 a barrel as this would push the global spare capacity back to the lows when oil prices reached $150 a barrel in July 2008. High oil prices would put the world economic recovery at risk.”
B) This is from PVM Oil Associates:
“The deteriorating situation in Iraq could be the source of an oil price and therefore a financial shock should be sending economic-growth forecasters back to the drawing board. There can be no doubt that if Iraq’s southern oil operations are impacted Brent could reach $125 a barrel and beyond. Saudi Arabia may have 2 million barrels a day of capacity it can turn on reasonably quickly but that leaves no spare capacity margin.”
C) This is from Commerzbank (OTCPK:CRZBY):
“It is hard to imagine that the oil production in northern Iraq will return to the market in the foreseeable future. So far, oil production in the south of Iraq, which accounts for 90% of Iraq’s oil exports, has been unaffected by the fighting in the north and center of the country. However, the sharp price rise in the last two days shows that this oil supply is no longer viewed as secure, either. Without the oil production from the south of Iraq, the market would be stripped of an estimated 2.5 million barrels per day.”
D) This is from the research consultancy Energy Aspects:
“Look at any forecast, they are calling for Iraqi production to be around 7-8 million barrels a day by 2018/2020 for oil prices to not rise substantially. And I think that’s the key, because that’s not going to happen. If this is contained within Iraq that’s one thing, but there’s a very different implication if it becomes a bigger regional conflict. That’s the biggest problem. Iraq’s at the heart of this big oil-producing region.”
What They Are Telling You In H2 2014
Let’s see now what the analysts and several other oil experts have been telling you lately:
1) In October 2014, Goldman Sachs slashed its 2015 oil price forecast. Goldman sees Q1 2015 WTI crude at $75/bbl versus $90/bbl previously and Q1 2015 Brent at $85/bbl versus $100/bbl previously. The U.S. investment bank said rising production will outstrip demand, joining other oil analysts who predict consumption will be dented by slower global economic growth and lead to a supply glut.
2) Other analysts who joined the bearish party lately, predict that the bear market in crude will continue with prices falling as low as $50 a barrel, in part because the global economy is slowing, pushing supply levels higher.
3) In late October 2014, fellow newsletter editor Dennis Gartman showed up and implied that oil could go to $40-$50 per barrel because among others, Lockheed Martin (NYSE:LMT) was working on a compact fusion reactor that could be ready within 10 years. He said:
“Fusion is going to be the great nuclear power of the next 150 years. And finally, we are driving less and less. We are using so much less gasoline than we ever have, in global terms, in national terms, in per capital terms. All of those things, I think, are going to be weighing heavily on crude oil. And where could it go? A lot lower, a lot lower.”
So within ten years from now, we will fit a nuclear fusion reactor on the back of our cars dumping our gas tanks. Let Star Trek come to life! Obviously, Gartman’s thesis also implies that Star Trek’s high-tech, innovative and game-changing tools will be on clearance, so all the people from China and India to Africa and America will not afford to overlook this irrationally cheap nuclear fusion reactor. I don’t even understand why an investor can take Gartman’s approach on oil seriously.
4) The technical traders also showed up a few weeks ago calling for $40/bbl, based on the following chart:
2013/H1 2014 vs. H2 2014: No Major Fundamental Change While Geopolitical Risks Deteriorate
According to Forbes, these are the world’s biggest oil consumers today:
1) United States.
5) Euro area.
As also shown in the previous paragraph, the calls in 2013 and H1 2014 for $150/bbl were based on the geopolitical tensions in the Middle East and the expectations about global growth with a focus on demand from the growing Asian markets, which are high in the list with the world’s biggest oil consumers.
And the facts below prove that nothing has changed over the last six months to justify a drop of 35% in the oil price that has occurred lately. In contrast, the geopolitical risks in the Middle East have deteriorated, and the security situation both in Iraq and in Libya has worsened recently. Even International Monetary Fund [IMF] admits that the geopolitical risks have worsened since H1 2014, according to its latest report.
Also, the world’s biggest oil consumers are growing at rates that either are in line with 2013 rates or exceed expectations. There is nothing to indicate that global supply and demand imbalance has fundamentally changed in the past six months. There is just too much speculation, emotion, panic and short-term lame thinking that have been used to determine the value of the oil price lately, and this slump in oil prices is clearly a result of sentiment and emotion.
Let’s proceed now with the facts:
1) Geopolitical risks deteriorate primarily due to ISIS, Iran and Libya: The extremist Islamic State of Iraq and Syria (ISIS) is still there, and the U.S. military and its allies hit ISIS forces with 15 air strikes in Iraq and Syria during a three-day period, The U.S. Central Command revealed a couple of days ago. Thirteen attacks were carried out in Iraq since last Wednesday and two more targeted Islamic State in Syria.
Meanwhile, ISIS keeps advancing in Iraq and Syria, after seizing Iraq’s second largest city Mosul on June 10th. The attacks have been escalating since 2013 and H1 2014, while American, British and Syrian soldiers were beheaded in October 2014 and November 2014, which is confirmed by Obama Administration. Apparently, there is no improvement compared to the situation in 2013 or H1 2014.
Furthermore, world powers failed to reach a nuclear agreement with Iran last week and extended talks for seven months. This means that the Western economic sanctions are not going to be lifted anytime soon, freezing the ability of Iranian banks to conduct international transactions while Iran’s daily oil export restrictions will remain too. This also means that Iran will continue working on its nuclear program by the summer of 2015, impacting negatively the destabilization risk in the region. And there is obviously no improvement compared to the situation in 2013 or H1 2014.
Also, there is no risk improvement in Libya compared to the situation in 2013 or H1 2014. In late August 2014, Libya’s ambassador to the United Nations warned of “full-blown civil war,” if the chaos and division in the North African country continue.
Libya currently has two competing parliaments and governments. The first government and elected House of Representatives relocated to Tobruk a few months ago after an armed group from the western city of Misrata seized the capital Tripoli and most government institutions, as well as the eastern city of Benghazi. The rival previous parliament remains in Tripoli and is backed by militias.
And just a couple of weeks ago, Libya’s political strife intensified as the rival government that has seized the capital took control of Libya’s largest oilfield (El Sharara), according to Reuters. Libya’s oil production rose above 900,000 bopd in September 2014, sharply above lows of 100,000 bopd in June 2014, but it has already fallen to around 500,000 bopd at most, as a recovery in Libya has faltered so far, according to Reuters. This translates into a material drop of approximately 400,000 bopd from Libya only.
2) GDP Growth Rates: Let’s take a look now at the GDP growth rates of the world’s biggest oil consumers:
A) United States: According to the latest news of September 2014, the U.S. economy grew 4.6% in Q2 2014, exceeding earlier estimates. And according to the latest news of November 2014, the U.S. economy grew 3.9% in Q3 2014, exceeding once again the consensus estimate of 3.3%, as illustrated below:
B) China: China grew 7.6% in 2013 and grows 7.4% (on average) to date, as shown below:
Also, China’s GDP per capita continues growing in 2014 at the same pace it has been growing over the last couple of years, as illustrated below:
On top of that, the Chinese central bank initiated an easing cycle just a few weeks ago. How can a serious investor ignore this initiative that will have material effects on China’s future growth and China’s oil consumption of course?
C) Japan: The Japanese economy grew in Q1 2014 and contracted in Q2 and Q3 2014, as illustrated below:
But on average, Japan grew 1.52% in 2013 and grew 0.89% in 2014 too, based on the three quarterly GDP figures to date.
Additionally, Japan’s GDP per capita continues growing in 2014 compared to 2013, as illustrated below:
D) India: As shown below, the Indian economy grew 4.5% in 2013:
i) “There is no light at the end of the tunnel visible in India’s GDP release.”
ii) “It was slightly below expectations but I feel the overall growth rate of 4.9% would be achieved this year (2014)” said C. Rangarajan, Chairman of the Prime Minister’s Economic Advisory Council.
iii) “These numbers clearly show that attaining a growth rate of 4.9% in 2014 is not possible.”
That was also the time when Brent was around $110/bbl and all the oil prognosticators were projecting $150/bbl, as shown in the previous paragraph.
However, the Indian economy picked up steam and rebounded to a 5.7% rate in Q2 2014 from 4.6% in Q1 2014, led by a sharp recovery in industrial growth and gradual improvement in services.
And under the Modi government and thanks to a series of fundamental economic reforms, the Indian economy continued its growth and grew 5.3% in Q3 2014, as illustrated below:
Needless to mention that these GDP rates in Q2 2014 and Q3 2014 were well above the analysts’ expectations.
Additionally, India’s GDP per capita continues rising in 2014 compared to 2013, as illustrated below:
And according to yesterday’s news from Reuters, Indian factory activity expanded at its fastest pace in nearly two years in November 2014. The HSBC Manufacturing Purchasing Managers’ Index (PMI) rose to 53.3 in November 2014 from 51.6 in October 2014, its highest since February 2013, and the thirteenth consecutive month of expansion in activity. The analysts had expected manufacturing activity to lose some steam and predicted the index would fall to 51.2.
On top of that, India overtook Japan as the world’s third-biggest crude oil importer in 2013 and the U.S. Energy Information Administration [EIA] projects that India will become the world’s largest oil importer by 2020.
E) Europe: Europe continues growing in 2014 albeit in a slow rate, as illustrated below:
But the current slow growth in Europe was there in 2013 too. In fact, Europe has been limping forward for years and this is nothing new, as clearly illustrated at the previous chart.
The Half-Truths And The Peak Oil
Given the fact that neither the geopolitical risks have declined since H1 2014 nor the average GDP growth rates in the world’s biggest oil consumers have dropped compared to 2013, the oil bears had to discover something else to strengthen their lame approach to oil and the supposedly supply glut.
Therefore, it does not surprise me the fact that I have seen the chart below more than 20 times in numerous online articles over the last weeks, given also that there are always willing authors who behave like parrots repeating what they hear:
The thing is that this chart itself tells you half-truths for the following three reasons that you will not find all together in any of the recent bearish articles about oil:
1) This chart above compares apple to oranges. It compares Saudi’s conventional production with U.S. oil production which is primarily a result of drilling unconventional shale wells that peter out quickly. The gap between the extraction cost in Saudi Arabia and the U.S. is approximately $60/bbl. Extracting oil from shale costs $60 to $100 a barrel, compared with $25 a barrel on average for conventional supplies from the Middle East, according to the International Energy Agency [IEA].
In other words, new oil is not cheap and the rising oil production in the U.S. over the last couple of years has been conditional upon the high oil price. Most of the wave of the U.S. production is currently unprofitable and the current low oil price discourages new drilling.
2) The U.S. shale players are on a steep rate treadmill because of the high decline rates of the unconventional wells, and an investor must be in denial to not see it.
3) The sweet spots and the spots with high productivity in the main oil basins in the U.S. (Williston, EF, Permian) cover a finite amount of land and eventually the number of the wells at the sweet spots is not infinite. The shale producers say that they have reserves [RLI] for approximately 10 years but this does not mean that their drilling locations are sweet spots.
The shale producers have already drilled in many of the best areas, or sweet spots. Once those areas have been drilled out completely, operators will have to move to more-marginal locations and well productivity will fall precipitously. Meanwhile, the advances in technology cannot make wonders to boost the recovery rates overnight.
As such, it is imperative to keep in mind that the peak oil in the U.S. is not a myth. At the current oil price, the supply of the unconventional oil production in the U.S. will quickly prove self-correcting. Both the oil production and the crude inventories in the U.S. will stall soon and will go into a permanent decline effective H1 2015 as a result of the ongoing reduction in drilling activity, the high depletion rates of the unconventional wells and the finite number of the sweet spots.
In fact, the rapid decline has already started. First, the Energy Information Administration said yesterday U.S. crude-oil supplies declined 3.7 million barrels on the week ended Nov. 28. Analysts surveyed by Platts had expected crude inventories to increase by 380,000 barrels on the week.
According also to today’s news from Seeking Alpha, new permits, which outline what drilling rigs will be doing 60-90 days in the future, showed heavy declines for the first time this year across the top three U.S. onshore fields: the Permian Basin, Eagle Ford and Bakken shale. Specifically, there is an almost 40% decline in new well permits issued across the U.S. in November 2014, with only 4,520 new well permits approved last month, down from 7,227 in October 2014.
These numbers indicate a sizable dent in U.S. production in the not too distant future. Most of that dent will come from the highly leverage players holding lower quality land.
The Oil Sector In 2015 And The Real Estate Analog
The ETFs (NYSEARCA:IYR) and (NYSEARCA:VNQ) measure the performance of the real estate sector of the U.S. equity market and include large-, mid- or small-capitalization companies known as real estate investment trusts (“REITs”). Their charts over the last couple of years are illustrated below:
All the investors know the fundamental problems behind the slump of the real estate sector in the U.S. a few years ago. Given that no fundamental improvement can take place overnight, it took the real estate sector in the U.S. a few years to recover from its lows in 2009.
I am sure now that many readers wonder why I talk about the real estate sector in an oil-related article. What is the relation between the real estate sector and the oil markets?
I mention this example because I strongly believe that the oil price will recover like the real estate sector has recovered from its bottom over the last three years. But, there is also a big difference here. The recovery of the oil price will be much quicker than the recovery of the real estate sector, given that this slump of the oil price has been driven by lame thinking, arbitrary speculation and sentiment, while having nothing to do with evaporating geopolitical risks around the world or a material deterioration of the global supply-demand fundamentals.
On top of that, there are some additional geopolitical clouds on the horizon that can make oil jump by H1 2015. For instance, the current low oil price has brought many OPEC members to their knees, while the holders of those countries’ sovereign debt are toast as long as oil stays at the current levels. Iran, Iraq, Libya, Algeria and Venezuela are not prepared to withstand low oil prices for long and they are now in serious danger of political upheaval at current prices. According to yesterday’s news from CNBC, the first signs of an escalating social unrest in Venezuela are already there, and things will definitely get worse over the next weeks.
Furthermore, Russia and Saudi Arabia will be anxiously watching the rapid depletion of their sovereign wealth funds, which will make the political situation in these two countries dicey over the next months.
In other words, I obviously agree with Andrew John Hall, who is known as the God of Crude Oil Trading. Although many investors and readers do not know this oil legend, Hall is secure in his view that the price of oil is destined to rise sooner rather than later, mocking those who are convinced that a U.S. shale boom will mean long-term cheap, abundant energy.
Fellow investors, please educate yourselves for your own benefit. Everyone talks about buying low and selling high, but he often does the opposite. The typical investor often buys high because he feels good. And he sells low because of panic and lame thinking.
Therefore, this is the essence of my investment thesis. This oil price fall is a sentiment-driven slump. This is short term and sentiment-driven noise in the big picture story. Right now, oil has come to the point where it is unloved, which is exactly when you have to expose yourself to the sector. This oil downturn cannot last long and oil will bounce back by early 2015.
On the supply side, there are not any “elephant” conventional discoveries over the last years, and this is why the conventional oil production from the U.S., the North Sea, Mexico, North Africa and the Middle East has been falling over the last years. Cheap and easy oil is gone forever, and the global marginal barrel currently is in the $80 to $90 range.
Due to the current low oil price, oil supplies will become critically tight by early 2015, largely because production leader Saudi Arabia is not able to pump as much extra oil as many people believe. In fact, Saudi oil production has peaked at approximately 10 million bopd over the last years, as illustrated below:
On the demand side, the investors must not ignore that world population keep growing at a satisfactory rate in an energy intensive world, as witnessed by the GDP growth rates and the GDP per capita for the world’s biggest oil consumers mentioned above. As a result, global oil demand continues growing unabated at average of 1 million barrels per year.
Meanwhile, the geopolitical tensions are escalating and the crude oil price is best proxy for geopolitical risk.
After all, how can the investors weather this temporary storm and benefit from this oil price shock? Well, big fortunes will be made to those with the patience and foresight to pick right and hold tight. Just pick quality oil stocks with low key metrics (i.e. EV/EBITDA, EV/Production, EV/Reserves), sit tight, and you are going to do very well given that the strong players will remain and the weak ones will vanish.
For instance, stay far from the heavily indebted companies with a high Net Debt to EBITDA ratio, because many highly leveraged U.S. shale producers will go broke over the next couple of years. The rising tide will not lift all boats. Even if WTI jumps at $85/bbl tomorrow, several U.S. shale oil producers will not avoid bankruptcy while others will be sold for pennies on the dollar. Beggars cannot be choosers.
And now you know why I sent out last Thursday a Market Update to the subscribers of “Nathan’s Bulletin,” urging them to load specific quality picks. And when Brent crests that $90 mark again, they will be glad they did.