Friday, November 14, 2014

Oil price and the economic recovery pendulum

Something I've been noticing ever since oil (WTI) entered it's rubber band like pattern with constant support at $80 (to support lower EROEI extreme energy development) and it's upper resistance of $110 (because once it hits $100 affordability and gas prices become an issue causing demand to decline and usually reaching a downward turning point at around $110) is that symbiotic economies such as the U.S. and Canada keep going through opposing boom/bust cycles. In the last 5 years, generally, when Canada's prospects have been looking up (which usually corresponds to when oil is relatively higher) the U.S. prospects have been looking down, and vice versa. We see this also today, with a very depressed oil price (which has breached the $80 extreme energy support level - more on this later), Canada's prospects are looking down and our hopes are resting on the (new) U.S. recovery (it seems hopes for higher oil prices have been dashed in the near-term).

Of course currency valuations, and a whole host of other factors come into play but on a very basic level there has been a recurring pattern of boom in one country and bust in the other and they tend to follow the swings in oil. The reasoning is simple:
  • In the case of the America's, which relies heavily on consumption and spending to boost economic growth, cheaper energy means more spending power. This has suddenly become cheered by mainstream economists everywhere (most of whom were also cheering for oil prices to continue to rise as a sign of economic health, oddly) which has lead to headlines such as "America's Consumers Are Basically Getting An $80 Billion Tax Cut". It's interesting that you rarely see articles on expensive oil calling it an $80 billion tax increase though, isn't it? But I digress...
  • Canada however, does better when asset prices are high (or at least Canadian businesses do, not necessarily Canadians) as much of Canada's industry is in the business of selling raw resources. Asset prices tend to rise and fall together and I'd say are largely dictated by the price of crude oil as any change in oil price will usually have a direct effect on the operating costs of other asset driven business.
$80 is a significant support level particularly when it comes to the investment aspect of extreme oil projects. Projects that are already operational and funded can still squeeze profit out of these relatively low oil prices however when it comes to the investment side, particularly regarding startups, the situation becomes quite a bit more bleak.
That’s not the case for many small oil sands producers. Sunshine Oilsands Ltd., for instance, suspended construction at its West Ells oil sands project and signalled its intention to raise U.S. $325-million through a debt offering.
Another part of the problem is that some smaller oil sands companies have not produced bitumen as advertised.

“There’s a chill that’s been put on the ability to raise capital because of the performance of some of the assets,” Mr. Bloomer said of the junior oil sands industry. “There’s a number of them that have not performed very well at all.”

As Ms. Dathorne said, junior oil sands companies need to demonstrate their ability to generate cash flow from their operations above their breakeven costs. Many haven’t been able to do so.

Mr. Bloomer said that Connacher intends to grow its production steadily, by adding new wells to its two existing steam-assisted oil sands projects – rather than raising large amounts of capital and trying to build new projects from scratch.
But something strange is happening in the oil markets; WTI recently breached that $80 support and breached $75 today. Largely the narrative around this phenomenon is that it's a fracking boom energy miracle, that there is a glut in supply and thus prices are low. This narrative is likely playing a large part in the (new) anticipated U.S. recovery everyone seems to think is right around the corner.

It's not exactly a false narrative, as it is misleading. The basic facts are true, yes there is an oil glut, yes the fracking "boom" contributed to it, but the way these facts are being presented omits some parts of the puzzle that just don't add up.

Both Brent and WTI have fallen roughly $20 in the last 2 months. This of course has been largely driven by Saudi Arabia which has, despite the oil glut, kept right on chugging and even lowered their prices which gave the final push needed to break the psychological barrier of $80. This action is largely being chalked up to Saudi Arabia "battling for market share" which I believe is incorrect. Or again, perhaps, rather misleading in terms of what "market share" really means.

However, simply battling for market share isn't really their style. Certainly not to this extreme. You're probably seeing a lot of comparisons to oil price in 2010 right about now as that is the last time the price of oil was at these levels but let me remind you that that was on an upswing after demand had been destroyed by the 2008 economic collapse and the IEA's own data shows that while production overall has increased, so has consumption, and OECD oil stocks have remained relatively flat certainly nothing to warrant such a rapid decrease in price. Yes there was a drop in global demand but that in the last 5 years has never been enough to break the $80 barrier on price as that barrier is a required support to keep production at pace. Which maybe explains why the IEA is warning that these lower oil prices are actually going to lead to a supply crunch, and price spikes.
The challenges lie across the energy spectrum but are particularly acute in the global oil market, where the recent plunge in prices will deter capital expenditures that are needed to offset declining production from aging fields, even as lower pump prices spur demand growth.
That decline in supply and increase in demand would drive prices higher in the coming years than they would be under a stable price scenario.

“The short-term picture of a well-supplied oil market should not disguise the challenges that lie ahead as reliance grows on a relatively small number of producers,” primarily in the Middle East, it said.

In an interview from Paris, IEA chief economist Fatih Birol said Canada’s oil sands are an important source of secure supply as other major producing regions – from Russia and the Middle East – face political upheaval.

“We expect Canadian production will be a very important cornerstone of the security of global oil markets,” Mr. Birol said. The IEA forecasts that Canadian production will grow from four million barrels a day currently to 7.4 million by 2030, with virtually all of that growth coming from the oil sands.
Unfortunately the IEA, as an economically-political institution that is itself vested in the continuation of infinite growth, has to put hope somewhere. I expect that "deterred capital expenditures" in oilsands development are going to damper their Canadian outlook.

So, given this information and the supposed supply glut, isn't it interesting that everyone all of a sudden is drilling unabated to the point where it nearly becomes unprofitable? The Saudi's with their vast reserves of conventional oil and established networks can produce oil much more cheaply than the U.S. and many competitors, the Saudi's need for oil revenue largely comes from how much they fund with it to quell their population. However, when it comes to the U.S. or Canada we need that revenue simply to cover the added overhead the industry depends on and even then it isn't enough. Yet despite all this the drilling continues unabated. It's to the point where the in the U.S. they are fielding risky, and largely untested technology just to "keep the boom going".
Companies experimenting with downspacing, including ConocoPhillips (COP), Continental Resources Inc. (CLR) and Anadarko Petroleum Corp. (APC), are still trying to figure out how quickly wells will become depleted when they’re so crowded together, said Leo Mariani, an analyst with RBC Capital Markets in Austin. If that happens too fast, those initial extra profits might eventually become losses.

It may take as long as five years before the industry has a solid understanding of how much oil they’re leaving in the ground by crowding wells so closely together, Mariani said.

“It definitely works, but you might end up with 80 percent of the recoverable oil,” he said. “The question is whether the economics will be as good. It’s certainly not without risk.”

In the short-term, most tightly spaced South Texas wells so far are yielding more oil, not less, the Drillinginfo analysis shows. Technological advances including spacing and higher per-well productivity have been “important to maintaining production” amid falling prices, the Paris-based International Energy Agency said in an Oct. 14 report.

In 2013, Marathon’s Eagle Ford wells that were tested at the closest spacing levels were 34 percent more prolific after six months compared to wells spaced further apart in 2011.

“What we see is that we are getting better over time,” Robertson said in an April interview. “We have a very small body of knowledge about this kind of spacing so far in the industry, but this is our single greatest opportunity to create greater value.”
Seems a little odd, ya? To chase lower prices and create an even larger glut? Also keep in mind that all of this financing that's being talked about here is financing under central banking emergency measures. Ultra-low interest rates. If it's difficult for these projects to show they can break even now, or that the depletion rates of the wells are largely unknown due to the experimental technology being fielded then what would financing be like once interest rates rise? What will profitability look like?

It's often said in Canada that Big Oil runs the Harper government, but what's often left out is that the Big Banks run Big Oil as they are the ones that finance it and as oil is largely what provides for the excessive consumption we've become accustomed to, hence the tight correlation between oil consumption and GDP, which happens to be a direct requirement needed for the banks to operate the monetary system Ponzi-conomy. Banks by far have the single largest stake in oil production as aside from the loans given directly to the energy sector, virtually every other loan's probability of repayment rests heavily on an uninterrupted, stable, and affordable oil supply. For this reason I find it unlikely central banks will ever be able to raise interest rates (they may try but will likely be forced to re-lower them once again) as a full uninterrupted supply of a core component of GDP growth pretty well demands emergency low interest rates just to remain viable.

What you are seeing here is not normal, it is an oil price war, and one which I believe is largely targeted at the United States. The week put out a good article on how Saudi Arabia hopes to reduce U.S. output however I don't think market share is the true answer as to why. Here is an interview with an analyst from October of 2013:
Q. How worried Is Saudi Arabia about the U.S. shale oil and gas revolution?

A. They are worried more about the politics than shale oil and gas. Saudi exports to the U.S. have continued at previous levels — in fact they have increased slightly. The primary reason for that is Saudi Arabia is in a joint-venture partnership with Royal Shell Dutch (Plc) in the Motiva refinery operation [in Port Arthur, Tex.], which has throughput capacity of just over a million barrels per day. They are exporting around 1.2 million barrels per day to the U.S.

As far as gas is concerned, Saudis don’t export natural gas, so they are not worried about the shale gas revolution.

What they are worried about is the rapport between the U.S. and Iran with new president Hassan Rouhani extending his hand in friendship, and the discussion that followed in Geneva looking for a way around Tehran’s nuclear-enrichment problem.

Q. Do you expect the Saudis to embark on a bold move to express their unhappiness — such as a production cut?

A. No, no, I don’t think they will go that far. But they are indicating their unhappiness with U.S. [Middle East] policy, and also its non-policy regarding Syria.

Q. What about shale oil and gas potential in Saudi Arabia — they have been drilling offshore and north of the country?

A. I think that’s marginal. Experimentally they probably want to find out what kind of reserves they might have. But they are not concerned with so much oil and gas.

Regarding U.S. shale, I have a quote by Ibrahim Al-Muhanna, [an adviser to Oil Minister Ali al-Naimi]. His direct quote is as follows:

“The shale oil and gas revolutions are adding greater depth to the petroleum market. Diversification of energy supplies in terms of type location and sources.”

And he added, later on, “it is creating a floor around oil prices of around $80 per barrel.”

So, he is reflecting the views of the royal family and the government, that they are not bothered too much.

Q. What’s CGES’s own view on the U.S. shale revolution?
A. The North Dakota experience is that that you have to drill a lot of wells to keep production going because the depletion rates are rapid. Once you drill the well, the pressures drops, and they have to drill and go further out into the field. So this is costly, around US$50 per barrel.

If the Saudis were to increase their output with the intention of dropping the price to US$60, quite a lot of shale drilling would stop in the U.S. I am not saying the Saudis would do it, but they have the ability to stop fracking.
 Over at Zero Hedge they believe Saudi Arabia is colluding with the U.S. to essentially do the same sort of economic attack but on Russia further damaging the Russian economy in exchange for finally bombing Syria but I find it hard to believe they would be so reckless when they've recently been so suave at manipulating the world populations into supporting what they want. Too many vital dependencies of U.S. hegemony are at risk in such a collusion and so I'm more inclined to believe that the manipulated downward price is aimed at the United States as a geopolitical weapon.

One possible reason may be that Saudi Arabia is worried that if the U.S.'s lofty predictions for output work out that the incentive to remain in the pact with Saudi Arabia forged after the 70's oil shocks which provide them military equipment and international protection of their brutal archaic regime may evaporate.

So what does this all mean for you? It means in the near term if Saudi Arabia is successful you can probably expect oil to reach $60 / barrel. The perceived plentifulness and cheapness of energy will likely contribute to a new consumption trend which may actually end up being the longest leg of supposed growth in the recovery as oil price will have a fair amount of runway before affordability becomes a major issue again.

But don't get too comfortable, this glut is artificial and unsustainable, even if demand did meet supply at these price levels as the longer this goes on the less incentive there will be to continue. Should the Saudi's fail at their goal I anticipate oil price will return to it's previous pattern it's been following for the last 5 years at least until other factors start to interfere with the perfect storm of low interest rates and junk debt. However, if the Saudi's succeed in their goal I'd expect then an oil price spike shortly after and some pretty big fireworks in western financial markets.

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Richard Fantin is a self-taught software developer who has mostly throughout his career focused on financial applications and high frequency trading. He currently works for CenturyLink

Nazayh Zanidean is a Project Coordinator for a mid-sized construction contractor in Calgary, Alberta. He enjoys writing as a hobby on topics that include foreign policy, international human rights, security and systemic media bias.


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