Market Memo: Between a (Permian) rock and a hard place—an OPEC post-mortem

05-26-2017

As evidenced by yesterday’s big sell-off, there was disappointment with “more of the same” from OPEC’s 172nd meeting in Vienna yesterday. Heading into the meeting the hope was for a surprise deepening of OPEC cuts from last November from 1.2 million barrels a day to something beyond that, in addition to a 9-month extension of the production cut. Looking ahead to 2018, many would like to see some clarification as to how OPEC will wind down this policy because, as we know from history, the longer the OPEC cuts last, the greater the likelihood of non-compliance. Investors are already beginning to ask, “What is the exit strategy here?” 

As a whole, OPEC compliance has been excellent thus far, but the response you will get from bearish investors (and it seems to be all of them) is “compliance has nowhere to go but down from here.” Additionally, the incredible market-share gains of U.S. shale production continue to surprise to the upside, shifting the cost curve ever lower. And while the rate of change may slow due to cyclically rising service costs, a good part of this shift is structural. Bottom line: investor consensus points to a wait-and-see approach and, in general, a view to avoid the Energy sector. 

As a bit of an aside, I spent the last several days at an energy conference about 300 miles south of here in Austin, Texas. Sentiment on the investor side was as poor as I’ve ever seen it. Some of the comments included: “No one cares about this sector.” “Long-only investors are nowhere to be found.” “Everyone is surprising production to the upside with no end in sight.” The overall level of investor fatigue was palpable and everyone appeared grumpy. Performance isn’t good and the pressure is high. But when sentiment is this bearish, it gets my attention. 

So, what can go right? I have a few thoughts: 

  • Inventory draws and normalization of inventory levels This is the obvious one. We started to see draws in March and some follow through in April and May. Seasonal factors should help to further improve this dynamic both on the crude and the finished product side. But investors seem to want further evidence of this in the data and this creates substantial week-to-week volatility.

  • Backwardation This may be THE key point. One of the reasons we have seen such extraordinary growth in U.S. shale production is that producers have had the ability to hedge forward production and lock in higher rates of return for their capital investments. Backwardation of the forward oil curve takes this off the table for producers. It leaves producers with the choice of using their balance sheets to grow production, which we do not see happening given how badly burned they were when oil collapsed, or to begin to slow production growth. I think the latter is the most likely scenario and this is longer-term constructive. Producers will have to start thinking about hedging 2018 production in the coming months, but we believe they will want to lock in prices above $50. The forward curve is barely there, if at all.

  • Saudi “Vision 2030” and the Aramco IPO The Saudis have clear incentives to put in a floor for crude prices in order to reduce their budget deficit and launch their IPO. In fact, it was very underreported that during the OPEC meeting’s question-and-answer session, the Saudi minister said that other OPEC members would reduce production further to compensate for any production growth by Libya or Nigeria, both exempted from the cuts. It is clear that OPEC is willing to lose share to stabilize pricing.
       
  • The possibility of new sanctions against Iran This, of course, is the wild card. But given the current administration’s desire to shift Middle East policy toward its historical partners in the region, the probability of these sanctions returning continues to rise.

  • Investors are very underweight Energy Investor consensus has been to underweight the sector, favoring other areas of the economy that are showing better growth and higher returns on capital. If there is a sustained rise in prices, investors will find themselves behind the curve and moving quickly to become more equal weight the sector. 

Although we may not be nearing an inflection point, in the short term, the market is likely to remain choppy and perhaps range-bound. But everything occurs at the margin, and it is clear that there are reasons to look forward and be at least slightly more constructive. Patience, discipline and perhaps a good antacid are the order of the day.