How to Interpret Oil's Underperformance

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IN THIS PUBLICATION:

• Not since before the US Shale revolution has the success or failure of oil investments been this dramatically impacted by OPEC.

• We note that a budget-friendly oil price for Saudi Arabia is $103/barrel for Brent – significantly above current prices.

• S&P 500’s bull market and the implications of poor market breadth.

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 have a lot of exposure to oil and we’re quite bullish.

• In the past six weeks or so, speculators have sold 400 million barrels of oil… so of course the market is going to be heavy, that’s a lot of oil.

• Speculators currently have one of the lowest net long positioning in the history of the product.

• We’ve had the SPR release globally which is 300 million barrels (round numbers), you had China offline for 200 days at two and a half million barrels per day (500 million barrels)… Russia dumped 200 million barrels before the price caps came in, it was a warm winter (which is like 100 million barrels less demand), Iran dumped their floating inventory because they need dollars…

• We start looking around the world and realize, wow, there’s a billion and change barrel swing excluding the speculators (which add another 400 million barrels) – and that’s a lot of oil over 300 days. We’re talking about (again, round numbers) a 5 million barrels a day change in balance [oil demand is just above 100 million barrels a day]… and oil took it like a champ, dropping from mid-80s to low-70s.”

[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.

• The International Energy Agency (IEA) estimates total oil demand to end 2023 at 103 million barrels per day, and given where supply is expected to be, that implies that by the end of the year the market could be undersupplied by as much as 2 million barrels per day (c. 2% of total supply).

• The market has been moving into a deficit situation in the last couple of months, but it’s in the second half that real undersupply should start to materialize.

• Bear in mind that the IEA has a poor track record at forecasting demand, with its estimates usually undershooting the true level that eventually materializes. Goehring & Rozencwajg, for example, estimates that Q4 demand could reach as high as 104 million barrels per day (would imply c. 3 million barrels per day deficit).

• That is not to bash the IEA – overall oil demand is notoriously hard to forecast, and in a recent interview with Grant Williams, Mike Rothman from Cornerstone Analytics flagged that consensus has underestimated the actual level of demand for more than 20 consecutive months (even the gap between 2023 demand estimates of IEA and Energy Information Agency – kind of the US version of IEA – currently stands at 750k barrels per day… which is quite significant).

• In fact, consensus used to expect we’d see peak oil demand in 2019, as economies focused on moving towards “greener” sources of energy… but fast forward three years and we’re sitting on oil demand that’s 3 million barrels per day higher than what we had in Q1 2019, implying yet again that peak oil is nothing but a headline.

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

• Conventional non-OPEC oil production peaked in 2007 at 46.2 million barrels per day (we’re 4% below that currently), and if we want to include OPEC in that equation, then global conventional oil production peaked in 2016 at 84.5 million barrels per day (we’re 5% below that currently).

• What made up the balance for growing oil demand and falling conventional oil supply has been the growth of non-conventional oil production sources (think shales, oil sands, and biofuels). Between 2006 and 2015, US shales accounted for 65% of that growth, increasing to 85% between 2016 and 2023.

• What this means is that as conventional oil supply decreased and demand continued to trend higher, the world became increasingly more dependent on US shale production in order to avoid structural undersupply.

• The challenge we’re facing today is that 75% of non-OPEC oil supply growth in the last 8 years came from the Permian basin in the US, which for the first time since the explosion of shale, has seen productivity decrease in 2022 by as much as 8%.

• This productivity decline matters because, according to Goehring & Rozencwajg, it’s a precursor to peak production (this is a consequence of the basin having produced more than 50% of its recoverable reserves, a point referred to as Hubbert’s peak, after which production growth should flatten and turn negative – this has already been witnessed in other shale basins as you can see below), which is expected to occur by end of 2024.

• Realistically, however, this doesn’t mean that this is only a 2024 problem as lower production growth of non-OPEC production already implies widening deficits in a world where demand continues to grow faster than supply and above what consensus expects.

• What happens when the key source of supply growth of the past 8 years starts producing less? The world becomes more dependent on what OPEC, and especially Saudi Arabia (KSA), wants to do.

OPEC's Spare Capacity

• OPEC’s spare production capacity is an opaque number, so estimates vary a bit. The current generally agreed level of Core OPEC spare capacity is 4 million barrels per day (could increase up to 7 million if one includes Iran, Venezuela, and Russia, according to Michael Kao).

• Many analysts say that this number is inflated (OPEC has the incentive to increase the number as it allows them to claim more influence in the oil market), but we’ll take it at face value.

• This spare capacity number matters quite a bit as OPEC, for the first time since the shale revolution, has once again become the swing producer – i.e. the player in the market that has control of the largest spare production capacity, which helps control production levels and gives it significant influence on the direction of oil prices.

With that, consider this:

• It is generally accepted that every year, we need to find around 5 million barrels per day of new oil production if we assume historical rates of depletion (2%-3% per year) and that oil demand grows in line with history (1%-2% per year).

• We have pretty good visibility on how much new production can be expected from conventional and unconventional capital projects, which Michael Kao estimates to be around 2 million barrels per year over the next several years.

• So, if we subtract those 2 million new barrels of oil per day from the 5 million we need to find every year, this leaves a gap of 3 million barrels a day that needs to be filled by either spare capacity coming online or from other smaller projects that somehow we don’t have visibility on.

• Historically, these two variables (which are very hard to forecast and also depend on the geopolitical interests of OPEC, and namely, Saudi Arabia) have added 2 million barrels a day to production.

• If history repeats, this, in theory, leaves us with 1 million additional barrels a day that can only come from one place – OPEC’s spare capacity.

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:

• exceeds US industrials and consumer staples sectors

• surpasses all 2,000 constituents of the Russell 2000 index

• is larger than US materials, real estate, and utilities combined

• close to the market cap of the EuroStoxx50 index.”

Consider this:

• High-quality tech has been THE trade of the year.

• Market breadth is horrible (top 5 companies’ weight in the S&P 500 is 24% currently vs 18% at peak of the dot-com bubble and 25% at peak post-COVID), and of the total S&P 500 performance so far this year, more than 80% has been explained by the 5 largest components of the index (100% if we include top 7).

• That is to say – if you didn’t own Apple, Microsoft, Amazon, NVIDIA or Alphabet, then you’re likely underperforming the market.

• Goldman ran a study on the 12-month implication of such market breadth: “Following 9 other episodes of sharply narrowing breadth since 1980, the S&P 500 typically traded sideways during subsequent months as rotations continued within the market. In addition to below-average returns, drawdowns have also been larger than average in these experiences. Eventually, however, a “catch up” has been most common, with S&P 500 valuations and prices increasing alongside a reversal of intra-market momentum”.

• Calling for a catch-up opportunity for the rest of the market after a short period of sub-par returns is not unreasonable if you think that most of the market is, in fact, cheaper than history – the bottom 450 stocks in the S&P 500 currently trade at 15x forward PE (vs 16.8x long term average for the whole index).

• The S&P 500 is currently +20% higher vs the bottom in October, which prompted Bank of America to highlight: “...after crossing the +20% mark from the bottom, the S&P 500 continued to rise over the next 12 months 92% of the time (vs. avg. 75% overall), returning 19% on average (vs. 9% avg. overall) based on data back to the 1950s”.

• The divergence between stock and bond markets is striking though. The yield curve is deeply inverted, and JP Morgan’s Nikos Panigirtzoglou (Cross-Asset Markets Strategy) highlights: “Aligning equity markets' pricing to bond markets' expectations could lead to 20% downside”.

• I was taught that the bond market reacts more rapidly to new developments, which are then fed to the equity markets. Will this time be different?

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.

• We've been reading Finance Homie for a few weeks now and really recommend you check them out. It's PE, VC, and IB news, insight, and analysis, written with enough personality to not put you to sleep. They've crossed the 7,000 reader mark and it's written by a current PE investor. Check them out here.

• Yes, we're (completely unbiased) recommending our own YouTube channel - The Lykeion Channel. To date, we've launched one podcast with Roger Hirst as host, and we've had Harris "Kuppy" Kupperman, Grant Williams, Jacob Shapiro, and Julian Brigden on as guests, and the channel is just getting started. New pods and video content will be released there, so please make sure to go check it out and make sure to subscribe, here!

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

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