A Perfect Storm For Global Oil

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

In This Week's Weekly Analysis:

– A Perfect Storm For Global Oil
– Iron Ore: Seasonal Pattern To The Rescue?
– FNArena Adds Franking To Stock Analysis
– Coal: It Could Definitely Get Worse
– FNArena Sponsors ASX Investor Series
– Buy-Backs Rule
– Rudi On TV: The Week Ahead
– Rudi On Tour
 

A Perfect Storm For Global Oil
 

By Rudi Filapek-Vandyck, Editor FNArena

What the hell is going on with global oil prices?

It used to be the case that were someone with some kind of authority to suggest an interruption of some sorts might happen, at some stage, under certain circumstances, to one particular well in the deepest, darkest part of Africa and traders would slap an extra few dollars on the internationally traded crude oil price.

Today, bombs are falling in the Middle East and the world is bracing for yet another bout of regional unrest and lasting and possibly far-reaching instability, but the price of oil is as low as it's been for years.

Of course, to those who believe the market is always right and one simply has to read the message, the implication of today's weak oil price indicates there will be doom and gloom next year.

To be fair, crude oil has historically been a more reliable indicator for the economic and geopolitical state of affairs across the globe than many other indicators, but any reliability as a forward market indicator goes usually out the window once a market is in oversupply. It happened to the Baltic Dry Index. It happened to copper. And now it's happened to crude oil.

For good measure: over-supply is not by default a signal demand is falling. It means supply has caught up and is growing faster. This is exactly what's been happening thus far this year.

Global demand for crude oil and its derivatives, like diesel, is still growing, in particular in many developed economies. But growth has certainly disappointed on the back of weaker-than-expected economic strength in Europe, Japan and in China. At the same time, supply strength has taken just about every expert by surprise, in particular US shale producers (otherwise known as "tight oil").

Other factors that have all played their part in this year's 20%-odd price correction:

– a general geopolitical risk fatigue among investors (One prepares and then nothing happens. And again. And again. And again)

– general weakness in risk assets as markets start preparing for a shift in Fed interest rate policy

– heightened risk to global economic growth as Europe falters yet again, and Japan looks weak and China is still looking a bit shaky too

– a resurgent US dollar is impacting both on USD-denominated prices for energy and commodities as well as on projections for global demand

– globally, inventories are high and refinery runs are lower (both should be temporary, also because the second is partially related to larger-than-usual maintenance this year)

– sudden regional shifts are taking place with US exports into Canada forcing European cargoes to be redirected into Asia while rising diesel exports from US, India and Asia into Europe have caused a collapse in refinery margins over there

– China's Strategic Petroleum Reserve (SPR) likely reached its targeted size in Q2 this year

– the unexpected physical over-supply of crude oil in the Atlantic Basin caused Brent to flip from backwardation into contango in July, incentivizing onshore and offshore crude oil storage (contango is when the price is higher further out than today's spot, which is a bearish market structure)

– Brent's futures structure shifting from backwardation (positive) into contango (bearish) triggered massive outflow of investors from long positions further out (according to a recent Macquarie report, long futures positions by investors have fallen from 240K in mid-June to 36K contract equivalents in early October. During this time, Brent has fallen from US$115 to US$92 per barrel, and the price is below US$90/bbl as I write today's story).

Ironically, the unexpected return to over-supply has put the onus back on the Saudis, who like to act as the global oil market's regulator. With no shortage in conspiracy theories, of course.

One line of thinking has the Saudis cooperating with their former close ally, the USA, in keeping downward pressure on the oil price. Both Islamic State and Iran stand to benefit a lot from high oil prices, and today's situation is hurting Putin's Russia too.

One other line of thinking suspects the exact opposite: this is the Saudis playing the same game as the Big Three producers in the iron ore market. Allow prices to fall, for a while, and bankrupt the higher cost producers. Resume normal practice afterwards.

But similar to the story unfolding in iron ore (where the Chinese might be too determined to allow the return of the old oligopoly), analysts have already pointed out that if Saudi Arabia is thinking about copying the playbook from Rio Tinto and BHP Billiton for the crude oil market, it might be heading for even greater disappointment.

The official narrative is that tight oil producers in the US require high oil prices to remain in business. Widely quoted estimates assume West Texas (WTI) priced below US$70 means death for the industry. Some sources place the cut off price at US$80/bbl. One advisor to the Saudi Oil Price Minister was recently quoted saying US shale needs US$90/bbl as a minimum.

However, all these estimates might be underestimating US energy entrepreneurship's ability to adapt to an environment of lower prices. Already, technological advances are being made that further reduce cost levels and allow for cheaper production. In addition, Citi analysts noted in a recent sector update, those oft referred to floor prices are based upon full cycle costs of production, yet there are a lot of players in North Dakota, Texas and elsewhere with acreage already acquired, rigs contracted, and even crude prices hedged. All these players will stay in business, even if prices were to drop much lower.

Citi analysts suggest what counts at this stage of crude oil market dynamics are half-cycle costs and these are in the significantly lower band of US$37-45/bbl. This implies any attempt by Saudi Arabia, or anyone else for that matter, to try to price these producers out of the market is doomed to fail, and fail miserably. Saudi Aramco might be pumping oil at a cost of no more than US$2/bbl in parts of its oil assets, the Saudi Kingdom has reportedly budgeted for an average price north of US$90/bbl and there are other members of OPEC that are in budget deficit already at current prices.

Citi's conclusion is thus: "Even at US$75/bbl or perhaps below, US oil production would almost certainly grow in 2015 and 2016, not changing much the need for OPEC to cut if the market is to be balanced".

OPEC's decisiveness and adherence to production cuts hasn't always been exemplary, and that's probably an understatement with governments in financial strife often too eager to break ranks in the hope it will remain unnoticed and it might benefit their domestic finances.

But wait. It gets more complicated than this. Saudi Aramco produces sour crude. The oversupply is currently in light sweet crude. The variant that comes out of wells in Algeria, Angola, Libya and Nigeria, among OPEC members, in addition to US shale producers. The Saudis would still remember the experience of 2011 when Libya's production halted but none of Libya's customers wanted to buy Saudi's sour product instead.

It is still likely OPEC wants to see a more balanced market, but given the current situation any solution requires the involvement of the light sweet crude producers, probably with big papa Saudi Arabia playing carrots and sticks behind the scenes.

There is an alternative, and it won't be pretty for anyone positioned for higher oil prices soon.

Analysts at Credit Suisse recently lowered their short term oil price forecasts, just like so many of their peers have been forced to, but CS's oil market update is the first, on my observation, that genuinely toys with the idea that Saudi Arabia won't be able to stop the slide. Were this the case, CS analysts believe the economic floor price of crude oil is positioned at US$80/bbl for Brent and at US$70/bbl for WTI.

Risks are now to the downside, indicate CS analysts. Their revised price forecasts signal just that: Brent is expected to average US$97/bbl next year, implying no sustainable return above US$100/bbl, after which the analysts anticipate a grind towards US$86/bbl in 2016-2017.

In the background of all this sits one gigantic irony: 2014 marks the first year ever in history of the five year average price for crude oil climbing above US$100/bbl (as I reported earlier this year). In CS's blue print for future years, 2014 is at the same time marking an important inflection point for an industry that had become used to a triple digit price environment.

Credit Suisse's revised forecasts certainly stand out, they are remarkable and should not be summarily dismissed by investors in the sector and in equities, but they as yet do not have a lot of carry around the globe. Macquarie analysts point out French producer Total is screening new (long life) projects at US$100/bbl. Macquarie: "this is the first time since the GFC that we can remember a global major using a price higher than the spot price to test new developments, perhaps suggesting that the Majors believe that the recent weakness will be temporary".

Most sector analysts would agree, as witnessed by price forecasts updates by Macquarie, by National Australia Bank, and by others this month. Most price forecasts adjustments assume the present dip is but a temporary phenomenon and Brent shall swiftly bounce back above US$100/bbl as global growth expands and markets re-balance.

Nevertheless, all still depends on OPEC reining in their own supply. No wonder, Macquarie analysts suspect this bout of price weakness might well last longer than most expect, as there are quite a number of factors that need to fall into place and without a swift rebalancing instigated by a decisive OPEC, markets can take a while before they rediscover equilibrium.

There's that comparison again with iron ore.

Meanwhile, lower oil prices are likely to provide a boost to consumer spending and to economic activity in general, as has historically always been the case, in the quarters ahead. This in itself might alleviate some of current concerns about global growth next year, once the dust has settled after global investors re-calibrating their portfolios. Lower oil prices also tend to weigh on consumer price inflation which is something the RBA and the US Fed might welcome, but not so much the ECB in Europe.

For Australian petrol prices, see below a correlation chart published by National Australia Bank, showing how Australia's retail fuel prices have gradually moved in synch with Brent crude as WTI lost its global benchmark status. (Note to all market commentators across this country: stop referring to WTI as "the price of oil". You are several years behind the curve already).
 

For investors in Australian oil and gas stocks, the industry already is going through major transformation with shares in Woodside Petroleum ((WPL)) now offering a dividend yield in excess of 7.5%, fully franked, and with Oil Search ((OSH)) the co-owner of one of the lowest cost, highest quality new gas assets in the world, and looking for more.

Both Santos ((STO)) and Origin Energy ((ORG)) should be inside the final year of pulling their large LNG projects in Queensland into production, though this does not make them risk-free. Current share prices seem low, as acknowledged by analysts at Macquarie in last week's sector update, but then were prices for energy to stay lower for longer, as suggested by CS, this would erode most, if not all, of the projected upside potential. Gas producers are still impacted by lower oil prices as their long term contracts with customers are mostly benchmarked against crude oil.

The graph below shows the impact from recent (mild) oil price downgrades by Macquarie for Woodside, Oil Search and Santos. Direct result: lower prospective dividend yields for two out of three.
 

Lastly, a fact I have been sharing (a lot) during live presentations and on TV, but never in print. The price of oil may have fallen this year, the price of finding oil has not. Research shows oil companies nowadays have to spend, on average, more than three times the investment they used to in order to find an oil well that is commercially viable. The ratio of three times more was recently confirmed by Morgan Stanley analysis on the Cooper Basin.

This easily explains why mid tier companies in the sector in Australia have been more hit and miss in recent years rather than consistent in their shareholder rewards. The game has become three times as difficult. This also implies that, on a risk-adjusted basis, investor portfolios should reduce their exposure by two-thirds.

Finally, there are some valuable lessons to be learned from the current situation in the iron ore market and against the background of unexpectedly weaker dynamics in global energy markets. Were gas prices to head south, at some point, high cost producers would not be in a comfortable position. All Queensland LNG projects sit relatively high on the global producers' cost curve.

A few things to think about, surely?

Iron Ore: Seasonal Pattern To The Rescue?

I know, I know. It's been a while since spot iron ore in China has been below US$80/tonne for such a long time and despite all the criticism coming from just about every corner of public life here in Australia and elsewhere, major producers Rio Tinto ((RIO)) and BHP Billiton ((BHP)) are stoically and defiantly sticking to their own story to justify increased supplies: it's either us or someone else, and we prefer it to be us.

To be honest, if I were at the helm of one of these companies, and in a position to put the squeeze on my competitors, and make good money while doing it, I'd do the same. Since when should Rio and BHP care about preserving cash flows for multi-billion dollar investments made by others, often on silly, bull-market (mis)guided estimates? One cannot help but think the reason why Glencore's CEO Glasenberg has proved so vocal these days might be linked to Glencore's own ambitions in Africa that look a lot less attractive right now. (Note to Ivan: iron ore is not the same as diamonds. You cannot just corner the market and make the customers pay whatever you decide they should).

Adding insult to injury, both major producers in Australia have been communicating to the local investment fraternity this month they both expect the global seaborne market to remain in surplus for probably another two years.

However, there is hope. At least on a short term horizon there is. The seasonal pattern chart below, thanks UBS, shows how iron ore tends to dip in August and in October, before staging a noticeable price recovery on the back of re-stocking by Chinese steel mills between November and year-end. The average price rise over the two-month period is 5-10%.

So there's hope… as long as history keeps on repeating itself. When the price recovery does announce itself, it'll be interesting to observe how market commentators are likely to colour the event. From tragedy basket to traders' new momentum champions? It can happen quicker than you or I can possibly say "but there's more supply coming next year and the year after".
 

When someone mentions "seasonal pattern", please, no more jokes about the ABS.

FNArena Adds Franking To Stock Analysis

For those who've yet to discover our newest addition to Stock Analysis, future estimates for dividend paying companies in the FNArena universe of some 370 listed stocks now come with added information about the franking. We've chosen to display the franking on the last pay out, if there was a payout last year.

The added franking info has been available for a few weeks now. The addition has already caught my attention a few times since. Did you know there's a mere 7% franking on top of the dividend from Ardent Leisure ((AAD))? I know, it's getting really nerdy now.

One more piece of old school market wisdom: investors should never pass on an opportunity because of a lack of franking. That's enough on the subject, for now.

Coal: It Could Definitely Get Worse

It's dangerous to extrapolate experiences in one commodity into others, but on my observation it seems like coal markets are starting to look a helluva lot like uranium this year. You know, once you're down the head kicks just keep on coming.

To be fair to uranium: the price has finally started to move higher in weeks past, but it has been a long wait. Look over your right shoulder, I'd say. See that graveyard? That's full with contrarian market hopefuls who called the bottom in years past. Too early can be quite unforgiving in this game.

To be fair: it has been quite easy to be proven too early in the uranium market as yet another negative event showed up once the dust had settled after the previous event. But isn't this what is happening with coal? Global investors are increasingly shunning the sector, if not out of green considerations, they do it because they fail to see significant return on investment ahead. Now China's in on the coal reduction/cleaner air strategies as well.

There's plenty of additional bad news potential, still. Have a look at the projections below, published by CIBC last week, as to how power generators in the US are expected to switch out of coal at accelerated pace from next year onwards. It ain't looking pretty indeed.
 

FNArena Sponsors ASX Investor Series

ASX Investor Series, Sydney October 16, ASX Auditorium, 12:30 pm

Starting this week, ASX are launching a regular program of company presentations open to the public. Held monthly at ASX over lunch (12:30 – 2pm) up to 8 companies will present followed by an informal meet and greet session with CEOs over light refreshments. FNArena support these events and see them as a great opportunity to hear directly from companies.

Attendance is free however registration is required as places are limited.

Buy-Backs Rule

I've labeled it the Americanisation of the Australian share market. Economic momentum might be patchy, and the Aussie dollar still very much too high. No real help can be expected from Canberra and top line growth is still a demanding target. But none of this stops boards rewarding shareholders, just like their corporate peers have done on Wall Street in years past.

International research suggests a strong causation between companies who buy in their own capital and share price outperformance. At the very least, share buy-backs provide support to the downside in case of a defensive policy.

Here at FNArena, we've put together a list of companies that have announced buy backs:

Ansell ((ANN))
Cape Lambert Resources ((CFE))
CSL ((CSL))
Donaco International ((DNA))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
Rio Tinto ((RIO))

If you know of any more companies, do tell us and we'll investigate and add them to the list. Our address, as per usual, is info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm
– Thursday, Switzer TV – between 6-7pm

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 13 October 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

****

THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

****

MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of August available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms