How to Interpret Oil's Underperformance

We look at oil's supply and demand fundamentals and at the possible implications of poor market breadth.

How to Interpret Oil's Underperformance

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OPEC is Once Again the Swing Producer. Why it Matters.

This note is NOT about central banks’ policy, recession indicators, or inflation – you’re welcome.

Instead, I got influenced by my upcoming trip to Dubai (reach out if you’re there and want to connect) and decided to focus on oil. Thought it’d fit the vibe.

See, the long-term cyclical nature of investing in oil implies that it’s natural to see periods of underperformance that test the resilience of investors (like me) who are fuming as they see NVIDIA shareholders doing victory laps (with an NTM PE of 48x… just saying). Luckily though, we had Harris “Kuppy” Kupperman on Roger’s podcast earlier this week, to calm our spirits and eloquently list several reasons why price action has been so weak. We quote:

[We recommend you listen to the whole interview as, in my opinion, it’s the best one we’ve recorded to date…].

The thing about longer-term investments though is that they’re usually built on top of tangible and quantifiable fundamentals that, if they do materialize and persist, should eventually be reflected in market prices. “But no one cares about fundamentals anymore!” you might argue, as you lay out all the stats about passive flows, ETFs, and excess central bank liquidity. And yeah, you are mostly right for a significant portion of the equity market that won’t, in fact, re-rate to appropriate valuation multiples any time soon (I have an extensive list of Sum-of-the-Parts names that on paper are stellar investments but that the market will never care about). But for oil in particular, given it is in fact a physical market that powers the world economy, touches every corner of the world, and influences many corporate and consumer decisions, fundamentals do matter, and market prices will eventually need to adjust to reality.

Below we’ve tried to summarize what reality currently looks like.

oil supply and demand, stock changes

Given that demand backdrop, how easy is it to increase supply in order to make up for the 2H23 expected deficit and beyond? Well, not easy at all actually.

There are two key sources of supply growth to consider when talking oil: US Shale and OPEC spare capacity.

US Shale

Permian, Shale production, Canadians Oilsands
Permian Productivity
Hubbert's peak, permian basin, depletion

OPEC's Spare Capacity

With that, consider this:

Historical Oil growth
Oil supply and demand outlook

But how likely is OPEC to provide that oil to a market where

1) Prices do not reflect a level required to balance their domestic budgets, and

2) The US no longer has command and control over KSA and therefore, OPEC at large?

There are obviously many more nuances related to this, the most important of which is having a good understanding of where demand will go (as assuming 1%-2% demand growth could prove to be very wrong), but the key point we’re trying to make here is that, when you look at oil markets right now, and given how many perma-bulls and perma-bear analysts there are out there, before making any investment thesis you need to understand that now, more than ever before since the US Shale revolution, the success of oil investments will be dramatically impacted by the actions of OPEC given how (1) US Shale is peaking, (2) they’ve once again become the swing producer, and (3) they’re the only player in the market that has enough spare production capacity to fill the gap between future supply and demand.

Again, quoting Mike Rothman:

OPEC countries have a fairly good handle on the state of the physical balance, and I don’t think most people still understand that for the last seven years, since 2016, their intent is to get what I would call a budget-friendly oil price, which you look at the Saudi budget, if you look at the comments from the last two Saudi ministers, current minister, and proceeding minister, they think the 2010, 2014 price average, which was about $103 for Brent is a fair price and that inventory is at those levels were targeted. And frankly, that was the goal. And it’s not a new thing. You go back 20-some-odd years, the idea of managing price by managing inventories and managing your production to do that is the modus operandi.

Once again, we’re reminded that geopolitics should matter more to investors now than at any period of time in the last 50 years, and that’s also why both Roger and Jacob wrote about oil in last month’s report (and will continue to write about it over the next months).

Market Breadth Implications

Outsourcing the state of the union to Dominic Wilson (Senior Advisor at Goldman):

Hard to find more superlatives, but the 6 big tech US stocks have gained more than $3 trillion in market cap YTD. That:

Consider this:

S&P 500 components, performance, concentration

Well, I don’t really know. We’ve said this before, and we’ll say it again: this is the hardest-to-forecast macro backdrop of the last 50 years.

In the words of Stan Druckenmiller: “This is the most complicated, non-road map, unanalyzable situation I’ve ever seen in terms of having a lot of confidence in an economic prediction going forward… I honestly don’t see a fat pitch right now. What I do think is that some really fat pitches are going to emerge in the next 8 to 24 months, and I don’t want to blow my cash and be in a horrible mental state, down 8% making a big bet on something that I didn’t have an amazing conviction on when I think the roadmap is going to be good.

That is to say – knowing when to play or step aside is as important as knowing how to play. This is not the time to be a hero. Be prudent and reduce your gross exposure for the time being as most of the really profitable investment opportunities are likely still ahead of us.

Thanks for reading through! Obviously, none of this is investment advice.

As always, we'll see you out there...

Published in: Markets
Diego Tremiterra

Co-founder and Editor-in-Chief. Covers Markets, Business, and Thematic Oversight. Currently a hedge fund Jr. PM, ex-Goldman Sachs capital markets and startup COO.

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