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Why are we bearish on the oil price?

Screen Shot 2016-02-15 at 4.56.12 PM

Why are we bearish on the oil price?

In this blog, we describe the framework for how we think about commodities and use it to explain why we believe the oil price will likely stay lower for longer. Montaka has a number of positions in the portfolio that will profit from such a scenario, on behalf of clients.

Now, imagine you compiled a list of each oil-producing region in the world with: (i) how much they were producing, measured in millions of barrels per day; and (ii) the operating cost to deliver said production, measured in dollars-per-barrel. Imagine you then created a rectangular box for each oil-producing region with its width reflecting production and its height the cost of its production. Stacking these boxes from left to right, smallest to tallest, will result in something like the following chart. This is essentially the “supply curve” of the oil industry, in economic speak.Screen Shot 2016-02-15 at 4.18.18 PMNow, imagine you walked along the horizontal axis (which reflects the volume of oil currently being produced) until you reached the point that was equal to the volume of oil that the world currently consumes (known as “demand” in economic speak). Well, at this point, the height of that box will essentially represent the global oil price. This is illustrated below.Screen Shot 2016-02-15 at 4.26.53 PMIn simple terms, think of the very low-cost producers (bottom-left boxes) as the Saudis and other OPEC nations; and think of the higher cost producers as North American oil projects. The chart below illustrates a far more detailed version of this framework, courtesy of Citi.

Screen Shot 2016-02-15 at 4.50.12 PMNow, what happens to the oil price if, for example, the Saudis accelerate the volume of oil they currently produce? (And, by-the-way, this is exactly what they have been doing). Well, our framework can tell us what will likely happen. Assume the bottom-left box on our chart is the Saudi production: now to expand its production, we extend its width to the right; and this shifts all the other boxes to the right as well. The new arrangement is our “new supply curve” that incorporates the expanded production from the Saudis.

Screen Shot 2016-02-15 at 4.51.08 PMTo evaluate the price, we do exactly the same as before. We overlay demand and determine at what height it intersects with the supply curve. This is the new global oil price level, as illustrated below. Note how the price has fallen! As low-cost producers increase production, the oil price should fall.

Simple enough, right? So surely this means that if the Saudis were to “cut” their production, the reverse should be true and the price should revert back to its original level. Well, not so fast…

You see, one of the underappreciated second-order effects of the Saudis expanding their oil production last year (and the resulting collapse in the oil price) has been the enormous cost-reduction efforts undertaken by the higher-cost producers, particularly in North America.

As illustrated by the Bernstein table below, cost reductions across the board have been significant and typically averaged savings of around 15-20 per cent in 2015 alone. We expect such cost reductions to continue well into 2016, at a minimum.Screen Shot 2016-02-15 at 4.51.42 PMSuch cost-reduction programs have the effect of “flattening” the global supply curve. To go back to our original framework, the height of the boxes have now reduced, as shown in the chart below. This means that if, for example, the Saudis cut their production back to original levels, the oil price would not return to its original starting point: it would remain lower!Screen Shot 2016-02-15 at 4.52.14 PM

To summarize where we are today, we know the following basic facts:

  • OPEC production accelerated to 3-year highs in 2015, led by strong production from Saudi Arabia. While the exact motivation is unclear, many believe the Saudis are trying to push much of the North American supply out of the market.
  • The resulting low-oil prices have perversely created the incentive for other OPEC nations to also accelerate supply to maintain oil revenues that are needed to fund public budgets. This only exacerbates the oil price downturn.
  • Low oil price expectations have motivated oil producers around the world to aggressively cut costs out of their operations. As illustrated above, this has flattened the global supply curve, meaning that prices will likely remain lower for longer, even if OPEC supply is rationalized back to original levels.

Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To invest with Montgomery domestically and globally, find out more.

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Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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19 Comments

  1. Thank you Wade for the YouTube link.

    It is interesting if BRK closed their position in 2013, only to reopen in Sep 2015 – given the dramatic changes within the sector since late 2014, and the ever depressing (supply-side and demand-side) outlook.

  2. Roger has often expressed his enthusiasm for a Buffet/Graham style approach to investment, what are your thoughts on Berkshire’s recent increase in it’s investment in oil companies? i.e Phillips 66

    • Hi Steven,
      I have not looked at Phillips 66 specifically, so cannot comment. With respect to the Ben Graham approach to investing, we most definitely subscribe to many of the underlying concepts he taught.
      AM

      • Thanks Andrew, I suppose to be more clear, the point I was trying to make is that Buffett is increasing his exposure to oil, whilst Montgomery, based on your article is bearish and would seemingly stay out of the oil space altogether. Does Montgomery not see any potential opportunity/value in beaten down oil stocks at all? I appreciate that you cant comment on any companies directly.

      • Hi Steven, our view is that the oil price will remain depressed for longer than most people are expecting. As such, producers of oil and many oil-related service businesses do not have particularly bright prospects over the medium term, in our view.
        AM

      • I think we need to draw a clear line here. Phillips 66 is a oil refinery company, not oil producer which has direct exposure to oil price volatility. It seems to me oil products and services companies are doing particularly well. Caltex is a good example. The company is still resilient even the oil price collapsed to the bottom. There are risks to oil refinery businesses but it seems to me these companies are exempted from the current turmoil so far. Perhaps Andy can comment further on this.

  3. Tristan Harrison
    :

    Is there a comparable link to other commodities where the product has different levels of quality? Eg iron, salmon (tassal), beef, cheese etc?

    When the price changes, or the demand (increase or decrease) does the high quality product win or lose out normally?

    • Hi Tristan,
      Typically not, in my opinion (though the producers themselves will tell you otherwise until they are blue in the face). A commodity, almost by definition, is hard to differentiate – even if there are slight differences in qualities. A price downturn (or upturn) will typically impact all qualities. For example: VALE, the Brazilian iron ore company, has the highest quality iron ore in the world. Yet it is still suffering enormously from the global iron ore oversupply situation that currently persist.
      Hope this helps,
      AM

  4. Hi Andrew, thanks.

    Another reason why the oil price will stay lower for longer is that as the US shale oil companies go bankrupt, private equity funds and others will buy up their assets at 10-20cents in the dollar and as a result the capital cost of producing shale oil for the new owners will be substantially lower.

    Kelvin

  5. Hi Andrew.

    Did your analysis look at the demand side too – presumably you might expect demand to increase at lower prices or is it relatively inelastic?

    Thanks.

    • Great question, Curtis.
      Demand for oil is certainly more elastic than for other commodities, so as prices fall, demand for oil should increase – all else being equal. For the analysis shown, I assumed an immaterial change to oil consumption growth as a result of lower prices. At the moment, oil supply is dominating the balance and that’s why the price has fallen so significantly. Over the coming years that may change – though probably not in the near term. Global aggregate demand growth is sluggish (at best) at the moment.
      Hope this is helpful.
      AM

  6. Hi Andrew,
    Thanks for this excellent explanation & the accompanying graphics. You make understanding the situation so clear in such an easy to read manner. It’s as though you are talking to me face to face. I do appreciate this type of explanation.

  7. Well explained Andrew, simple enough and to the point.
    Is it possible to point me in the direction for similar data / graphs for gold as well?
    Thanks,
    Yavuz

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