This guest commentary was written by "Fed Up" author Danielle DiMartino Booth. Make sure to watch her recent conversation with Hedgeye CEO Keith McCullough.
Asian Fusion’s got nothin’ on Chef Caveman.
At least Stone Age culinary connoisseurs knew enough to grease rocks before using them as cooking apparatus. You might concur that logical leap would make hot-rock table-cooking tuna a might bit easier. The question is, would you have ordered what was on the menu back then? The main ingredients alone might give you pause. A fine flour ground from ferns and cattails? A touch of water for that just-so batter consistency? Maybe it was the grease that made the difference. If that’s the case, it’s true — some things never change.
Some 30,000 years on, pancakes remain a hot hit with a hip history. In Neolithic times, einkorn wheat was all the rage in the Italian Alps. The Ancient Greeks added sweets, as in honey, to augment the allure. The French put pancakes on a diet; their “panne-quaiques” required thinning the batter, and voila, thus was created the crepe. As for us red-blooded Americans, let’s just say we rejected fancy flapjacks for puffier pancakes, preferably piled one on top of each other, slathered in melting butter and smothered in sticky syrup.
The Saudis are discovering the hard way that we also prefer our shale formations to be served up in tall stacks. Just a guess here, but there might even be a pattern: the taller the shale stack, the shorter the store of OPEC’s patience. It turns out that strong-mouthing oil prices upwards in crude form, the old-fashioned way, by announcing pared production, isn’t nearly as efficacious when those other announcements, that of deep discoveries, outweigh output cuts.
One can only imagine the dismay at the Wolfcamp Shale’s shooting to stardom last November. Though the formation is not a new discovery per se, the statistics released by the U.S. Geological Survey obliterated precedent. At 20 billion barrels, the recoverable oil is nearly three times that of the Bakken-Three Forks formations, which catapulted North Dakota into the energy hall of fame.
As one gourmet geologist explained: Think of a typical shale formation as a short stack of layers that can be drilled horizontally. The Wolfcamp lies at the outer edge of petroleum potential; it’s such a tall stack, the layers could number into the double digits.
The relationship between supply and demand has a funny habit of holding true to form. Though a matter of pure coincidence, it is telling that the Wolfchamp news roughly coincided with oil price’s most recent peak. Since then, its per-barrel price has fallen by about a fifth to $44-ish despite the Saudi’s best efforts to push the price back towards $60, which is still down 60 percent from 2014 highs.
the Saudi Aramco IPO: Is It Happening?
It’s fair to ask if $60 is an arbitrary target? Think of it as the least sweet, sweet spot that enables the planned initial public offering of state-owned Saudi Arabian Oil (Aramco) to well, work, mathematically-speaking. You can bet your bottom petrodollar the very idea of taking the crown jewel public stirred a bit of controversy.
Consider Aramco’s IPO the brain child of 31-year old Mohammed bin Salman. By relative ruling royals’ age standards, the newly elevated crown prince is literally a child. That’s a good thing as he’ll need youthful verve and more to implement his ambitious plans to diversify the Saudi economy away from its oil dependence, the seed money for which is the planned proceeds of the IPO.
A little economic diversification could go a long way for Saudi Arabia, the region’s largest economy whose GDP is forecast to barely register in the positive this year. That’s a far cry from Iran, its geopolitical nemesis that’s expected to generate economic growth north of four percent this year.
Oil’s stubborn refusal to stage a compliant rebound is partially responsible for the accelerated announcement that Prince Mohammed would succeed his father to the throne. In his prior role as chairman of the country’s Council for Economic and Development Affairs, he pushed against his elders, jockeying for the IPO to be listed expeditiously exhibiting an appreciation for how fickle markets can be.
Of course, demographic challenges and political posturing with neighboring nations that support the Saudi’s enemies are also at work. But it’s hedge funds that could pose the greatest impediment to Saudi Arabia’s aspirations. Some of those cowboys manning their screens are a might bit more piqued than even the Saudis at crude’s refusal to rebound to even half its peak.
OPEC and U.S Shale
As reported by the Financial Times, hedge funds’ patience with OPEC’s assurances that prices will rise is effectively tapped out. Short positions that profit as oil prices fall stand near record highs, equivalent to 162 million barrels. (A word of caution to the shorts: Squeeze hurts. See 6/27/17 trading if you harbor doubts.)
Unlike prior episodes of bait and switch, though, OPEC has stood and largely delivered. It must be salt in the wound to trim two percent of global supply out of production and not even get a rise out of prices.
Afraid that’s just the way things go in a world saturated with supply, supply that keeps building despite OPEC’s opposite obstruction. Exempted OPEC members Nigeria and Libya have tacked on some 600,000 barrels-per-day (b/d) to supplies since the fourth quarter. And US-based shale producers look to drive another 700,000 b/d by this time next year, pushing total production to a record 10 million b/d. Yours truly was all of three months old when the last record of 9.94 million b/d was set in December 1970. Imagine that.
Tack on prospects for natural gas production and growing export activity and the US looks prime to dominate on the production stage for the foreseeable future. The question is at what price?
While it’s true, that some existing wells in the Permian Basin can break even with oil barely above $20 a barrel, even the leanest frackers would prefer a price with a $50-handle. That makes it much more attractive to tap new wells, which typically begin to break even when oil prices cross the $50 threshold.
Perhaps the most problematic platitude, for those who recall all too vividly the last time prices were this low, is that the current rut is a pure supply story and therefore none too knotty for the financial markets. OK, so developed world inventories are nearly 300 million barrels above their five-year average. And, yes, Europe and Japan are not in economic sinkholes. And, no, the Chinese economy has not withstood a hard landing (do they even allow that?). Still, there’s just something about conventional wisdom that never sits right…
What to Watch: Oil Company Bankruptcies
It may not feel like it but there have been 225 bankruptcy filings in the oil patch since 2015. According to the theme of the recent Wall Street Journal story that featured that stat, energy producers have “adapted” to the new low-price world. “Companies say they are focused on living within their means at even this price,” so says the Journal.
There’s no doubt operators are lean. But does that alone justify their share prices trading close to where they were from 2011 to 2014, when oil traded north of $100 a barrel? Apparently so. As the article went on to say, “Companies have driven down costs by squeezing suppliers and contractors, trimmed less profitable projects and tackled a once spendthrift culture.” Heck, they don’t even want to see triple-digit prices again. (Can someone please cue an eyebrow lift??)
Maybe we’d best not use the stock market as a guiding light, which leads us to bonds. As awash as the world is in oil, its oversupply has nothing on the mountains of private equity dry powder that have piled up. The overabundance of capital looking for a home helps explain why there were so few – yes, few – bankruptcies across the energy sector. No doubt, fresh debt infusions have bought many flailing companies a lifeline. That’s a great thing if they’ve become more efficient and profitable operators as a result.
But it’s dangerous to assume all will be well regardless of how low oil prices go, which the high yield market has already refuted. Deutsche Bank’s Oleg Melentyev is a veteran of bond cycles and an authority on when break evens break down, leading to break points. He’s also a great friend whose guidance has yet to fail.
In Oleg’s estimation, debt levels among high yield energy issuers have yet to present a challenge. So long as oil stays above $40 a barrel, some form of stasis will prevail, albeit with the prospect that yields continue to rise. Appreciate that you know this, so consider the following public service announcement to be Pavlovian after years of writing Federal Reserve briefing documents: Bond yields move opposite price. There, said it.
Should that old West Texas Intermediate drop below $40, or worse, flirt with $35 a barrel…well then, things could get testy, shall we say. For the moment, the not-transitory decline in oil has acted as a deterrent against sudden moves by hawkishly-inclined central bankers. In other words, more justification yet for the complete complacency that’s comatosed the markets.
If there’s one quibble with Oleg’s observations, it’s that we’re now in the process of double-netting-out. Like it or not, “ex-energy” is back. Listen, it’s the bulls’ jobs to net out nastiness; they invented one-time charges that recur in perpetuity. The fact that they quit reporting all that netting when the skies clear is also what makes them bulls, or possibly full of bull. Besides, who wants to know what S&P 500 earnings growth would be if you netted out the massive rebound in energy shares?
So you’re down with the vernacular: “ex-energy.” But what about “ex-energy and ex-retail”? You’d better get used to it as the retail sector is in deeper distress in junk bond land than energy. “Of course ex-energy and ex-retail, the high yield market has nary felt a flutter over the last two weeks!” How’s that working for you?
For the time being, the hope is US oil supplies will stabilize, relieving the downward pressure on prices. A pause would certainly mark a shift after a frenetic year at the drill bit: Total rig count in North America – the US and Canada – ended the week of June 23rd at 1,111, more than double the count from a year ago of 487. The rig count has risen for a remarkable 23 consecutive weeks.
It could be a novel approach is what’s needed to stabilize prices at a level that allows bond investors and so many other interested parties to sleep at night. Maybe the solution is moving up Shrove Tuesday. As of now the calendar calls for the day, also known as Pancake Day, to arrive on February 13, 2018, the day before Ash Wednesday. Why not hit the confessional early, deplete all those fattening ingredients from the cupboard as was customary among the old English, and call a moratorium on drilling? Think of it as the oil market’s answer to Lent, That is unless you’d prefer oil prices continue to fall. It all depends on the position you’ve assumed and whose side you’re on.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Danielle DiMartino Booth. DiMartino Booth spent nine years as a Senior Financial Analyst with the Federal Reserve of Dallas under Dallas Federal Reserve President Richard W. Fisher. Her brand new book “Fed Up” explains why the current Federal Reserve system is due for a serious revamp. DiMartino Booth currently runs Money Strong, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
