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Point of View

Shale (Re)-revolution?

By Matthew Brittain, Investment Analyst

Following the oil crisis 12 months ago, crude oil has recovered back to a comfortable price in the mid fifties and has pretty much fallen off the radar of the average investor. While this commodity catches its breath we will have a look at a few of the drivers and share our longer term view.

Crude rallied around 20% after the December meeting of the Organization of the Petroleum Exporting Countries (OPEC) in Vienna, where participating countries agreed to cut output (and even managed to convince some non-OPEC members to join in!), but has since traded sideways while the market waits for evidence that the cut is squeezing the market. Over this period speculative investors having been buying up oil as fast as they can – hedge funds have a record long position of over a billion barrels – so is it not surprising that the price has not rallied even higher? This type of investor is not committed to these positions, so what happens when they head for the exit?

CHART 1: Brent Crude Oil Price $/barrel


chart-1.png
Source: Bloomberg

So, not only have we seen speculative positioning at extremely bullish levels but also inventory data shows that stocks continue to build in the US. Any rational investors would be extremely cautious.

 CHART 2: World Crude Oil & Liquid Fuels Inventory

 

chart-2.png
Source: Bloomberg &US Department of Energy

Nevertheless, a strong bull case exists for crude. (Obviously given the speculative excitement!) To understand it there are few points to consider:

  1. It is far easier for a commodity producer (from a farmer to a miner) to secure financing if they have a set selling price for their goods. To do this they also participate in the futures market, locking in a price by selling contracts and taking the other side of the speculative punters’ trade. These producers have jumped at the opportunity to lock in the first reasonable price and their activity would have dampened the impact of the speculators. Indications are that producers are now sufficiently hedged and will now probably be less active in the market.
  2. Secondly, there is a mismatch between production levels and when this shows up in supplies. The December OPEC cuts take a few weeks to take effect plus it takes another few weeks for it to find its way across the oceans to the storage facilities where it would show up in the high frequency data. So it is only now that we would expect the supply cuts to show. There are also a few seasonal factors that justify a build in supplies.
  3. These first two points are only really useful for a shorter term view, and we know how unreliable short term forecasts of any kind are. The real story is in the longer term demand vs supply dynamic, and this is what we really want to get right. Cheap oil prices have driven sales for larger vehicles and the expanding middle class in emerging markets supports the longer term demand profile. So all good on the demand side.
  4. Supply side things look even rosier. Most oil field production peaks early on in the life of the project and declines steadily over the life of the project. This means that producers need to constantly develop new wells not only to meet growing demand, but even just to meet existing demand. Projects that are coming on line this year were sanctioned years ago in the good times, but the knee jerk response to the oil crisis in 2015 was to scrap plans for new projects so there isn’t really much new supply coming down the line after this year.

Shale to step into the breach?

 

Large offshore wells take years of development and wouldn’t be able to react to such an environment. During the crisis U.S. shale producers were very impressive -driving massive efficiency gains throughout their value chains and emerging in some case as some of the lowest cost producers of oil globally. Should conditions justify a greater supply of crude it is only really OPEC and U.S. shale that could respond – and even OPEC are unlikely to be in apposition to do much more than reverse their recent cuts. So maybe now is just the time to get excited about one of the most hated sectors in the market, U.S. shale.

*Insight for this article inspired by a conversation with Westbeck Capital LLP

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.