Testing the bear case

The bears are building their case around the ongoing oversupply of oil, which can be estimated on the basis of how much oil is stored each and every day around the world, and that number appears to be approx. 1.25 million barrels in a range of 1.0-1.5 million barrels (nobody knows the exact number).

The 1.25 million should be seen in the context of total daily consumption, which is around 95 mbpd. The oil industry’s official mouthpiece, the International Energy Agency, puts the number at 93 mbpd; however, industry insiders we have spoken to think the real number is closer to 96 mbpd.

One would assume that, if oil prices are going to drop to $20 as a result of oversupplies, excess storage capacity would have to be used first, so how much storage capacity is available? Again, nobody knows the precise number, but industry insiders whom we have spoken to are of the opinion that there are approx. 300 million barrels of storage capacity left around the world. Should nothing else change, one would therefore expect storage capacity to run out 7-10 months from now.

We note that oil prices have never traded below the marginal cost of production for any extended period of time. Never! We define the marginal cost of production as the total cost associated with producing 1% extra oil. Example: If total oil production is 96 mbpd, the marginal cost of production is the cost of raising the daily production level to (just under) 97 million barrels. Producers have always made cuts in output if (when) oil prices dip below their production cost. If oil prices were to drop to $20 as suggested by some, there is no reason why most producers should behave any differently this time.

I say ‘most’ because Saudi Arabia has obviously changed tactics. Where they used to defend the price at all cost, they now put more emphasis on their market share. That said, being the lowest cost producer in the world, Saudi will still make a profit at $20 and are not likely to fundamentally change tactics as a result of $20 oil prices. Far more likely to be affected are oil projects like shale, deep water drilling, horizontal drilling and various North Sea projects, all of which have production costs well in excess of $20.

We therefore expect oil prices, should they drop as low as $20 (and we would assign quite a low probability to that), to recover relatively quickly. The marginal cost of production is now in the $40s where, 10-15 years ago, it was in the low $20s.

Iran is the joker in the pack. It has been cut off from the international market place for a number of years and is in desperate need of cash. The recent nuclear agreement appears to be the first step towards allowing the Iranians back and, because of their desire for revenue, they will probably not be overly price sensitive. All other things being equal, $20 therefore appears a more likely outcome, should the Iranians be allowed back before the present supply/demand imbalance has been sorted out.

Having said that, we would still assign a low probability to oil prices falling as low as $20 even for a short period of time and a near zero probability of the oil price lingering at those levels for an extended period of time; however, even if a drop to $20 is unlikely, it is not impossible. On the other hand, should it happen, it would represent quite a unique buying opportunity, we believe.

Back in July, we suggested the upper end of the trading range to be around $80. That view was based on the average production cost of non-conventional oil (deep water drilling, horizontal drilling, shale, etc.) which appears to be in the range of $70-80 (again, no one knows exactly what it is). That view remains fundamentally intact, but we have received new information which suggests that ‘the end of cheap oil’, which is a structural trend that we have subscribed to for several years, may begin to have a meaningful impact on the supply side as early as 2017-18.

As a consequence, the price of oil could overshoot on the upside within the next 2-3 years, just like it could overshoot on the downside near-term. Having said that, for the reasons just mentioned, and despite the fact that we expect plenty of volatility going forward, we expect the price to be capped for quite some time to come due to the shale revolution, and that cap is unchanged from the level we estimated in our July paper i.e. $80. The only caveat is the ‘risk’ of temporary but relatively brief overshootings as described above.  

It should be emphasized that such an environment will be meaningfully different from the sort of trading environment we experienced prior to the financial crisis – and prior to shale - where Brent traded as high as $145.61 in July 2008 (chart 1). One would therefore need to carefully consider how to ‘play’ the expected volatility going forward - more about that in the next section.

Before we go there, one final note. The Saudis clearly expected most shale producers to throw in the towel, if only the oil price could be kept below shale production cost levels for a while, but that hasn’t happened (yet). The most likely reason behind that is the relatively easy access to credit in the U.S. at present – a phenomenon that we don’t recognise at all in Europe where banks are still busy repairing their balance sheets following the great recession and the implementation of Basel III.

The ultimate outcome of this tug of war is anyone’s guess but, whatever the result, volatility is likely to be quite high as a consequence. Our view therefore remains the same, i.e. that the price of oil (Brent) is going to be quite volatile in the years to come, but not as volatile as it was in the 2007-14 period. We don’t expect the price to drop below the marginal cost of production for any extended period of time, and we don’t expect it to rise above the production cost of non-conventional oil. Having said that, absolutely nothing will prevent the price from either exceeding or dropping below those levels for relatively brief periods of time (as in weeks).

The winners and losers

Given the myriad of possible outcomes (see our July report for a more complete picture), we wouldn’t be surprised to see the oil price testing both the low and the high end of our anticipated trading range more than once in the next few years.

Our first recommendation is therefore to avoid long-only trading strategies and even be somewhat wary of long/short managers with a long bias, and/or of managers who have made most of their past profits on up-trends. A proven track record on how to make money in a falling price environment is quite important in this sort of setting, we believe.

If our belief that shale is likely to cap the oil price turns out to be correct, we would also be wary of managers who have made most of their profits in the past on the back of the excessive moves we have experienced in recent years. In the environment we foresee it will be critical that the manager in question has documented his ability to make money on the back of more modest moves.

We would also favour managers who incorporate relative value as part of the overall strategy as opposed to managers who rely – and have relied in the past – exclusively on directional trades.

All other things being equal, a capped oil price would also limit the expected returns of CTAs, which would cause us to do bit more homework than usual before any capital is put to work in those types of strategies. Some CTAs have made extraordinarily high returns on the back of the big moves we have experienced in oil prices in recent years, and those big moves are not very likely to be repeated anytime soon.

So, back to the question: Are oil prices likely to drop to levels as low as $20 and, if so, should we re-consider our strategy as a result? As long as the trading ‘rules’ described above are adhered to, we almost hope they do, even if such an outcome is not terribly likely.

The majority of oil traders we have spoken to recently are either bearish or very bearish, and an oil price dipping as low as $20 would make them a considerable amount of profits. The main risk to the average oil trading strategy right now is therefore not an oil price at $20 but rather an oil price which takes everyone by surprise and suddenly finds itself at much higher levels.

Finally, we note that certain types of illiquid investment strategies could also benefit from the price environment that we expect. A narrower trading range should benefit most private equity opportunities, and royalty opportunities also stand to benefit.

Niels C. Jensen

6 October 2015