January 9, 2019: Review of 2018
2018 started with the energy markets still recovering from the shocks of the massive price declines of 2014 and 2015 and OPEC attempts to nurse prices higher. Those OPEC maneuvers included first an increase in production by the Saudis in an effort to punish rivals and later a concerted efforts to cut production to sop up excess supplies and let expected rising demand worldwide push prices higher. This strategy did work but also encouraged a creative and persistent US industry to lower costs further. Prices in 2018 not only recovered but began to get frothy as Brent prices exceeded $80 and WTI got over $70. Talk was rampant of $100 oil in the summer because of potential shortages as US tightened sanctions on Iran. What we should have remembered then, as we all did when prices started down, is the volumes that will come from Permian Basin.
As prices rose in 2018, the US administration began complaining of the high prices to our “ally” the Saudis. Obligingly, they increased production. But so did the Russians (unasked, and because they could) and the US, also because we could. Prices fell immediately. The differences in the major producers (US, Russia, Saudi Arabia) is that the Russians can live with the lower price. For the US, it is still marginally profitable now and individual companies make their own decisions based on economics. At current prices, (around $60 Brent) the Saudis, however, cannot live within their budget needs. So, at the urging of the Saudis, OPEC agreed, again, to cut production. Those cuts will likely work again to raise prices…at least for a while.
Before that situation, prices of oil plunged with the benchmark WTI (West Texas Intermediate) falling from $70 to $42 on Christmas Day (with WTI discounts because of take-away constraints even lower). That was the cause for all of the pain in the industry and for oil investors in 2018. The decline was swift and brutal.
General markets were also hit hard. Concerns arose about rising interest rates and trade wars raged. The result was the worst market performance in the last ten years. Despite all that, we believe that the market has a good chance to regain its footing in 2019. The economy is still quite strong and the Fed now seems ready to suspend further rate moves. In the end, we think the oil markets will stabilize as well.
Strategic Issues in the Way Forward
As the volatility of 2018 recedes and the factors that could affect the markets in 2019 are put in place for the oil markets, there will be certain markers to watch. Superseding any of those factors concerning the oil business, however, will be major economic issues such as current trade negotiations with China, actions from the Fed,
and discord in the US Congress. We believe the USA and China will reach a reasonable trade agreement this year. It will not be perfect but should be better by far than dealing with China as it acted over the past several decades. What we mean by that is that China has ignored or broken trade rules and coerced technology transfers for trade. China will likely become a better trading partner to the world after a deal is reached… for at least a while. They are unlikely to go far enough with trade agreements to loosen the Communists Party’s grip on power, but in order to
get any agreement from the US, they will have to give enough.
The Fed will probably refrain from raising rates in 2019 as there is little evidence to support further tightening, just as we believe there was none to support the increase in December. Lastly, it appears that Congress will again be a mess and will likely act foolishly and do little in the best interest of the country. No news here. We all hope this can change. We expect the markets to largely ignore Congress after a trade deal has been reached with China.
The Energy Market
The price of oil is all important, but it is near impossible to predict. The price has to be high enough to make finding new supplies profitable, or the volume of this key commodity will begin to dry up. To be sure, many places in the Middle East can produce oil and gas at negligible prices, but they also have large budget needs and luxury lifestyles that equate to finding costs in the real world. So, the price of oil must at least average over time a price high enough to stimulate production in the real world to satisfy demand. In the dream world of the Saudis, that price would also be high enough for them to balance their budget. The actual markets may not provide both at the same time.
The weakest link in this equation is the Saudi budget. In the current environment, they have less ability to control their own future through price manipulation. They will feel the pressure of low or even moderate prices first. The US will be second. Russia may not bother at current prices as long as they can sell their oil and gas. They may be subject to sanctions, however, for their persistent effrontery to world peace. In the meantime, they are greatly helped by the fact that their costs are in the weak ruble while sales are in dollars. No other producers really matter in this little dance.
Things to watch in 2019
The things to watch this year are 1) OPEC production cuts, 2) Permian production volumes and new take-away capacity, and 3) Worldwide oil demand numbers.
OPEC has announced that they will collectively cut production by 1.2 million bbl./day beginning in January in order to raise prices. Prices are indeed higher already in the New Year. The indications are that the cutting is taking place and there are even pledges from the Saudis that they may cut even more than they promised. OPEC has every reason to make these cuts to keep prices up, but many members are prone to cheating and their reporting is unreliable. Any differences will eventually show up if cheating is occurring through demonstrable supply surpluses. Nonetheless, we can expect prices to rise through the first half of the year.
Permian production will rise quickly as soon as expected pipeline capacity is finished. It is anticipated that 2mm bbl. /day of new take-away capacity will be in place by year end 2019. In two years, we expect that capacity will be full. By the end of 2022, there could be another 2 mm bbl. of take away in the Permian and production could rise by 4mm bbl. /day in five year’ time.
As far as expected demand, the International Energy Association (IEA) thinks worldwide demand for oil will increase by 1.4MM bbl. /day next year and could increase by more than 6 million bbl. /day in five years’ time. We have just outlined a lot of moving parts for the price of oil and it makes little sense to guess the price. That said, the most likely scenario seems to be that prices will be high enough to keep the Permian production profitable and demand most likely will be high enough to absorb at least the four million more barrels a day that the Permian could produce over five years. There could even be some room in demand for the Saudis and the Russians to add a little more production over time at prices not much higher than $60-65. At those levels, there would be little likelihood of large volumes coming from anywhere else.
Conclusion
All of the three major points we mention must be watched carefully, even if our conservative conclusions mean that oil prices move only modestly higher this year and for several years. With that expectation, the only place that will see any significant volume growth will be the Permian Basin. We think energy investors must mostly look there for good returns. As for us, we have made our choice for our best pick in the energy markets and that is the quiet Colossus that stands astride the best oil field in the world.
Sincerely, Dana McGinnis & Mission Advisors