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You Can’t Jawbone a Physical Oversupplied Market Featuring: Warren Pies

Published Date: April 16th, 2020

Synopsis:

Oil has been front and center this past week, and in spite of a historic production cut from OPEC+ and other G20 countries, prices have again dipped their heads below $20 a barrel. Warren Pies, chief energy strategist at Ned Davis Research, has returned to help viewers separate the signal from the incessant noise. Pies reiterates that it is in fact COVID-19 related demand disruption that is the driving force for low oil prices and not a price war. He also explains why talk is cheap in a physical market like oil and provides a roadmap for investing in the post crisis recovery.

One of our best new guests here at Real Vision has been Warren Pies, chief energy strategist at Ned Davis Research. The past month, he's been on multiple times to talk to us about what he's seeing in the energy space, especially considering the demand shock we're seeing from the coronavirus and the price war that we've seen between the Russians and the Saudis. With news this weekend about a historic production cut from OPEC+, we thought it was a perfect time to bring Warren back for a quick timely update.

WARREN PIES: Warren Pies, energy strategist for Ned Davis Research. I've been on Real Vision a couple times in the last month, beginning of March initially, and then most recently, one month ago, March 13th to discuss the oil markets, the energy sector, we've discussed tankers and basically, everything in energy. The OPEC+ Production Cut Agreement: Separating Signal From Noise Well, there has been a lot of noise the oil market in particular. Obviously, everyone has probably beating the dead horse of the OPEC+ meeting, where more or less everybody got on board including G20 countries, consuming countries, producing countries. Traditional OPEC, OPEC+, so we went from last time we talked, it was every man for himself. We talked about just producing as much as possible outright, that was part of the reason why we saw such a dramatic collapse in crude oil prices. Really, I think we'll talk about the meeting more specifically, but really the meeting and having a pass has revealed what the true proximate cause of the pain in the oil patch has been and that is just complete collapse of demand. We had the OPEC, and I don't want to be too glib in dismissing it, we had the OPEC sideshow, but it, to a certain extent, was a sideshow because you have the coronavirus, that was really the center of our first conversation. Then OPEC, Russia, Saudi Arabia, they had their messy divorce, and that was what got all the attention. Under the surface, really, what mattered as opposed to the supply dissension was what was going on underneath the surface, and that's a total collapse in global oil demand. We had, due to coronavirus, once the coronavirus really started impacting the United States and shutting the United States economy down, we were talking about 30%, 35% reduction in total global oil demand. That's 30, 35 million barrels just using round numbers of demand destruction due to all the shutdown. We have the OPEC meeting going on in the background, Saudi Arabia and Russia realized it was a real foolish time to start producing all out, so they came back together and at the, really, behest of President Trump, so Trump pulled this whole thing together, wanted to make a big deal and a lot of it ended up being optics, in my opinion. There's a true cut coming now. It looks like Saudis and Russia are going to cut about 5 million barrels combine, the rest of OPEC's going to do a little less than 5 million barrels so you're at like 9.7 million barrels of supply reduction. That's a great-- it's historic, OPEC, OPEC+ cut. You've never seen anything like that. The problem is we have this underlying demand reduction destruction story. That is, just totally swamped the cuts that we're seeing from OPEC. When you have 10 million barrel reduction from OPEC, and 30, 35 million barrel reduction in demand, it doesn't change the ultimate calculus for the crude oil market too much. You're still in a huge hole. Now, there are also G20 non-OPEC+ countries who gotten involved and are going to cut production and extensively, this is going to be another 10 million barrels a day reduction in production supply. This though is opaque. There's no hard and fast rules or outlines, any true commitment. There's no organization to force these cuts. Some of it is a little bit double counting, because I think they're also getting credit some of these G20 countries for stocking their strategic petroleum reserves. If you add a barrel into your SBR, does that count as an effective production cut? That's the hazy math that's going on under the surface here. I'd say, let's just for the sake of argument, let's give a full 20 million barrel a day reduction to the combined group of producing countries in OPEC, and G20. We're still short, potentially, even if we're conservative on our demand destruction estimates, we're still short 5 million barrels a day or oversupply 5 million barrels a day in the oil markets. That's unprecedented. I think most people can't put that in historic context. What I've been doing is going back to like the great recession during the financial crisis and looking at what happened to demand there, and I've overlaid there some charts that overlaid gasoline demand in United States versus 2008. I've centered this crisis period around the collapse of Lehman Brothers, just to show, put it in context, and really, there's no comparison. At the height of the financial crisis, you're talking about maybe for a short period of time, a three to 5 million barrel a day oversupply in the market and then OPEC cut roughly 4 million barrels in two combined cuts between October and December of 2008 back then. They were able to balance that market. Let's say you were three to 5 million barrels a day oversupplied during the worst of that crisis, and then OPEC comes in and cuts about 4 million barrels of production, you're getting yourself into a normalized market within that range. Even after all the cuts, given the most generous interpretation of what happened at the most recent meetings and what everyone's saying, we're still probably five to 10 million barrels a day over supplied in the market. That's why you saw prices do April 16th , 2020 - www.realvision.com 4 The Expert View: You Can’t Jawbone a Physical Oversupplied Market what they did. We had a quick 8% rally, and that was like if you blinked, you missed it. Now, we're back into the downtrend in the oil markets.

How Long Until We Run Out of Storage Space?

Well, it depends because we've talked about this. What's going to get utilized is floating storage. We are- - I know Real Vision has covered this a lot and I'm not a pure tanker analyst but what I understand is the oil market and I understand that when you have as steep of contango that we have currently in the market, you're going to incentivize every potential storage avenue which includes a floating storage, which is ultimately tankers. Now in the United States, I think by the end of April, the Cushing which is the main inland storage hub will be full.  You're seeing Cushing, even though WTI is trading at like $23, $22 and Brent's at like 30s, so you have this massive window in between-- differential between the two, global crude and inland United States crude, WTI is still trading at a big premium to other hubs around the country. At some points, I've seen Louisiana Light Sweet were trading at $11 discount to WTI. What that does, just to cut to the bottom line, is WTI Cushing will become like a magnet for all the crude around the country. You're going to get as much crude filling into Cushing as quickly as possible and that will happen first, and that's going to happen in the next couple of weeks. Once that happens, you're going to have a real problem on WTI pricing, and that's going to pressure WTI. The whole system is a mess. At the end of the day, how much time we have before storage globally fills up is a hard question to answer, but we are not going to-- the bottom line is we're going to continue to fill up tankers and every tanker can hold 2 million barrels of crude. You have, let's just say an 850 VLCCS globally. You can just start doing back of the envelope math. If you had 250 tankers that are being utilized just for floating storage, that's an additional 500 million barrels of storage capacity. You don't know exactly when we hit the theoretical limit, we'll hit the theoretical limit, what prices will do before we get there and how quickly producers will shut in. All those things are moving parts, but we don't have a precise time for that. Ultimately, the market is so oversupplied, oil will continue to be incented to go into storage and when I say that, when you incent oil into storage, that means the curve will stay in steep contango to open up every available storage avenue in market, and it will stay there until we start seeing balance in the market, which is not going to happen anytime soon.

What is Curve Shape Telling Us? 

We are continuing to steepen on my measure, and what I do is I smoothed that out. We went over it last time, but yeah, we're continuing to see steepening right through this OPEC meeting. We had a few days where we had dramatic-- it had never got flat and [?] anywhere close to that ratio, but we saw that continual came in a little bit in the anticipation of the OPEC meeting and I think the market was trying to weigh out what exactly is going to happen there, is there going to be some shock in that announcement? Ultimately, the takeaway for all this, the curve is still steepening. It's at record levels at this point in my measurement. The big takeaway on the oil market, Donald Trump, the entire thing is, there's a physical component to this market. It's not like the stock market, this is not a confidence market. You can't jawbone a physical oversupply of 5 million barrels a day. You can't talk this market up and keep it there. Because ultimately, at the end of the day, it's a supply and demand situation, you have a physical commodity at the end of the chain. It's a major difference between this and the stock market, for instance. Stock market, you could come out and Trump can get angry with Powell and the traders might say, well, we need to adjust our valuations, our risk premiums come in, whatever. That's ultimately, a confidence thing. That's not how the oil market works. You may have some very small geopolitical risk premium at different times, but when you have this oversupply in the market, there's no talking it up, there's no solving this problem through, Trump getting up and having another press conference. It doesn't work that way. It's a fundamental difference. I think a lot of investors try and map their experience in the equity markets over into these physical commodity markets and it doesn't really work. It doesn't translate.

What is the Potential of Further Production Cuts?

This dramatic headline, 9.7 million barrel cut, it's a two-month thing too. It only goes through the end of June. Starts May 1 st , goes into June and they taper down to 7.6. We could see an extension of that maybe,  something like-- but this is where-- and I provided this report, I think, to Real Vision at some point after one of our conversations, this is where you start getting into the budgets of respective orders and countries and you start realizing that the pain is so acute in a country like Saudi Arabia. At this point, it's real for Russia as well. Saudi Arabia is going to be running massive deficits at current pricing, and now you're lowering your production. Their baseline is 11 million barrels a day according to the new agreement, and they're reducing that down to 8.5, so that's a 2.5 million barrel reduction based off what their stated numbers are. According to the Saudis, they would be producing 12.3 million barrels a day currently, so you're talking about, if they're telling the truth, you're talking about a 3.8 million barrel cut. At current numbers, you're running about $150 billion deficit for the Saudis. You're talking about $500 billion of forex reserves in that country. You could start seeing reserves drain quite quickly at current prices in production. To cut production further from here only worsens their situation, and I think they've really reached-- this has been a real stretch for them to get to where we're at post-OPEC+++ agreement. The bottom line is if your economy, essential part of your economy, is oil production, and you have prices collapse down to $20 a barrel, it just doesn't work for anybody. Everybody's in pain. Russia was in pain. That was a part of another report, I believe are provided for you, is that anything sub-40 doesn't work for global oil producers, generally speaking. US shale production obviously doesn't work in a sub-40 environment. The Saudis break even at $85 a barrel budget breakeven, which is what's important. They try and make you focus on lifting costs, but we want to talk about budget breakeven. No, that doesn't work for them either. In Russia, they're somewhere in that $50 barrel range for budget breakeven as well, so it's a degree of pain, everyone's in pain. It's just a matter of degrees. Russia was in pain, they have less storage. They refilled their some physical realities that affect the way they can shut off production less efficiently than the Saudis. They have less storage capacity as well. There are some problems with Russia if we were to go through this protracted oversupply scenario, but I still think that of the three major producing countries, the Saudis, the Russians, the United States, the Saudis are the least prepared for this environment. That was what my ultimate conclusion was. Again, it doesn't matter. $20, $30 Brent, it doesn't work over a long term for any of these countries. US shale, we're going to see a big recapitalization there as we've talked about. US shale is going to be recapitalized. It'll be absorbed probably by a combination of a couple big major producers. Then you're going to see, hopefully, for the safety industry, costs come down at that point, but as it's currently constituted, US shale will not exist going forward.

How Long Can This Go On?

Well, that's the question everybody would like to know the answer to is, the answer would tell us when we can come out of our houses, ultimately. I wish I knew how long. Again, I'm not an epidemiologist. I have no clue where the policy line's going to be drawn on this and that's going to dictate ultimately, how long  we're oversupplied. How long the coronavirus, COVID-19, stays with us is exactly-- is really the true issue here for the oil markets. The OPEC thing is behind us now. We're still stuck with oversupply and it's going to be that way until we reopen the economy. My personal feeling is that the way things have rebounded recently, energy stock prices and the way the oil market even to a certain extent has reacted around this, is that the market is-- and what we've talked about the past in the tanker stocks, can give you an interesting view into this. All those assets that I watch I would guess that the market is too optimistic about resolving this demand destruction. We may have a V-shaped recovery in the stock market, but we are not in my opinion, I don't see how it's possible to have a V-shaped recovery in oil demand globally. It just it doesn't really make sense to me. I don't see how we get there. I think if the market thinks that we're going to have demand normalized by just taking OPEC's numbers, they think that they can be cutting 5 million barrels of production from their inflated numbers already by the end of the year, which looks really like about a 3 million barrel cut, I think they're overly optimistic. I think the demand will not have normalized to that point by the end of the year. It doesn't really align with what I'm seeing on the ground from the economic shutdowns. The upshot of that is that you need to have patience if you're deploying capital into the energy space. We had some great deals we talked about last time. We talked about Williams and Chevron and a couple other really core holdings within the sector. Those have run but I don't think there's as much urgency to put that money to work. Today's the last time we spoke, I think this thing's going to be a little bit longer running and we've had a big move already.

How Low Can Oil Prices Go?

For oil prices, their strong support is zero. I would say that no, I think that all bets are off. Do we ultimately get lower than we were during the most recent plunge? I think we'll revisit that. If I had a gun to my head, I think we will revisit where we were back at the worst of the worst in March. I think that you can tell that the differential across the United States and what we talked about going on at Cushing, there's just a real mess in the oil markets, and OPEC has now, they've gone ahead and taking their shot and the market is digesting it. Again, once the true realization of how oversupplied we are in the market and the physical reality is there, I think prices will move lower and unfortunately for anyone who's been to a higher oil prices, at least.

What Will the Recovery Look Like?

Eventually when we do come out of this because we will come out of it, I think it's important to have a roadmap of what that recovery is going to look like and how that recovery translates into your investment portfolio. We've talked a lot about oversupplied. That's been the big theme of our conversation today and in previous conversations as well. Oversupply, ultimately, it will dictate the shape of the curve, which then dictates storage realities. Right now, I still like those tanker stocks we discussed, they really haven't moved despite the improving economics. There is a real risk that at the end of this, you see a falloff in ton mileage, but the near term economics and the oversupply is so great I think that you can look through that and you're still getting a good deal on those stocks. Afterwards, what we're going to see is a-- because we've talked about gasoline demand coming off, refined product, inventories swell, the swelling of refined product inventories ultimately will collapse refining margins, and that's what we're seeing right now. That causes refineries to curtail throughput. Once refineries reduced throughput, that's a negative for refiners. Refiners have been important storm in a lot of the other oil crashes we've seen in recent years. I won't go too far into why, but it's just those have been supply-induced crashes. This is a demand-induced crash. You see a different dynamic at play. It's too early to buy refiners is my point. Eventually, what will happen as you get this recovery is you'll see consumers start to normalize behavior that will first come through as higher refined product prices while we still have this glut in the crude oil market so what you'll see is improving refinery margins. At that point, it'll be time to rotate in refiners and at some point down the road ultimately, that will flow through into better, stronger crude oil prices, which is when you would want to go into more oil sensitive names like upstream names. The order in my view is you're in tankers now, you're waiting for refiners as we start to improve incrementally, and then eventually down the road, the later cycle in this energy recovery would be upstream.