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    MARKET EDGES

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We've started discussing some of our TAIL prices and themes lately, which relate to a duration of three years or more.   Following its dramatic re-flation year-to-date, oil is now trading very close to its TAIL price; a breakout above would be bullish for a longer term duration.  We've discussed the longer term bullish case for oil in a number of notes, and it relates to long term supply constraints. 

The best evidence of supply constraints is simply to look at global oil production over the last five years.  According to BP's 2008 Statistical Energy Review, in 2004 global oil production was 80.2MM barrels per day and in 2008 global oil production was 81.4MM barrels per day.  This is unique in that the global economy was growing and the price of oil was increasing, which of course led to massive investment in oil exploration.  Despite that massive investment and increase in global demand, oil production had a very difficult time keeping pace.

The simple fundamental reality of resources such as oil and natural gas is that they have decline rates.  That is, the amount of oil that can be extracted from any field over time will naturally decrease over time, so for production in a region, or the world, to grow, the amount of new oil supply brought online must offset the natural decline rates that exist.  The last five years show us that we have barely been able to budge the global decline rate.  As a point of fact, global oil rig count hit a 20+ year high in 2008.  This means that more wells were drilled and completed in 2008 than since any year in the past 20 years.  Rig count has been on a steady up tick from the 1990s, and accelerated over the past five years.  Once again, massive investment in production, but a very tepid increase in supply.

This simple conclusion from the combination of massively increasing drilling activity and flat global production levels is that oil is supply constrained.  I'm not necessarily a peak oil theorist (I'll leave that to our VP of Marketing, Todd Enders and his San Francisco brethren), but when it comes to TAIL investment themes, those with a duration of three years or more, this thesis that it is much harder to get incremental oil out of the ground than it has ever been in the past is one to keep front and center, especially as oil breaks out on longer durations and the fundamentals begin to show incremental improvement.

And, on the margin, oil fundamentals are improving.  Some fundamental data points that we've picked up and wrote about in recent notes include:

  • - The International Energy Agency increased its forecast of global oil consumption by 120,000 barrels per day last week. The Agency's new projection is for 83.3MM barrels per day in demand, which is down 2.9% y-o-y. This data point is noteworthy for the fact that this is the first time in 10 months that the IEA has raised their oil demand forecast, so signifies an inflection point in demand even if levels are well below y-o-y levels.
  • - Last week IEA's head Nobu Tanaka told Reuters that OECD stock levels for oil were at 63 days, but he expected them to be at 57 days by year end. It is conventional wisdom that that 50 days of forward cover is very bullish for oil prices, 53 days is bullish, 57 days bearish and 60 days very bearish.
  • - Earlier today, the DOE reported the oil inventories in the U.S. declined by 3.9 million barrels, which was the second week of declines. Both of which we substantially greater than expectations.

Clearly, so far in the year-to-date, US dollar strength and inflation concerns have been driving the price of oil in US dollar terms, but there is a fundamental case staring at us from the TAIL.

Daryl G. Jones

Managing Director

Oil’s TAIL is Supply - tail