Andy Hall’s Astenbeck Capital annual letter for the year ended December 31, 2015. The “Oil G-d” is still bullish despite the near universal gloom surrounding the now (nearly worthless) commodity. It is hard to find many long term managers that are not extremely bullish on the asset class but Hall lays out his thesis below in a letter to investors obtained by ValueWalk. Another hedge fund which is going long on the sector is Elm Ridge Capital. The hedge fund recently sent a presentation to investors detailing the bullish case for oil, and we recently posted that commentary here. Besides, for Elm Wood and Astenbeck Capital it is hard to think of other names who are long. Anyway, without further to do readers can find the full letter below. The latest Astenbeck Capital news was first reported by Barani Krishnan of Reuters.

Dear Investor,

If 2015 ended badly, then the start of 2016 was even worse. Global markets were wracked by pessimism over the outlook for economic growth. The epicenter of this anxiety was China. Concern that the Fed’s move to raise rates looked premature added to the worries. The price of oil continued to plunge along with those of other risk assets. This only added to the negativity: oil’s collapse was being read as the harbinger of some greater economic malaise.

Astenbeck Capital: 25 percent rally in oil spot prices

Sentiment has since improved somewhat as central banks yet again announced further easing (BOJ) or its possibility (ECB). Some sanity also returned to oil markets when the head of Saudi Aramco suggested that prices had totally detached from reality. These comments along with rumors of possible cooperation between Russia and OPEC to curb production helped to trigger a 25 percent rally in spot prices. Even so they are still almost 10 percent lower since the start of the year.

It is the nature of markets to overshoot both on the way up and on the way down. Predictions of $200 oil in 2008 helped spur prices to unsustainable and self-defeating levels and contributed to the subsequent global economic collapse. Similarly predictions of $20 and even $10 oil have helped to exacerbate the impact of what in reality is a relatively modest oversupply. We estimate it to be about 1 percent of global oil consumption. This is at a time when spare production capacity has seldom been lower and geopolitical risks higher. Nonetheless, one emboldened pundit pronounced last week on CNBC that he would never again see $44 oil in his lifetime. As far as we know this expert is in rude health so his call is a brave one for the reasons we discuss below.

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The oil industry had already shelved $400 billion of projects when oil was trading at $50-60. Oil prices below $40 will see further curtailment in investment. At $30 and lower huge swathes of the industry become totally uneconomic and face insolvency. Because of transportation and quality differentials, Brent and WTI trading at $30 means that prices for many grades of crude oil are actually in the $20 range or lower, putting them not much above, and in some cases below, their lifting costs. Prices for West Canadian Select – the principal Canadian export grade – hover in the mid-teens or about half the cash cost of production. Canadian bitumen is selling in the single digits. For a few days last month the posted price for some grades of crude oil in Wyoming were actually negative which meant producers had to pay users to take the stuff away.

Astenbeck Capital: E&P companies scaling back production

A recent analysis by Calgary-based analysts RSEG reckons that virtually no North American E&P company covers its borrowing base with WTI at $30 – that is to say these companies’ proved developed (PD) assets are worth less than their net debt. This makes it difficult if not impossible for these companies to raise new debt. Moreover, PD assets decline with production so to maintain debt coverage requires production to also be maintained. In order to do this at current strip prices and stay within cash flows requires new wells to have breakevens below $30 for the top tier operators. For the second tier operators the required breakeven is below $20. Actual well breakevens are at roughly double this level for even the very best operators. For third tier operators current netbacks are negative so it behooves them to actually let production decline regardless. This means then, at current strip prices, the entire E&P industry is, sooner or later, headed for insolvency as they burn through their cash reserves. Dozens of smaller operators had already filed for bankruptcy by the end of 2015 owing in aggregate $13 billion according to law firm Haynes and Boone. Even assuming a price recovery later this year, analysts predict that up to a third of U.S. E&P companies and half of U.S. shale drillers could disappear in 2016 because of insolvency. To increase their odds of survival, the stronger companies are again slashing their capital expenditure budgets. Last week, Hess, Continental Resources and Noble Energy announced cuts for 2016 ranging from 40 percent to 66 percent.

It’s not just the independent E&P companies and shale drillers that are hurting. Chevron just reported a quarterly loss of around $600 million, the first loss for the company in 13 years and much worse than had been predicted by the analyst community. In response, the company announced it was cutting its 2016 capex budget by 24 percent.

Across the globe, companies are now guiding production forecasts lower as they once more take the axe to capital expenditure. Canadian producer Husky Energy scaled back its production forecast for this year by about 5 percent. Two weeks ago China’s CNOOC set out plans to cut capex by more than 10 percent in 2016 and reduce oil production by around 5 percent. The annual production forecast by CNOOC’s listed entity is an early proxy for the investment and production plans of the other state-controlled Chinese oil producers. Chinese oil production last year was over 4 million bpd. Producers in the North Sea – which saw production grow in 2015 because of projects initiated when oil was $100 – are also retrenching. Rig utilization last month had fallen to 63 percent in the U.K. sector and 71 percent in the Norwegian sector, the lowest levels since at least 2000 according to RigLogix. Operating costs in the North Sea run as high as $45/bbl according to Macquarie Group Ltd. Rig Zone, RigLogix’s parent company, also reports a slowdown in offshore drilling in the Gulf of Mexico and Southeast Asia.

National oil companies too are reeling along with the governments that depend on the oil revenues they generate. The IMF parachuted into Azerbaijan last week to discuss the terms of a possible $4 billion bailout. Oil accounts for 95 percent of Azerbaijan’s exports. The country has been plunged into crisis as its oil revenues have collapsed and with it the government’s virtual sole source of income. Scattered protests have already occurred in response to rising prices and unemployment following the collapse of the manat – the local currency. Oil production in Azerbaijan looks set to contract by around 5 percent in 2016 as investment there is curtailed.

Astenbeck Capital: Affects of oil prices on Kazakhstan’s currency

A similar tale is unfolding in nearby Kazakhstan, another Central Asian autocracy that until now had bought stability through generous handouts funded from the revenues generated by $100+ oil. Collapsing oil prices were initially offset by allowing the Kazakh tenge currency unit to massively devalue. However, the economic climate continues to deteriorate and protestors have appeared in recent weeks on the streets of the capital Astana and the former capital city of Almaty. The Kazakh energy minister has indicated that at current prices the country’s oil production would shrink by 8 percent in 2016 as investment to maintain production could not be supported.

Even Russia, the world’s largest crude oil producer, is struggling in the face of yet lower prices. Last year Russia confounded expectations and grew its oil production notwithstanding the collapse in prices. A rapidly devaluing ruble allowed oil companies there to actually step up drilling activity and with it oil production. However, the government – largely dependent on oil revenues to fund itself – is mulling tax increases which would result in oil production contracting according to Russian oil industry executives.

Russia bears watching as its unreformed economy stagnates and it increasingly gets bogged down in costly military adventures. This leads some Russia watchers to wonder if support for Putin could prove less durable than many imagine. According to this line of thinking, high oil and gas prices allowed Putin to buy support while $30 oil and a collapsing currency could test its durability.

If the FSU is reeling, the story is not much better in other oil exporting countries. In Africa, Nigeria continues to struggle with the ongoing insurrection from Boko Harem in the north and the Niger Delta militants in the south. The latter appear to be stepping up their efforts to sabotage oil exports by blowing up pipelines. If these problems weren’t enough the country has to face the fact that current oil prices are below the level needed to sustain production. The Chairman of the Petroleum Technology Association of Nigeria recently said that current prices were below Nigeria’s average production cost of $30 to $35/bbl, that losses due to vandalism added another $10 and that oil production was no longer sustainable. Meanwhile the Nigerian government is seeking an emergency loan from the World Bank and African Development Bank to fill the growing gap in its budget caused by much reduced oil revenues. Angola, the other West African OPEC producer, is also struggling because of low oil prices. Bloomberg recently reported that production costs there average around $32.50/bbl and if current market prices continue “the situation becomes unsustainable” for the oil companies according to the Director of the U.S.-Angola Chamber of Commerce who added that companies were already laying off workers.

Things are no better across the Atlantic in South America. Reuters recently reported that oil produced in Colombia, Ecuador and Venezuela was being sold for less than the cost of production. Venezuelan Diluted Crude Oil (DCO) was selling for as little as $15/bbl and Colombia’s principle export grade, Vasconia was on offer for as little as $21. President Rafael Correa was reported saying that Ecuadorean oil was selling at a price that failed to cover production costs of $24/bbl. The situation in Venezuela has become so dire that many observers are predicting an imminent and total collapse of the economy. Venezuela produces over 2 million bpd of oil. In Brazil, Latin America’s other large oil producer, things are not quite so dire. Nonetheless, Petrobras, the government majority owned producer, has just announced further cuts to its planned capital expenditure through 2019 – down 24 percent – which will make it difficult if not impossible for the company to maintain its recent growth trajectory.

Astenbeck Capital: Middle East also hurt by oil prices

Low prices are even causing strains in the very low cost OPEC countries in the Middle East. Production in Iraq is expected to decline in the latter half of 2016 because of cutbacks in investment ordered by the cash strapped government. It’s hard to quantify what the precise impact might be although guidance recently released by the London based company Genel Energy relating to its production venture in the Kurdish region in the north of Iraq suggest that declines could be dramatic. Gross combined production during early January at two major Kurdish fields, Tawke and Taq Taq, had fallen 75,000 bpd, or more than 25 percent, from peak levels last year. The Kurdistan Regional Government (KRG) is in arrears in payments to foreign oil companies and although it began making payments last September these barely cover operating costs according to Energy Aspects. The latest fall in oil prices puts the sustainability of these in doubt and as a consequence the oil companies have reduced spending to minimal levels with a predictable impact on production. A similar story could well unfold in the much larger southern producing region. Basra Heavy crude oil sells for $20 or less. The IOCs have been instructed to cutback investments as the government struggles with collapsing revenues. There have been reports of its inability to pay the salaries of its employees.

Because of all these cutbacks in investments and their impact on production, we estimate non-OPEC production will shrink by at least 1 million bpd in 2016. OPEC production – led by growth from Iran -should grow by around 6-700,000 bpd. Total global oil supply should therefore shrink by a little under 500,000 bpd. Demand on the other hand should grow by around 1.2 million bpd in our (conservative) estimation – down from 1.8 million bpd in 2015. This means the global supply/demand balance should tighten by 1.7 million bpd on our reckoning. Other forecasts predict a similar improvement in global oil balances even if their underlying assumptions regarding changes in the components of supply and demand are somewhat different. However, the consensus view is that the surplus of supply over demand in 2015 was around 1.8 million bpd. Accordingly, that would imply that on average in 2016 the surplus is barely eliminated. This, together with an implied cumulative stock build since Q3 2014 approaching 1 billion barrels, leaves most analysts relatively downbeat regarding the outlook for prices until 2017 or even later.

The problem with this view is that observed inventory builds have been much lower than those predicted by the supply demand balances of agencies like the IEA and EIA and analysts who base their own forecasts on them. A detailed analysis of observed changes in global oil inventories (see appendix) suggests that the real surplus of supply over demand averaged 1 million bpd in 2015. In the second half of 2015 the observed surplus, as manifested in the observed inventory build, was as little as 400,000 bpd against an implied surplus of 1.8 million bpd. This was despite the very warm start to the winter across the Northern Hemisphere and lackluster GDP growth in the U.S. in Q4. Whilst seasonal factors have pushed the surplus higher in Q1, observed inventory builds suggest the underlying imbalance is about half that implied by most analysts’ supply demand balances. This means the market should move into deficit earlier than is generally anticipated. Moreover, the observed cumulative inventory build since 2014 is only about a third of that implied by consensus supply and demand balances. Therefore, the inventory overhang is much smaller than generally believed. Furthermore, given the lack of spare production capacity in a world of heightened geo-political risk, higher levels of inventory cover would seem appropriate.

So, while the market remains oversupplied in the short term and prices are likely to be volatile and subject to downdrafts, as 2016 progresses the current imbalance turns to a deficit. This will result in quite rapid reductions in inventories and should provide the catalyst for a sustained rise in prices from levels that are required to destroy supply to levels that are required to create it. For reasons discussed in previous letters we believe that level to be in the range of $60-80/bbl. We continue to believe that the longer prices remain at current depressed levels the greater the risk of a shortfall in supply down the road. It will be difficult for the industry to reverse quickly the decisions to cut investment in longer term projects. Stretched balance sheets will also need to be repaired before companies step up capital expenditures. Also, companies and their lenders will want to be assured of the durability of any price recovery before committing capital.

In the event that supply does not respond quickly to higher prices – a very real risk in our opinion – then prices would need to rise higher still – to levels that would destroy demand. So while the IEA talks of “the world drowning in a flood of crude oil” the extreme pessimism this sort of rhetoric engenders is ultimately self-defeating and risks setting the stage for the exact opposite outcome.

Best regards,

Andy Hall
Astenbeck Capital

Astenbeck Capital Andy Hall Hotelling Theorem
Astenbeck Capital’s Andy Hall This chart is from S&P Capital IQ
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