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Crude Carnage Continues As Goldman Warns "Storage Is Running Out"
WTI Crude is back below $45 again this morning - pressing towards 2015 and cycle lows -after Goldman Sachs' Jeffrey Currie warns 'lower for longer' is here to stay, with price risk "substantially skewed to the downside." His reasoning are manifold, as detailed below, but overarching is oversupply (Saudi Arabia has a challenge in Asia as it battles to maintain mkt share, the Russians are coming, andother OPEC members want a bigger slice) and, even more crucially, storage is running out. As Currie concludes, this time it is different. Financial metrics for the oil industry are far worse.
As Goldman Sachs' Jeffrey Currie explains...
1)Although spot oil prices have only retraced to the lows of this winter, forward oil prices, commodity currencies and energy equities/credit (relative to the broad indices) have now all retraced to levels not seen since 2005, erasing a decade of gains. This creates a very different economic environment as the search for a new equilibrium resumes: financial stress is higher, operational stress as defined below is more extreme and costs have declined further due to more productivity gains, a substantially stronger dollar and sharp declines in other commodity prices. These differences reflect not only a further deterioration in fundamentals, but also the financial markets’ decreasing confidence in a quick rebound in prices and a recognition that the rebalancing of supply and demand will likely prove to be far more difficult than what was previously priced into the market. This is all in line with our lower-for-longer view. While we maintain our near-term WTI target of $45/bbl, we want to emphasize that the risks remain substantially skewed to the downside, particularly as we enter the shoulder months this autumn.
2) In January, we argued that one of the key tenets of the New Oil Order was that capital is now the new margin of adjustment. As shale has dramatically reduced time-to-build (the time between when producers commit capital and when they get production) from several years to several months, oil prices now need to remain lower for longer to keep capital sidelined and allow the rebalancing process to occur uninterrupted. This spring’s rally in prices did prove to be self-defeating. Not only did all the capital markets reopen as oil prices rose, but producers began to redeploy rigs and remained under hedged, which is a reflection that the industry simply had not faced enough pain to create real financial stress that would create change.
3)This time it is different. Financial metrics for the oil industry are far worse. Forward oil prices are c.10% lower (at $58/bbl the 3-year forward oil price is at its lowest in a decade). At the same time leverage for the industry is rising as hedge books are much lighter, with 2016 hedge ratios at 9% versus a five-year average of 25%. Energy equity markets relative to the equity indices are at the lowest level since 2005 and at 3-year lows on an absolute basis. Energy high yield as an OAS spread ratio has also pushed above December 2014 highs. Although financial stress is higher, it alone is still unlikely to create the rebalancing needed due to the unique market structure of the New Oil Order, sidelined capital and declining costs.
4) The market structure of the New Oil Order is unprecedented. In January we showed that high-quality producing assets were on average owned by weak balance sheets while strong balance sheets on average owned the lower-quality producing assets. In other words, the IOCs and some NOCs own most of the higher-cost production while E&Ps, particularly US E&Ps, own much of the lower-cost production. Historically, weak balance sheets typically owned high-cost assets and vice versa, creating a linear relationship between lower prices and financial stress, which historically led to more financially motivated supply cuts as prices dropped. Yes, we have seen some of the few companies with weak balance sheets and high-cost assets run into trouble and go into maintenance mode, but they are not sufficient to shift the market balance. In contrast, the weaker balance sheets with high-quality assets issued equity during the spring, when capital markets were open, to buy more longevity by reducing leverage by half a turn. On net, from a financial perspective, the adjustment process is now likely to take longer.
5) Logistical and storage constraints are also tighter this time. We have argued for decades now that modern energy markets mostly rebalance through operational stress. Operational stress is created when a surplus breaches logistical or storage capacity such that supply can no longer remain above demand. Although perceptions this past April were that the market was near operational stress, it is now far closer. We estimate that the industry has added c.170 million barrels of petroleum to crude and product storage tanks since January and c.50 million barrels to clean and dirty floating storage. With increased operational stress in the system versus six months ago, we now attach a substantially higher probability to this being the margin of adjustment than we did in January. While the probability of blowing out storage this autumn is higher, the market will need to balance or adjust before next spring’s turnarounds.
6) Should the market breach logistical and storage capacity constraints, this would kill the storage arbitrage between spot and forward prices and create a significant flattening of the entire forward curve (though front timespreads would likely blowout initially). Historically, once storage capacity is breached across all crude and products, supply must be brought back below demand immediately. To create the rebalancing physical constraints create a collapse in spot prices below cash costs as supply is forced in line with demand (late 1998 is a good example), creating the birth of a new bull market. Breaching crude storage capacity alone is not sufficient, as it simply leads to an increase in refinery runs creating product where storage capacity is available, so both crude and product storage needs to be breached. Further, this only requires breaching capacity in one or two of the key product markets given constraints on refinery product yields. In the current market, the likely candidate is distillate as inventories, particularly outside of the US, are extremely high and margins are weak. As the curve flattens, long-dated oil prices historically have drifted down toward cash prices. As producers face increasing financial stress, covering operating costs and surviving becomes more important than future growth.
7) It is important to separate cash costs from total costs. As oil markets are substantially oversupplied by nearly every measure (see below), the need for new incremental capacity is limited at the margin. New incremental capacity requires prices above ‘total’ costs, defined as fixed (capex) plus variable/cash costs (opex). However, in an environment where the market only needs to produce from existing capacity, prices only need to cover variable/cash costs to keep existing capacity operating. And herein lies the paradox, for the high-cost, strong balance sheet producer, cash costs are $40-$45/bbl versus total costs closer to $75/bbl. In contrast, the low-cost, weak balance sheet producer faces cash costs near $20/bbl with total costs near $55/bbl. As the high-cost production is mostly oil sands and other costly to shut in conventional oil, the stronger balance sheet producers with this production will resist the costs of shutting in, leaving the easier-to-shut, lower-cost production held by the weaker balance sheets as the more likely candidate. This suggests the volatility and risks to the downside are significant. Furthermore, a stronger US dollar, productivity gains and other commodity price declines only creates more cost deflation, via the negative feedback loop, making cash costs a moving target to the downside.
8) Commodity and emerging market currencies have also erased a decade of gains, reflecting the significant macroeconomic imbalances many of these countries are facing, created in part by the sharp decline in all commodity prices. This not only impacts emerging market demand for oil, Latin American demand in particular, but also lowers the costs to produce oil and commodities in these countries. To illustrate the sensitivity of oil cash costs to the Brazilian real (BRL) and Canadian dollar (CAD), we find that a 10% move in BRL or CAD shifts cash costs by 3% and 5% respectively. The BRL and CAD have weakened year-to-date by 31% and 14% respectively. Further, as we argued late last year, 2015 supply growth in regions facing sharp currency depreciation have been revised up since March by the IEA: Brazil (+24 kb/d), North Sea (+65 kb/d) and Russia (+145 kb/d). It is important to emphasize that markets have never seen such a large appreciation in the US dollar at the same time they have seen such a large surplus in the oil market. While it is unprecedented in the current direction, the weakest US dollar ever recorded on a trade-weighted basis was when oil prices peaked above $147/bbl in July 2008. As we have emphasized in all of our research since 2013, it is the same macro forces working in reverse today that pushed markets to the highs during the previous decade. The crude market didn’t go to $147/bbl on oil fundamentals alone, nor would it be collapsing like this on oil fundamentals alone.
9) Nonetheless, fundamentals are weaker today than in 1Q. Global supply is currently up 3.0 million b/d (and averaged up 3.2 million b/d over the past 12 months), driven in large part by a surge in low-cost production from Saudi Arabia, Iraq and Russia. The largest demand growth ever observed was in 2004 when China and the emerging markets kicked off the previous decade's commodity boom and drove a 3.15 million b/d demand growth number. In 2004 the emerging markets had clean balance sheets in strengthening currencies which reflected their good health. Today, that boom decade has been brought to a halt. These countries are facing large macro imbalances and debt. Not only has emerging market growth slowed, but any benefits from lower prices are mostly behind us now, as the benefits only last 6 to 9 months. We estimate that current oversupply is c.2.0 million b/d versus c.1.8 million b/d in 1H15.
10) The oil industry on average is not earning its cost of capital. The distinction between cash costs and total costs, also applies to ‘well’ versus ‘company’ returns. While the returns at the well can be economical at prices near $50/bbl, the returns for the company can be deeply underwater due to large-scale investments when prices were at $100/bbl. Even assuming an aggressive company decline rate of 25% over the past year, that would make 75% of the assets legacy production. While commodity markets don’t care about legacy fixed costs, and only about today’s cost to bring on a marginal barrel, potential equity and credit investors do care about those legacy costs and what they do to company long-run returns. In general, energy companies at present cannot earn their cost of capital over the long-term (defined as the past 50 years). Long-run returns are 10% versus a cost of capital of 12.5%. In other words, they are wealth-destroying propositions from the get go. The reason for this is the industry constantly invests in new capacity during the investment phase of the super cycle, i.e. high and rising prices, and brings on line this new capacity during the exploitation phase of the super cycle, i.e. low and declining prices.
11) While the supply and demand for the barrels of oil will likely find a balance between now and sometime in 2016 with an increasing likelihood of this being driven by operational stress, this doesn’t mean a sharp rebound in prices will occur quickly as so many other factors will likely weigh on prices. Not only will the macro forces keep prices under pressure, but historically markets trade near cash costs until new incremental higher-cost capacity is needed (even the IEA has revised 2015 non-OPEC output growth from existing capacity up by 265 kb/d since March). In addition, low-cost OPEC producers are likely to expand capacity now that they have pushed output to near max utilization. At the same time Iran has the potential to add 200 to 400 kb/d of production in 2016 and with significant investment far greater low-cost volumes in 2017 and beyond. Iran, like other OPEC countries, needs the revenues through volume. Even Venezuela accepted another $5 billion last week from China to produce oil from older fields. Finally, the capital markets for energy need to be rebalanced through consolidation and capital restructuring. This takes time to achieve. In the previous cycle this took from 1986 to 1998 and ended with the creation of the super majors. Today we expect it to go more quickly, just as we erased a decade in the matter of months, but it will take time.
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Goldman always talks their book. How many hundreds of billions worth of oil is Goldman short?
And gasoline just dropped below $4/gal in California yesterday.
No doubt on its way to 6 cents a gallon as in Venezuela.
Gasoline will be too cheap to meter soon.
Electricity will be too cheap to meter was the promise of nuclear power
Obviously the problem is not enough storage. I'm going to start an undground crude storage company. We buy up old oil wells and pump the oil back into the ground through the same pipes that brought it up. And then we charge money by the day for storage. It's handy, since the infrastructure is already there.
You can't know where oil price is going without knowing what caused the price drop in the first place. This is a proper root cause analysis.
A comment I just finished on the testosteronepit article on oil and job loses. Please note the part about wheat waiting to be shipped:
Crazy Cooter,
I appreciate your posts, but I have a different view. long post, sorry. What you said is true:
1) In the end, low prices are the cure for low prices, BUT
2) At the beginning of the bust of a debt fueled bubble, low prices may lead to low prices.
In the book, The Worst Hard Times by T. Egan written about the dust bowl, when wheat prices dropped, the farmers, especially the "suitcase farmers," actually "double downed"and broke more sod (turning desert in cultivated land) and planted even more seed the next season in order to pay their debts.
Example: they borrowed $6,400 to buy 640 acres of land, but could only use a small part of the land until tractors/ mechanization started to come into play.
They first plowed and planted 50 acres, got 40 bushels wheat per acre, $4 a bushel (not accurate in the numbers, just giving a context.) and made $6000, minus expenses of $1000. They paid the bank $1000 and pocketed around $4000.
The next year, wheat is $2 bushel. No problem, I'll double the land in cultivation and produce MORE with the lower prices, and I pay the bank, and make some money: 100 acres at 40 bushels per acre at $2 a bushel.
This stops working when the price falls low enough and production has been jacked up higher by everyone. Eventually a bushel of wheat on the ground at the railroad shipping depot waiting to get shipped to market was <10 cents a bushel. (Not sure I remember right nor remember the source, but wheat may have briefly gone to - 5 cents, a NEGATIVE 5 cents. Briefly, they paid you to take ownership!)
My point: Eventually, as cooter said, the price will rise, after the liquidations, but until then, perhaps these oil producers have to pay the "bank" a payment, and to do that they INCREASE their oil production to obtain the $ (at these lower prices), the OPPOSITE of what an oil well owner, with full owner ship, would do. If you owe nobody, you shut down your oil well until prices rise.
Now, in USA, the amount of debt on each oil well is amazing, and that's assuming there is no hypothecation, manipulation, or other interference (Obama and Coal mining). Sure there are oil well owners and companies who will sit this out and do well, but they are the exception.
Similar to a stock market bubble with people playing it with margins/ debt. Lower prices result in more people wanting to sell.
My 2 cents.
Maybe oil in storage is the new "wheat on the ground."
I'm going to start a municipal pothole storage company. We will have one crew that digs holes with jackhammers and a second crew that comes by and fills them back in with sand and asphalt. Highly scalable to provide new shovel-ready jobs on demand as the need becomes apparent. I will call it Princeton Pothole Diggers Inc. (Princeton PhD for short.)
That was only on the back of free oil, once opec got together and wanted it's share after 25 years, the dream of cheap electricity went down the drain so to speak, as did our gold std.
Storage is out..................LOL
It's stored in the ground........................now once it's out.....................that's a differant thing alltogether
They built hugh above ground tanks which could store oil until the price rose, now they can't build tanks fast enough to store the oil so the ability to store oil until the price rises is compromised. Just as is the price of oil due to competition for money is dropping. It's a double whammy of not being able to raise the price of oil, as your liabilites rise from the debt due to produce the oil now in storage.
I still can't find any under $2.70 here in PHX. Damn speculators.
You're too close to the left coast. I'm paying $2.22 here
Let me know when Californians are selling back their piss for $40 dollars a gallon. Gota get water from somewhere.
None, they're long now that's why they are trying to convince you to go short. Who do you think owns the full storage containers?
Uncle Warren?
With the price down, why is there so much to store? Could it be lack of demand? But the "recovery?"
Their is some space availble in gold and silver vaults i heard. they can store some oil there. and china has some cities that are kind of vacant
We will adjust the price AFTER we kill shale and Russia..
yours truly. .. Bandar bin buttfuck (Saudi Royalty)
oh, and IRAN too!!!
alright fellas, you know the drill. Maybe the bottom is in??????????
Hmmmmm, the squid says sell. What to do, what to do, what to do?
I'm long in seafaring international pirates raiding oil tanker ships and selling the crude on the open market. If only there was a ETF to trade this with. Do what squid doesn't say !
Wait for a 4-6% swing in the downside direction, and consider loading up on forward calls.
We need to start making barrels out of copper that's in those warehouses proplem solved
Shiller predicts earl may drop to $20 ?!
'Summer of Rekovery' in progress....
Goldman predicted $32/barrel crude oil earlier this year right before the market rallied higher by nearly 50% in just a few weeks.
Why would anyone listen to these crooks? They are the worst of the worst.
A couple of ZH/Goldman notes in the second week of March
http://www.zerohedge.com/news/2015-03-09/goldman-blames-weather-stronger...
http://www.zerohedge.com/news/2015-03-13/oil-prices-will-stay-low-despit...
And you're correct. Oil bottomed a week later.
If one is supposed to buy stocks when blood is running in the streets;
how about oil stocks when oil is running in the streets?
I have a couple of old coffee cans laying about - maybe they could use them? I mean - it's all for the cause so it's good right?
ZH its not like you haven't reported on this several times! [sarc] Wait for Goldman to catch up. I can almost foresee a crude liquidation throughout all non OPEC and OPEC nations . I wonder how long US shale producers can holdout during this continued crude drop in WTI and Brent
As long as the banks want to keep helping them out.
Go long on barrels!
I have twin sinks so one could be used to store oil. I need the tub so that's out. They'll find more space.
In case you didn't bother to read the article, one of its theses is that this is all a stronger dollar story. Gotta believe that a few two many countries loaded up (well gorged) on a bit too much debt in a currency they don't control (EM = buckees, ClubMed = Euros) and now have to "surprise"! figure out how the hell to pay it back. The so-called "cleanest dirty shirt", aka the buckee, is proving to be pretty darned stretchy, as an amazing number of outfits are trying to squeeze into it, and it hasn't busted yet, just keeps expanding. Any buddy but Schiff (who sailed to Puerto Rico) would be proud.