As OPEC members and adjacent friends (Russia) prepare to meet ahead of the official OPEC meeting held on December 5-6, there is a lot of chatter about whether or not the agreed cuts in place will be extended or be even deeper. To recap, the OPEC+ alliance agreed to take 1.2 million barrels per day (mbpd) of oil out of the market last year to support prices. The current agreement runs until March 2020, and producers will be meeting to review the terms.
It is highly likely that the same terms will be kept in place until end of the first quarter of 2020. After all, prices have been stable between $58-$65/bbl Brent for most of this year, so there really is not a need to change anything for now, depending which country you speak to. Clearly what everyone wants to avoid is what happened December 2018, when prices breached $50/bbl to the downside. That was an anomaly given the global macro backdrop -- with recession fears abounding and severe derisking into year end. But what lies ahead going into this winter?
Oil demand has been sluggish this year no doubt. According to the IEA, demand growth in 2019 is estimated to be around 1mln bpd, and not the 1.3-1.5 mbpd demand growth year over year witnessed in the previous years. Trade Wars between the U.S. and China have exacerbated the world economic slowdown that started in 2018. As the dispute heated up over the past few months, global PMIs and growth deteriorated significantly as global trade volumes were hit across the board. This is something that unfortunately OPEC cannot hedge or predict. It can only tackle the supply side of the equation.
OPEC (mostly Saudi Arabia) has suffered the most by taking barrels out of the market, and U.S. shale has benefitted and prospered as U.S. production in 2019 reached 12.8 mbpd. Today, government agencies are assuming the same rate of growth (typical) and see this distorting their inventory balance numbers, making them very bearish for 2020 onwards. Government agencies are backward looking, not forward. They are unable to and not set up to be proactive and commercial enough to see what is changing and dynamically adjust their numbers to forecast what can happen. That is the job of Hedge Funds, to game the system. By the time the price moves, it is already too late when reported by all the agencies and their advocates.
December is shaping up to be an important month for oil markets despite the holiday season. On December 3-4, Trump and Xi Jinping may meet at the NATO meeting in London. Judging by the daily and hourly "talks are so close, so so close" discussion, who knows what might be conjured up at that meeting. This has massive implications for global economic growth and perceived demand for oil and commodities. The market reacts first and looks for evidence later -- always.
At the Vienna meeting, Saudi Arabia will be pushing for more compliance no doubt, pressuring Iraq and Nigeria, the laggards. Then we have the famous Aramco IPO pricing on December 4. As an E&P conglomerate, it's fate will be linked to the direction of oil prices, to the detriment of the hosting country. For obvious reasons, they want to see and place this IPO as successfully as possible and see a healthy aftermarket. Given the state of Saudi Arabia's budget spending plans, a higher oil price certainly benefits them. Russia, on the other hand, has been slightly shy of its compliance cuts, but will not be pushing for deeper cuts as it is comfortable with prices above $55/bbl. It is a very delicate time, and one wonders, if this OPEC+ alliance will remain in place as the two biggest contributors have differing objectives and priorities.
The elephant in the room is U.S. shale. The capital that was open to these shale drillers since the boom began is now closed. As these companies have perennially over-promised and under-delivered, they are now running out of cash to sustain their business model. Investors are all too aware. Looking at the high-yield market, which has been suffering, a large majority of them are almost-bankrupt energy companies.
The U.S. added about 2 mbpd in 2018, but output is only up a few hundred thousand so far in 2019. According to Oilprice.com, during the next seven years, the top 40 shale producers will face about $100 billion in debt instalments and interest. These companies account for nearly half of U.S. production in 2018.
During the first half of 2019, this group generated about $23.7 billion in cash flow from operations while spending $28 billion in capex. Without access to cash, oil drilling rigs are falling -- as witnessed all this year. It just takes time to feed into the system. Sure, a lot of companies have a higher drilling efficiency, but still the rate of change is slowing.
Halliburton (HAL) , one of the biggest players in U.S. shale, has laid off about 3,000 workers. Even big oil companies are looking to sell $27 billion in non-core assets to focus on their core. Chevron $ (CVX) agreed to buy Anadarko Petroleum $ (APC) earlier this year, looking to expand their Permian exposure. But the industry is going through capex discipline as investors are tired of declining returns.
As we enter the seasonal winter heating demand season, distillate demand tends to pick up, anyway. At a time when OPEC is bent on keeping their cuts in place and U.S. shale might start to produce less and less, we could be entering an era of higher oil prices. The longevity of this uptrend will depend on U.S./China Trade War phase 1 deal. If a deal of sorts is in place, and some semblance of trade picks up again, then these exposed commodities can start to normalize.
Commodities are dictated by demand and supply -- and operate in a short timeframe based on seasonal requirements. Whatever our view for 2020 may be, the stars seem to be lining up for supportive oil prices, barring an outright collapse between U.S. and China. The rate of change of U.S. production needs to be monitored. But as history has taught us, by the time the sell side and government agency reports pick it up or posit a view, it will already be too late.