Andrew Hall letter to the Astenbeck Capital Management investors
H/T Zero Hedge
Despite generally supportive economic data, markets were unnerved last month by the sharp selloff in the Chinese stock market and the specter (yet again) of a Greek default. Metals prices were pummeled for no apparent reason and oil drifted to the lower end of its recent trading range. Oil equity prices returned to the lows seen back in March. Current turbulence increases the odds that monetary authorities will continue to be accommodative for longer.
Andrew Hall – Oil
Despite the lackluster price action, underlying fundamentals for oil continue to improve. It is becoming increasingly clear that the huge oil surplus that most analysts predicted for the first 6 months of 2015 failed to materialize. The current global inventory surplus is probably around 240 million barrels – most of it crude oil. This is about half what was being projected earlier this year. The difference can be attributed primarily to phenomenal demand growth in most markets. Contrary to the counter-intuitive beliefs of the analyst community, oil demand is price elastic. The collapse in prices in Q4 of 2014 has been met by a surge in consumption. Here in the U.S., apparent oil demand so far this year is running 862 kbpd or 4.6 percent above 2014. For the past 4 weeks the year over year growth in apparent oil demand is a whopping 1.34 million bpd or 7.2 percent. Vehicle miles traveled, as reported by the U.S. Department of Transportation, are up 3.9 percent for the year through April. Data published by the Bureau of Economic Analysis shows U.S. gasoline consumption up 5.1 percent in May compared to 2014 – this despite a rise in retail gasoline prices compared to April.
Demand elsewhere in the world – particularly in Asia – is also on a tear. Year over year growth in Chinese oil demand was up 0.6 million bpd in May. Increased gasoline demand driven by strong auto sales – especially for SUVs – accounted for 0.37 million bpd of the growth. Demand growth is also coming from less likely suspects. India has registered strong oil demand growth so far in 2015 and will become an important component of future growth. India has one of the lowest per capita oil demand levels in the world at 1.1 bpy (China’s is 2.96 bpy) but has the potential to accelerate rapidly. This year growth in India’s GDP will almost certainly overtake that of China. Even Europe is registering growth in demand for oil after years of decline. At the start of 2015 the principle forecasting agencies were predicting global oil consumption to grow by around 1 million bpd in 2015. They are finally beginning to revise their projections higher. It would not surprise us if growth this year climbed to close to 2 million bpd when all is said and done.
Low prices really do cure low prices and it’s not just on the demand side of the equation either. Supply will inevitably be affected by the 40 to 50 percent drop in oil prices over the past year – it just takes longer for the impact to manifest itself.
The majority of oil production growth since 2008 can be attributed to the development of U.S. shale oil. Three plays – the Bakken in North Dakota and Montana, Eagle Ford in South Texas and the Permian in West Texas and New Mexico – alone added over 1.2 million bpd of crude oil to global supply last year – almost double the growth in global consumption in 2014. That’s undoubtedly what grabbed Saudi Arabia’s attention and triggered the shift in their policy to one of maintaining production rather than price. This policy shift has been likened by some analysts as a war on U.S. shale oil producers: prices will have to fall to a level to curb its production – or at least the growth in production.
That is exactly what has happened. Since October of last year rig counts have collapsed with the price of oil. Until now however production has not responded meaningfully to this drop in rig counts. But that is to be expected: on average it takes about 6 months from spudding a well to bringing it into production. Hence, starting about now we can expect to see production roll over and sequentially decline during the second half of 2015.
However, many market analysts argue that because the fall in rig counts can easily be reversed any sustained recovery in oil prices will be limited. The current consensus thinking is that at WTI prices much above $60 – $65 shale oil producers will start bringing rigs back and with it more oil production. That’s because, $65 WTI is deemed to be the current average breakeven price for these plays. Furthermore, these same analysts argue that because productivity of wells and rigs is growing and the cost of drilling and completing wells is falling the WTI price necessary to see an increase in production is also falling over time and that will keep downward pressure on oil prices.
The problem with this analysis is that it assumes that U.S. shale oil producers are the marginal supplier. In the longer term – that is to say over the full investment cycle – they are not, even if they currently have to assume the role of balancing the market.
The reason that it has fallen on the shale oil producers to bring the market into balance is that they can economically modulate their production in the short term. During a temporary period of low prices it makes sense for a shale oil producer to stop drilling and completing new wells. The foregone production from doing so can be recouped as soon as prices recover. Furthermore, because the decline rate of a shale oil well is much greater than that of a non-shale well – typically as high as 60 to 70 percent during its first year of production – any slowdown in the rate at which new wells are completed will quickly translate into a drop in overall production. Non-shale oil producers on the other hand have little option but to continue producing oil all the way down to their cash cost of production which can be very low. That’s because any production they shut in during a period of low prices will not be recovered until the end of the life of the well which typically will be decades in the future. Given the time value of money, this seldom makes sense even though it will result in producing oil at prices that can be substantially below the full cycle cost. That shale oil producers have this operational flexibility to modulate production in response to changing prices does not make them the highest cost or marginal producer over the full cycle. It means rather that they act as an additional level of oil storage capacity. By not producing oil today they are effectively storing oil underground for tomorrow. With Saudi Arabia no longer compensating for temporary imbalances in the market, changes in oil inventories