Market Memo: 'Grand bargain' revisited—the good, the bad and the ugly

02-10-2017

With last fall’s “grand bargain” capping OPEC production and global growth on an upswing, there were good reasons to expect energy to perform well coming into 2017. But that window of opportunity may be narrowing—at least, that’s what the market seems to telling us. Energy has been the worst-performing sector year-to-date among hard assets (resources, metals, etc.) Midstream names—those companies that get oil from here to there—have performed well on a relative and absolute basis, but producers and refiners, not so much, leaving the broad energy complex vulnerable to further correction as the good appears set to be potentially overwhelmed by the bad and the ugly.

The good
OPEC compliance has been good so far, much to the surprise of the market. This has been driven to a large degree by the Saudis as well as the other large-producing Gulf Cooperation Council countries (see chart). While others have yet to hit their targets, the 1 million barrels-per-day decline is an excellent start for a market that was very skeptical about OPEC members’ willingness to comply. In fact, OPEC already is making noise about extending the cuts. Just this week, Qatar energy minister Mohammed Al Sada said it was open to rolling the agreement over beyond the original six-month time frame, and Iranian oil minister Bijan Namdar Zanganeh said OPEC likely would have to make cuts in this year’s second half. While this week’s U.S. Department of Energy data showed a huge crude build, imports drove the buildup and likely represented oil that’s been seaborne for a while.

The bad
What OPEC giveth, the U.S. is beginning to taketh away. Producing rig counts in the U.S. are now 250 off of their lows and up 60 in just the last four weeks (see chart, below). Just as noteworthy, wells drilled per rig are increasingly more productive, with innovations among Permian Basin producers carrying over to other oil-producing regions. With West Texas Intermediate hanging in the $50-55 per-barrel range, the window for exploration & production capital spending is wide open. The International Energy Administration expects U.S. output to average 9.53 million barrels-per-day in 2018, nearly a 6% increase from current levels (see chart, below). And if well productivity keeps improving, there may be upside to this number. We continue to see deals for acreage in the Permian—and to the extent that the enemy of returns on this newly acquired acreage is time, capital is going to have to go in the ground very quickly. Put simply, a supply-demand imbalance could be in the offing despite OPEC’s grand bargain and rising demand.


As of Jan. 27, 2017 Source: U.S. Department of Energy/Bloomberg News

As of Feb. 3, 2017 Source: Baker Hughes/Bloomberg News

The ugly
The crude markets do not appear to be positioned for a correction if this potential imbalance plays out. Non-commercial net long positions in crude are as high as we’ve seen in a decade, making a sanguine market ripe for a near-to-medium disappointment. I’m not calling myself an energy bear, but I am becoming increasingly picky as to where I think capital should be allocated in the energy market. My experience tells me that it is very difficult to make money in the stocks if the underlying commodity is a headwind. At this juncture, vigilance is required.

The opportunity
Perhaps there is a silver lining to all of this and I think it is important not to be too pessimistic if one takes a (much) longer-term view. While short-cycle shale investment is booming, longer-cycle projects need sustained pricing that is much higher than where we are today. And new investment in projects such as deep water offshore, oil sands and other longer-dated projects has evaporated. Because these projects are multiyear in nature and are high capital intensity, companies pursuing these projects need not just higher prices, but higher prices that are sustainable. The short-cycle nature of shale suggests that we will not see this kind of price stability in the near term, to the extent that $50 oil brings about waves of short-cycle production. Longer-term, however, as reserves and production dwindle and we have no new major large-scale discoveries, prices may rise accordingly. But in the meantime, the short-cycle, boom/bust nature of shale means volatility for longer.