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Re: Oil-Deep Dive & The Supply/Demand Singularity Revisited.
Pun intended on the "Deep Dive" part -- at least in the short-term. Read further to find out what I think the future holds for Oil.
For those of you who have followed me for a while, you know that I’m neither Perma-Bull nor Perma-Bear. If there’s anything I’ve learned in my years investing in the Oil Patch it’s that remaining religiously wed to an investment thesis even when the facts are changing can be extremely hazardous to your financial health.
It’s OK to have a long-term thesis (and I do), but in my opinion, you have to either modulate your conviction as macroeconomic conditions change, or at least duration-match your bets to your thesis to avoid getting shaken out during cyclical downturns.
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I chose the latter approach and made the choice years ago to bifurcate my bets by duration:
My long-term thesis is expressed through a self-liquidating private equity that I will not trade, but I consult with and advise the management team (and vice versa) almost daily.
If I have conviction in a short-term thesis (long or short), I will express either through futures or ETFs. Since 2018, I have consciously eschewed taking idiosyncratic risk, because my private equity fulfills that role in size, and I do not want to worry about poor idiosyncratic capital allocation decisions.
My long-term Bull Thesis for Oil has been:
There will be a corridor in time within this decade where Demand for Oil catches up to the lack of sufficient investment in long-term Supply, coupled with the unrepeatability of the Shale Miracle.
I’ve previously referred to this as the SUPPLY/DEMAND SINGULARITY. I can’t remember when I first started using the term, but here are a series of Tweets I made last year about it:
I still think the Supply/Demand Singularity could happen this decade, but macroeconomic developments have both pushed this out by a couple years and potentially shortened the corridor under which this can happen.
In this post, I show you how my thinking evolved every step of the way since early 2021 and how I arrive at my current conclusion.
If you don’t care about the evolution/context, please skip directly to the 2023 section.
In early 2021, I saw the stars line up for a significant bull market in Oil, both for fundamental and (geo)political reasons.
First, we had an incoming Administration which was extremely hostile to the Oil & Gas Industry whose domestic and foreign policies created a bullish backdrop for Oil. I also noted the significance of a Contango market moving into Backwardation in early 2021:
Finally, I talked about how Oil Inflation, as a primary feedstock into the macroeconomy, could have far-flung “Butterfly Effects” elsewhere:
These predictions proved correct.
WTI since BoY, 2021:
In late 2021, with a strong Oil Bull underway, I made the link between Oil and a Strong USD, citing how Oil would ignite Inflation and spur a quiescent Fed to become hawkish beyond anyone’s expectations and create a USD Wrecking Ball. This was a very out-of-consensus view at the time.
That analysis is here:
That prediction, along with related predictions about knock-on effects on Risk Assets, also proved correct. The USD Wrecking Ball came alive and wreaked havoc in Equities, BTC, and even Bonds:
DXY (USD) since BoY, 2021:
SPY (US Equities) since BoY, 2021:
BTC (Bitcoin) since BoY, 2021:
TLT (Long-Dated UST Bonds) since BoY, 2021:
Even though I’ve pontificated at length about the long-term capex starvation thesis in Oil leading to a long-term Structural Bull market in Oil, I started getting nervous about Negative Feedback Loops from a Hawkish Fed and a Strong USD. Also, what was an out-of-consensus bullish view was now very much consensus, and I began to voice caution about Oil in April, 2022:
By Summer of 2022, I had become outright bearish on Oil; I don’t have a problem talking against my own long-term economic interests precisely because of my bifurcated investment strategy. I gave an interview here:
Importantly, I cautioned that while Contango-To-Backwardation flips yield significant predictive signal, by the time Backwardation slips back to Contango, you’re likely to have already gotten decapitated. This also proved true.
In other words, when there is an adverse Demand Shock against Inelastic Supply, Oil (or any asset) can exhibit sharp drawdowns in a tight market. That’s exactly what happened for the balance of 2022.
WTI since BoY, 2022:
By late 2022, I was very concerned about the Negative Feedback Loop effects from an extremely hawkish Fed. Because Oil is a global commodity, no one would be immune, and I warned against the calls for a Great China Re-Opening — again, an out-of-consensus call:
So far in 2023, that call again proved accurate as Oil has struggled (and continues to struggle) to find its footing despite massive Chinese stimulus and multiple OPEC+ cuts.
In March, while the world was captivated by the Regional Banking Crisis, I warned that the real global elephant in the room was CHINA and to watch out for a CNY DEVALUATION:
This is what CNH (offshore Yuan) has done since my mid-March call:
CNH since BoY 2023:
Meanwhile, Oil continued to falter despite the Surprise OPEC+ cut announced in April, followed up with silly jawboning against speculators. I was surprised by the prematurity of its timing, and I expressed doubts that the cuts would hold, but even I did not expect that Oil prices would crump so quickly.
Why cut so early while the Fed is still tightening macro conditions and especially when cuts are also economically restrictive?
WTI since BoY 2023:
Short-Term Oil Demand Will Continue To Be Weak
Some Oil Bulls say that Oil is “holding up so well” despite all of this SPR supply and that this is a tell on strong Demand. I have the exact opposite take.
As my analyst friend Lakshmi points out, folks who continually cite SPR cuts selectively choose to forget that during the same time, we’ve had two OPEC+ cuts and multiple unplanned outages that together dwarf the SPR supply:
Oil is actually doing quite poorly despite huge net cuts:
This is when I began to voice concerns about how the increased Supply Elasticity would likely push out the elusive Supply/Demand Singularity which I originally thought would materialize by 2024:
My last piece details how the Fed and OPEC+ now find themselves in what I call a “Squid Game Tug-of-War,” in which there can only be a Pyrrhic Victor.
I believe OPEC+ is making a mistake with these premature cuts and not allowing the Fed to declare victory on Inflation. Not only is it also curtailing Demand without much to show for it (prices have not held up subsequent to both cuts), it is creating more and more Supply Elasticity (slack) while keeping the Fed tight — a bad risk/reward tradeoff for OPEC+ in my opinion.
This piece explains how the collateral damage from this Tug-Of-War is that Oil and CNY may now be in a mutually reinforcing Positive Feedback Loop, where lower Oil begets weaker CNY which further begets deflationary forces and lower Oil, and so on and so forth.
The problem for the Fed is that, despite the decline in Oil (what started the Inflation Conflagration in 2021), structural factors behind Labor and Shelter tightness have persisted in keeping Core Inflation extremely sticky.
This chart from Stifel breaks CPI components down:
On the one hand, I think that OPEC+ understands its leverage over the Energy component of CPI and has geopolitical incentives to keep the Fed tight and will potentially cut again as Core CPI begins to soften; on the other hand, I think it is ultimately self-defeating for OPEC+ because it gets locked into a modus operandi where it must defend prices continually or lose face/credibility. The price is increased forward Supply Elasticity, more Demand Destruction, and elevated OPEC+ Fracture Risk.
In either case, you can appreciate the Fed’s dilemma:
The Fed only has the blunt tool of Monetary Policy with which to bludgeon Aggregate Demand to lower Core Inflation, and the only way to hammer Aggregate Demand is to cause 1.5 mm to 2 mm job losses to take Unemployment from 3.4% to 4.6%. Because Labor and Shelter markets remain tight for structural reasons, however, the Fed will be forced to stay “Higher For (A Lot) Longer” than many (certainly Risk Assets) anticipate, at least until something big breaks — like China.
This makes the short-term outlook for Oil Demand particularly tricky. To give you an idea how difficult it is to forecast Oil Demand, the current gulf between IEA and EIA Demand numbers for 2023 is a whopping 750kbpd!
Although US demand numbers appear to be holding up still, very soft numbers for commodity demand (not just for Oil) out of Europe and China bolster my view that the Fed will be the last central bank to fold in its tightening cycle and that it is just a matter of time before domestic demand weakens as well.
For all of the aforementioned reasons, I am not sanguine on Oil Demand for the next 6-12 months — unless something breaks hard enough to truly allow a Fed Pivot.
The Shale Miracle Won’t Repeat…But Will It Decline Fast Enough?
Despite my near-term bearish view, I can still envisage a corridor for the Supply/Demand Singularity to happen, although that corridor is now pushed out and shortening. Hate to say it, but I’m starting to feel like Han Solo here:
I recently did a deep-dive on medium-term Supply/Demand dynamics with the management team of my PermianCo private equity, Lakshmi Sreekumar of Capital One, and Alexander Stahel of Burggraben. I want to share some key takeaways from these discussions.
In short, the Shale Miracle that depressed Oil prices from 2015-2020 cannot be repeated due to fundamental BASIN EXHAUSTION. This window in which the US emerged as Swing Producer is transitioning back to OPEC+ being Swing Producer, but the Trillion Dollar Question is:
How long it will take for US Shale to decline before other sources of Supply show up and/or something causes Oil Demand to go into secular decline?
Consider the Four Regimes for WTI over the last 20 years:
It’s useful to break up the last 20 years into 4 distinct regimes:
Regime 1 (2004-2008):
Pre-”Shale Miracle,” Oil Prices were very high because the world did not know where the next molecule was coming from especially in the face of China’s growth ramp, but prices may have also been exacerbated by relatively high cost of Oil Services at the time. OPEC+ was unequivocally Swing Producer.
Regime 2 (2009-2014):
Oil collapsed during GFC, but recovered with QE/ZIRP. OPEC+ began as Swing Producer, but Shale began its big ramp towards the latter part of this period even as several long-cycle projects turned on.
Regime 3 (2015-2019):
Enter the “Shale Miracle” with undisciplined emphasis on growth versus profitability. Although there have been technological improvements to Oil extraction around the world, nothing remotely compares to the impact of Shale which tripled volumes from < 3 mmbpd a decade ago to >9 mmbpd today. US was firmly Swing Producer during this period. Peak growth plateau was ~3 mmbpd from 2016-2019.
Regime 4 (2020-2023):
COVID spike down and spike up. Unprecedented monetary and fiscal stimulus + the Russian/Ukraine War created sticky Inflation for the first time in decades, prompting aggressive Fed tightening throughout 2022. Even though Shale still commands a formidable presence at ~9 mmbpd, because Shale growth is nearing peak, the US is ceding the position of Swing Producer to OPEC+ once more. Peak growth plateau is closer to 2 mmbpd.
Spare Capacity Heavily Impacts Regime 5 (2024 and beyond)
Note that the last several OPEC+ Swing Producer Regimes (Regimes 1 & 2) were pre-Shale with consistently high Oil prices. The US becoming Swing Producer broke the back of Oil prices in Regime 3, but Regime 4 has been very noisy thus far; the period since the Russian invasion has proven to be particularly volatile for Oil given the conflicting mixtures of war premium, SPR releases, Fed hikes, and OPEC+ cuts. Notably, since Oil peaked in Summer, 2022, OPEC+ cut twice (10/5/22 and 4/2/23) to short-lived effect each time but also built up significant Spare Capacity.
There are valid arguments over whether this Spare Capacity can make up for the collision of US Basin Exhaustion and the limited pipeline of Major Capital Projects (e.g. the big projects in the North Sea, Brazil, Guyana, and Saudi Arabia) coming on-line in the rest of the world over the next several years.
EIA estimates Spare Capacity to be ~4 mmbpd. Lakshmi agrees with this number — if you’re just considering Core OPEC. OPEC including Iran/Venezuela takes Spare up to 6 mmbpd, and OPEC+ (which includes Russia) takes Spare potentially up to 7 mmbpd.
While it’s valid to question the opacity of OPEC+’s MSC, or Maximum Sustainable Capacity (defined to be the maximum amount of Oil that a country can produce on a sustained basis), let us not forget that the attack on Saudi Arabia’s Abqaiq facility in 2019 took almost 5 mmbpd off-line, and yet KSA was able to call up enough surge production such that they did not miss a single delivery or declare a single force majeure. As Lakshmi aptly puts it, “When Oil is all you’ve got (from Saudi’s standpoint), you don’t take chances with Spare Capacity.” Saudi Arabia expects its MSC to be ~13 mmbpd by 2027.
Shale Basin Exhaustion Is Real…But When Does The Permian Roll Over?
Let’s do a quick overview of US Shale:
Total US Production is expected to be ~12.8 mmbpd by year-end, 2020 (Lakshmi’s 2023 exit estimate), and US Shale Production is ~9 mmbpd (70% of Total US Production).
Now let’s take a quick tour of the major Shale Basins:
Anadarko: 0.45 mmbpd, -33% from 2019 peak
Bakken: 1.2 mmbpd, -25% from 2019 peak
Eagle Ford: 1.1 mmbpd, -60% from 2015 peak
Niobrara: 0.67 mmbpd, -23% from 2019 peak
Permian: 5.7 mmbpd, still expected to grow for several years albeit at slower pace
The Permian Basin is the primary engine of both growth and absolute volumes. Since 2013, the Permian grew from 1 mmbpd to 5.7 mmbpd, adding 4.7 mmbpd in the last decade. Even though the rest of the basins appear to be in permanent decline, the Permian still grew by 700kbpd since January, 2022!
It should be noted, however that the 4.7 mmbpd added since 2013 came amidst an unprecedented amount of undisciplined Shale drilling — just as a number of conventional long-cycle projects came on-line. If a Hard Landing were to crash Oil prices to $50-$60, I would guess that Shale’s Supply Curve this time around would be fairly inelastic — Shale’s price response would likely be far more disciplined than in the past.
In addition, if you looked at a map of Midland, TX in 2013, you saw very few wells and a ton of “white space” — undeveloped sections. Today, you see 25k wells and very little white space. The top 13 public Permian operators account for 65% of gross production, but only 3 firms really matter from an inventory and capital budget perspective. That said, regardless of who you are, you are still beholden to geology, and geologically speaking, the Permian has proven to have limited “refrac” and advanced, “tertiary” recovery methods to squeeze incremental molecules out of a heavily developed region.
The next set of 25k wells in the Permian will cost much more and produce much less than the first 25k wells.
I think there is good reason why public O&G Equity multiples are low — the market perhaps assesses the longer-term non-repeatability of cash flows. Amidst public equities, at some point, we may well see a tug-of-war between irreversibly declining volumes against higher commodity prices as E&P companies essentially morph into self-liquidating royalty trust structures similar to my PermianCo private equity.
Tying It All Together — Wen Supply/Demand Singularity?
The two countervailing wildcards that still weigh on my mind are:
Whether global Spare Capacity can hold up
Whether China will enter a Secular Slowdown for Oil Demand
On the Bullish side, I think that O&G industry outsiders that blindly extrapolate Shale growth as far as the eye can see don’t understand that the Permian’s best days are behind it and that the Permian is the last remaining growth engine for Shale. The problem is that it is still expected to grow for several years — albeit at a slower pace.
Take a look at Figure 1 below, courtesy of the management team of my PermianCo. The colored bars show the amalgam of Global Supply Growth, with the blue numbers below it denoting the number of projects supporting that growth. The dotted black lines indicate the different growth plateaus from Regime 3 (2015-2019) vs. Regime 4 (2022 and beyond). The dotted green line is an estimate of Global Base Decline.
Factoring US Shale as well as the other Major Capital Projects from around the world (everyone in today’s discussion agreed on the visibility of major projects in the next several years), one can make the case that Regime 5 will see Total Liquids Growth top out at 2 mmbpd (peaking around 2024-2025) versus a 3 mmbpd plateau during 2015-2019.
Figure 1: Gap Between Global Supply Growth and Global Base Decline
We think Global Base Decline is running at around ~5 mmbpd, e.g. the world collectively needs to replace 5 mmbpd just to stay even (dotted green line). That may sound like a lot, but it was easily filled by “other projects” during 2015-2019.
How do we estimate Global Base Decline? One way is to estimate 3-4% decline on ~100 mmboepd and add in historical demand growth (or growth projections if we’re looking at 2024 and beyond). Another way is to just look at global Oil decline and exclude NGLs and/or biofuels, but we’d have to apply a higher 6%-8% decline on ~85 mmbpd for just Oil. Either way, I found it interesting for independent parties to converge to the same ~5 mmbpd estimate.
If you accept this 5 mmbpd estimate for Global Base Decline, the implication is that the “other projects” that managed to fill the 2 mmbpd gap in Regime 3 will now need to fill a 3 mmbpd gap in Regime 4 and beyond. Whether or not they can do so I think crucially depends on the answers to Question 1 & 2 above.
Question 1: Will Spare Capacity hold up?
While I have some doubts whether Saudi Arabia’s stated Maximum Sustainable Capacity is truly sustainable beyond surge production (as we saw during Abqaiq), note that we took all Major Capital Projects above at their NAMEPLATE CAPACITY. Even so, we see that the gap widens starting in 2026 after global Supply Growth peaks in 2024-2025. Iran is a bit of a one-shot wildcard in that an immediate lifting of sanctions could see 1 mmbpd+ of volumes flood the market immediately, but this is unlikely to be sustainable. It’s a much bigger lift for Venezuela to come back, so I have some doubts on 7 mmbpd of total Spare Capacity; however, even if we discount that number to 5 mmbpd, it is still a large number which will grow if there are more OPEC+ cuts.
Question 2: Will Demand hold up?
Even if true Spare Capacity is 5 mmbpd, however, the incremental gap of 1 mmbpd between Regimes 3 and 4 seems a bit of a thin bogey — especially if the Demand story falls apart.
Secular Demand Declines related to China specifically (whether it’s due to Demographics or its rapid EV adoption, which effectively substitutes Coal for Oil) worry me the most, and the longer this macroeconomic cycle stretches out, the more risk there is potentially of completely bypassing the viable corridor for a Supply/Demand Singularity.
So much of this is path-dependent too, depending on how the recovery (to the recession that hasn’t even happened yet) plays out. You see how difficult this is.
My Base Case is that 1 & 2 will likely cancel each other out, which leaves me with a slightly Bullish medium-term forecast. Unless the world goes into a period of sustained multi-year recession, I think there is still a corridor for the molecule shortage I call the Supply/Demand Singularity. However, it is likely pushed out to 2026-2027 and shortened.
This is the reason why I don’t think OPEC+’s premature decisions to cut supply are great for the longer-term bullish thesis — the more they fight the Fed, the longer it takes for Shale to peak and the longer time you give for Demand substitution to occur.
The market has an uncanny way to price things to one’s indifference point. I don’t like being short Oil here especially with OPEC+ in face-saving/price-defending mode. With Oil in backwardation still, I also don’t like getting super hedged up in out years in the mid-$60’s.
Meanwhile, what is happening in the world of currencies and a resurgent USD Wrecking Ball makes me think we are on the doorstep of Asian Contagion 2.0.
I called this possibility out last summer, but note the lag time between initial devaluations in 1997 and the spectacular denouement at the end of 1998. We are right on schedule:
Meanwhile, everyone and their kid brother (including one Stan Druckenmiller) has called the cyclical if not secular top in the USD:
I have a strong variant view on the De-Dollarization Thesis — Ain’t Gonna Happen:
In fact, I think there is a case for why we might not have even seen the cyclical top in the USD. The Fed doesn’t have to hike at all anymore for a USD Wrecking Ball to wreak havoc; all it has to do is pause and wait for other central banks to wilt first and out-dove the Fed.
I think there is a decent probability that it plays out exactly like this, and this is how a resurgent USD Wrecking Ball ignites a huge Risk-Off in an Asian Contagion 2.0.
If I am right about this, we may very well see a fast Downward Demand Shock to Oil (catalyzed by multiple currency devaluations). Perhaps then a more obvious Bullish Setup will emerge as a short-term buying opportunity.
We are NOT there yet.
I want to thank the management team of my PermianCo, Lakshmi Sreekumar of Capital One, and Alexander Stahel of Burggraben for their invaluable insights and work. They’re the ones doing the real work — I am merely synthesizing.
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