Andy Hall known by many as the “Oil G-d” had a rough 2015 as his bullish bets on oil did not work out. The commodity hedge fund is down 35% for 2015, as first reported by Kate Kelly of CNBC last week. ValueWalk has obtained a full copy of Andy Hall’s latest letter to investors- below readers can find excerpts from Andy Hall where he explains why he thinks the oil bears are (still) wrong.
Also see Andy Hall: Saudi “Rockefeller” Plan Could Backfire
January 4, 2016 Dear Investor,
Last year wasn’t much fun for anyone investing in commodities. Commodity indices fell to levels last seen 15 years ago and that were initially breached over 25 years ago. An uncertain macro-economic climate and a strengthening dollar provided strong headwinds which, combined with moderately oversupplied markets, drove prices to multi-decade lows. We opined last month that it wasn’t time to exit the oil market even though there was a risk that in the short term prices could move lower. And move lower they have.
No one knows exactly how much Iran will be able to increase its exports but if it is 500,000 bpd, as the Iranians claim, then the earlier lifting of sanctions will add on average 125,000 bpd of additional supply in 2016. There again, the latest reports from official Iranian news sources say Iran will only add to supplies at a rate that the market can absorb without unduly impacting prices. In previous letters we have argued that to correct a short term imbalance in the market, oil prices are being pushed to a level that is unsustainable in the longer term.
Yet, remarkably, the 5 year forward price for Brent crude oil has fallen dollar for dollar with the spot price over the course of the past year. Likewise, in the leg down seen last month, which was provoked by temporary deterioration in short term balances, deferred prices fell as much as spot prices, which makes little sense to us. While current prices are not sustainable, it is also apparent that the supply response to low prices is taking longer than expected. Production in places like the U.S. GOM, the North Sea and China has been boosted from projects coming to fruition that were initiated when oil was $100+. Production gains were registered in all three of these regions during 2015. In Russia, oil producers have benefitted from a depreciating ruble which has allowed them to meaningfully step up their drilling activity and as a consequence grow production by about 1 percent.
In the U.S., producers were able to offset collapsing rig counts – down two thirds from their October 2014 peak - by concentrating their activities in the most productive locations (the socalled sweet spots). The brief price rally last spring also allowed some of the weaker U.S. producers to raise fresh capital. So U.S. production, while no longer growing and down significantly from its peak, is still at the level of a year ago. It wasn’t only non-OPEC production that surprised to the upside in 2015: OPEC production registered an unexpected and sizeable increase due largely to a surge in exports from Iraq as infrastructure bottlenecks there were eliminated. Saudi Arabia also pushed its production to record levels. So while the demand response to lower prices was in line with expectations – demand was up by at least 1.8 million bpd in 2015 compared to a year earlier – supply has come in at more than 1 million bpd higher than forecast. This means the market will now only achieve a balance later than originally anticipated.
That said, things are clearly moving in the right direction. At the beginning of 2015, non-OPEC oil production was growing at over 2.5 million bpd year-over-year. By the end of 2015, that rate had most likely fallen to zero based on current estimates. Production from OPEC is very unlikely to show the growth it achieved in 2015. Saudi Arabian production is close to its practical limit. Iraq will have difficulty maintaining its current record production levels: the cash-strapped Iraqi government has given instructions to its IOC partners to cut back drilling as it cannot afford to see revenues diminished by cash flows being diverted to investment.
An updated and detailed country by country analysis suggests nonOPEC oil production should fall by around 1 million bpd in 2016. Crude oil production in the U.S. is expected to lead the decline as rig counts continue to fall and further gains in rig efficiency become harder to achieve. Growth in Canadian production is expected to be offset by continuing declines in Mexico.
Overall, liquid hydrocarbon supply in North America should fall by 500-600,000 bpd in 2016. In Latin America, (lower) growth in Brazil is expected to be largely offset by declines in Colombia. Europe should see production decline by a little over 100,000 bpd as the pipeline of legacy projects there runs off and maintenance deferred from 2015 impacts production in 2016. Russian government officials have intimated that production there will at best flat line in 2016. With production in Azerbaijan and Kazakhstan expected to continue to decline, total FSU production should fall by at least 100,000 bpd. China, which also benefitted from the startup of legacy offshore projects in 2015, is expected to see its production drop by 100,000 bpd in 2016. The state oil production companies are expected to slash investment in high- cost, mature onshore oilfields that have very high decline rates which will result in accelerating production declines. Production is also expected to decline in India, Malaysia and Vietnam. As mentioned earlier, while OPEC production will rise somewhat, it is unlikely to show the sort of growth seen this year. The biggest element will come from Iran, with smaller increments from core- GCC members generally offsetting declines elsewhere. This ought to leave overall OPEC crude oil production higher by about 500,000 bpd. With OPEC NGL and condensate production expected to grow by 200,000 bpd, total global liquids supply should decline by about 300,000 bpd.
Another downside risk is that Libya sees some sort of accommodation between its feuding factions and suppresses IS allowing it to increase oil production. This could add perhaps 500,000 bpd of additional supply. Against that, however, should be weighed the risks to supply from other fraught countries - be they Iraq, Nigeria, Venezuela or for that matter any of the oil exporting countries, all of which are now wrestling with severely depressed oil revenues and the impact of this on restive populations.
The escalating sectarian faceoff between Saudi Arabia and Iran as they jockey for regional dominance also adds a significant tail risk to the upside. While the recent news that Saudi Arabia (and Bahrain) has severed diplomatic relations with Iran has no immediate impact on oil supply, it further raises tensions in the heart of the world's largest oil exporting region. Finally, there is the risk that a slowing global economy would also slow the rebalancing process by reducing growth in demand for oil. However, our assumption of 1.3 million bpd growth for 2016 is already quite conservative – other forecasters are assuming higher growth rates. PIRA for example is currently forecasting growth at 1.9 million bpd for 2016.
The simple fact is that the accepted oil narrative has become uniformly negative: the glass is totally empty and lies shattered on the floor. The consensus view is that we are in a period similar to the late 1980s and 1990s which followed the previous Saudi decision in 1985/86 to defend market share and which resulted in a long period of depressed prices (although not as depressed - relatively speaking - as today). This analogy however ignores the fact that back then OPEC spare capacity and surplus supply were together approaching 20 percent of global consumption. Today, excess supply and spare capacity represent perhaps as little as 1 percent of current global oil consumption.
Yet, because of a universally pessimistic outlook, cuts to capital expenditure by the industry in 2015 and 2016 will - remarkably - almost certainly exceed those made during that earlier era of much greater imbalance. Skeptics will answer that this capital expenditure is not required, and go on to argue that the supply void created by the cancellation of high cost oil sands, deep- water and Arctic production projects will readily be filled by light tight oil (LTO) production in the U.S. and ultimately elsewhere as costs continue to decline. However, it's clear that based on various independent analyses, for U.S. LTO production to recover to growth rates commensurate with balancing the global oil market it would require WTI prices to be above $75/bbl (see nearby box). Moreover, it seems probable that many of the cost savings seen over the past year will be temporary. Service providers are operating at a loss which is resulting in bankruptcies and industry consolidation.
Any upturn will see a firming in service prices and therefore higher costs for oil producers. LTO production elsewhere in the world, where conditions are much less conducive to its development for reasons we have discussed in detail previously, will not make a meaningful contribution to supply for at least a decade, if ever.
Andy Hall on EV
But then some might retort that demand for oil is approaching terminal decline because of the wide scale adoption of renewable energy, electric vehicles (EVs) and the phasing out of fossil fuels. Yet even the most optimistic forecasts see EVs capturing only 5-6 percent of the world auto fleet by 2025 by which time the fleet will have grown 50 percent. Demand growth for gasoline has been extraordinarily strong during the past year with the U.S., China and India leading the way. The latest data show gasoline demand in the U.S. running at more than 5 percent above year ago levels (1). During 2015 apparent oil consumption in the U.S. grew at a faster rate than GDP. If intensity of oil usage can move higher in America then why not elsewhere in the world following a 60-70 percent decline in prices? It remains our view that the current extreme pessimism is setting the stage for a significant future supply shortfall and that the risk of this rises the longer that prices stay depressed and capital expenditure in future production is further reduced. To be sure, we have learned that the supply response to falling prices is slower than we and most observers expected. However, by the same token, it follows that the supply response to higher prices will also likely be slower than generally assumed.
Andy Hall on producers
For a start, oil companies and their backers will want evidence that higher prices are going to be sustained and are not just a blip. Secondly, producers are likely to use higher revenues to repair weakened balance sheets, at least initially. They will also want to execute hedges which will be difficult with depressed deferred prices as the market inevitably swings from a contango structure to backwardation as inventories start to be drawn down. Finally, many of the mechanisms that delayed production decline will go into reverse when prices do recover. Rig efficiencies will fall as companies move beyond their core sweet spots. Service costs will rise along with demand: some 250,000 people have been laid off in the oil and oilfield service industry. In a tight job market it will not be so easy to attract those workers back. If for these reasons the supply response to higher prices is delayed, then prices would need ultimately to rise to levels that destroy demand which would require significantly higher prices. Admittedly, in the very short term – through Q1 2016 – oil balances on paper look challenging. Refinery turnarounds will ramp up as we move through January which will result in additional builds in crude oil inventories.
Andy Hall on catalysts for higher oil prices
On the other hand that is probably already priced into the market and product inventories will meanwhile be falling. Gasoline inventories in particular are already below year ago levels and with current strong demand growth gasoline should be supportive of the overall complex. Moreover, while the exceptionally warm start to the winter has had a material negative impact on the demand for oil used for heating, a recent study suggests that (were El Niño to continue) a warm snowfree winter can add as much as 300,000 bpd of gasoline demand in the U.S. North East. (2) In 2015 prices rallied strongly in Q1 - precisely when the rate of crude oil inventories builds was at its greatest. Additionally, in the U.S. crude oil inventory builds should be much lower this turnaround season as domestic production will be declining whereas a year ago it was still rising.
So while recognizing that short term seasonal factors are theoretically negative we also are cognizant of the difficulty of predicting price trajectory in the short term – especially given current extreme positioning and the potential catalysts that could trigger short covering. We therefore continue to believe that the shorter term headwinds are ultimately trumped by the longer term outlook for prices which remains firmly to the upside: an industry that couldn’t function at $50 certainly can't function with prices below $40.
Andy Hall Chairman and CEO