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“Dumb and Lonely” – Rebalancing Has Been Choppy but Inventories Will Normalize by Year-End

Elm Ridge 2017 2Q Letter – “Dumb and Lonely”

“When you’re that successful, things have a momentum, and at a certain point you can’t really tell whether you have created the momentum or it’s creating you.” – Annie Lennox

  • Worst half ever (-12.5%) – this quarter and year have been all about energy, which accounted for all of our losses
  • While statistical data continues to come in generally as we would have expected, there are enough inconsistencies and one-off data points to scare off investors from fighting against an overwhelming shift in sentiment
    • Investment banks are now tripping over each other to lower their price assumptions and the sector has been the worst performer in the S&P 500 this year (trailing the index by more than 20%)

Lonely

  • Tumbling oil and oil-linked equity prices, followed by what seems to be the last remaining bulls from both the buy- and sell-side throwing in the towel, would lead anyone to question a bullish view of the oil market
  • I would hazard a guess that oil’s performance has as much to do with allocators seeking bond-plus like returns in a low-rate world, as it does with the data themselves – as FMMI research notes:
    • “In the hedge fund industry’s former years the investor base consisted of very-wealthy individuals, willing to take risk in an attempt to earn double-digit returns in a silver of their portfolio. That’s changed … institutions have sought refuges from market volatility… Underfunded and feeling vulnerable they believe they can ill afford to fall further behind. They’re looking for uncorrelated returns and want their portfolios… to produce bond-like volatility. For 2017 they’re targeting 7.5% returns with 6% volatility, a fairly ambitious target when the entire corporate bond market yields 3.9%. The rise of that risk-averse group, that now represents 2/3 of the asset base, has transformed the industry’s character”
  • Much heralded shift toward quant investing is just a logical outgrowth from the enduring low interest rate bond-plus investing environment, as machines are optimized for inductive logic to uncover and capitalize on pattern behavior at what seems to be an instantaneous pace
  • We got the psychology wrong and are still paying the price for taking on idiosyncratic risk in order to garner what we deduce to be some juicy rewards when the market gets too tight to ignore

Oil’s Well if it Ends Well

  • Rather than declining, OECD inventories actually rose 50m barrels through May; US oil rig count, up by 440 or 140% since the May 2016 trough, is back to early 2015 levels, and the prevailing story holds that producers are much more efficient and can easily balance the market at less than $50
  • Meanwhile, demand is supposedly weakening and it is now accepted that inventory levels won’t decline to normal levels by March 2018, when OPEC resumes production growth

Supply/Demand

  • Recent headlines suggest that a faster than expected US shale response and the return of Libya and Nigeria have muted the 2017 rebalancing
  • While US production has outpaced our bearish forecasts, actual monthly data compiled by EIA is still coming in well below its own oft-publicized initial weekly estimates
  • In spite of their recent ramp, Libya and Nigeria have underperformed our forecast by an equal amount, leaving our total global supply forecast largely unchanged
  • Demand is a bit more difficult to measure and IEA data has historically been subject to large revisions, averaging over +1mbd per year this decade
  • IEA’s initial 1Q demand growth estimate of 900kbd fueled macro concerns, agency still expects full-growth of 1.3mbd
  • Purported 1Q slowdown looks temporary: as India accelerated from a flat 1Q to up 4% since March and US grew 2% in both March and April
  • We still expect demand to grow in the 1.3-1.5mbd range this year and next

Inventories

  • Probably the most difficult aspect of the oil market to piece together, with both lagged and incomplete data
  • While our global supply and demand model shows a deficit of ~1mbd in 2017, it is nearly impossible to forecast where that deficit will draw from to meet daily consumption needs
  • OECD and specifically US inventory data are the most readily available and accurate and on a YTD basis have most certainly disappointed both the market
    • Widely watched weekly US figures only represent a quarter of the global market
  • Data sources for storage in non-OECD countries or for floating storage are not readily available in a timely manner
  • There is both tangible and anecdotal evidence on the forces that have worked to curtail reported OECD draws to date, such as oil held in more expensive offshore storage making its way onshore and the possible destocking of OPEC inventories as its exports have fallen less than production
    • Unless these less visible draws make their way to more accessible data, the market will continue to underappreciate the supply deficit we currently estimate and likely will be blindsided by the pace of draws to come
  • OPEC members ramped up production pre-deal – it would take 2 months for these shipments to reach US ports; indeed, they showed up in January and February with inventories building some 55m barrels in the US and more than 90m for the OECD in total
  • Since that time, US commercial inventories have drained more than 50m bbls and total OECD inventories close to 65m, when seasonality suggests they should be more or less flat over that same time period
  • US crude draws have been slowed by the sale of 13m bbls, out of a total planned yearly sale of 16-18m from its Strategic Petroleum Reserve to fund SPR infrastructure upgrades and NIH Opioid programs
  • Including the SPR and despite the poor start to the year, still recorded the largest first half draw since 2003; we’ve also compiled reports showing another 73m bbl draw from Singapore, non-OECD countries, China commercial and floating storage that brings the total since February to 150m
  • Looking forward, global oil consumption on average runs 1.6mbd higher in the 2nd half of the year
  • Non-OPEC, non-US production should be roughly flat, while Libya and Nigeria will add back 600kbd and the US another 500kbd; add these to current 600kbd shortfall and you get 1mbd draw in 2H17 which should bring inventories in-line with their 5-year average by year-end

us inventory

US Shale Production

  • Technological revolution does make for a great storyline and a number of US shale operators are trying to comfort investors with reports that they can make incremental returns at $35-40/bbl
    • That is if they do not include any costs other than drilling and completion costs
  • Continually improving technology may dramatically lower the break-even at any one location but the game gets harder as operators are forced to tackle more difficult geology down the road
  • When we grouped the best 2000 wells for the top 4 basins, found that productivity for this group in 2016 was about 4% worse than 2015 and in-line with 2014
    • Producers chopped the remaining number of wells by some 65% that allowed the averages to rise by the 25% figure that gets everyone excited
  • Admittedly, Permian has improved through any lens in each of the past 2 years which is why it accounts for 90% of our US production growth forecast
  • Adjusting for well lengths, 2016 average peak production did jump more than 17% over 2015 but when we look at actual data, top 750 wells improved at less than a 3% clip with all the rest declining
  • While it is common to declare that shale is growing over 100kbd each month, these claims are based on estimates from the EIA’s Drilling Productivity Report which is derived from a severely flawed formula
    • As activity rises, DPR overestimates production by taking the last month for which it has compiled production and then uses the change in the rig count since that time to forecast the four months – but changes in rig count only impact production 6-9 months later
    • Comparing just the last 2 DPR reports to actual state data from TX and NM, the DPR overestimated growth by a factor of 2
  • We only see US onshore growing closer to 800kbd – further, as shale takes share, the amount of production prone to higher decline rates increases – requiring higher activity to maintain the same growth rate
  • As we move to 2018, we expect crude, driven by Permian, to grow 700-800kbd assuming similar trends in productivity and activity; while a few GOM projects will begin producing next year, this should be offset by the lack of action in US conventional production which still accounts for 20% of total US production

Non-OPEC Non-US Production

  • Non-OPEC non-US sources produced slightly above 44mbd in 2016
  • Predominantly conventional, longer-cycle production, driven by projects sanctioned 3-5 years in advance and will not react quickly to swings in oil prices
    • Also subject to much slower natural decline rates, closer to 5-7%
  • Expectations are for 2017 production to decline slightly as we absorb capacity additions from decisions made under much higher prices, mostly in Canada, Brazil and Kazakhstan
  • Looking at international oil rigs, activity continues to be bouncing along the bottom since it fell 40% through January 2016, clear evidence the forward curve is too low for these producers
  • Some folks opine that non-OPEC production will grow because of the large amount of gross capacity coming online from projects sanctioned several years ago, this sort of analysis ignores both base decline rates and the amount of time it takes to ramp new projects toward peak production
  • In order for non-OPEC just to maintain current production, it will require 1.1-1.5mbd of gross capacity additions
    • Yet, there are only 800kbd slated to come on in 2018

Summary

  • Rebalancing has been slow and choppy at times – this is to be expected when the market we are analyzing is close to 100mbd, and only a few hundred thousand can completely change its complexion
  • Fact remains that global oil inventories are indeed normalizing, and prices remain well below what is needed to incentivize enough supply to meet demand long-term
  • Every indication is that 2017 will see a massive reduction in global oil inventories, and a likely return to historical averages by year-end – the same inventory levels that supported prices above $90 for several years
    • Our expectations are that OPEC and Russia will return to pre-cut levels in 2018 and grow from there
  • Confident that depressed investment will continue to bite into global supply, and the massive uptick in shale activity will lead to a reversal of efficiencies
    • With demand expected to grow 1.3-1.5mbd, and lack of new conventional oil fields, we see room for US supply growth of 1mbd+ annually for the foreseeable future, while still maintaining a balanced oil market
Image Source: IEA, EIA, Energy Aspects, Elm Ridge
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