Oil and the reflation rally

As investors assess prospects for the current reflation trade, we believe it’s worth keeping an eye on oil over the coming months.

As the Trump presidency faces its sternest political tests so far, the markets have begun to temper some of their frothiness, with the seemingly inexorable upward climb since the November elections now hitting a potential plateau. The Trump reflation trade has faded, with steelmakers in particular suffering, after having been bought up in the hope that the new President’s protectionism and championing of old industry would reenergise their currently challenged business models. It’s not steel that the portfolio managers I speak to are most focused on currently, though, it’s oil.

Oil could have been one of the key beneficiaries of the Trump regime and an obvious focus for reflationary pressures. Remember that three years ago, oil was over USD115 a barrel. Now, even in the face of a growing global economy, a pick-up in inflation expectations, Saudi-driven OPEC cuts and a crisis in Venezuela, oil has remained stubbornly under USD60 a barrel. It’s worth looking more closely at the recent history of oil – it’s a fascinating story, and a salient one.

In 2014, OPEC was facing a conundrum. With prices apparently settled in a new paradigm above USD100 a barrel, U.S. oil production was booming, threatening the cartel’s control over the market. Shale oil extraction and fracking, more expensive means of mining, were suddenly entirely viable in this new price environment. OPEC, driven by Saudi Arabia (whose per-barrel extraction costs are far lower than the more technologically demanding tertiary methods employed in the U.S.), responded to the threat by aggressively driving down oil prices, flooding the market with excess oil. At first, the plan appeared to work, and prices took a precipitous dive, from above USD115 a barrel in mid-2014, to under USD30 a barrel by the beginning of 2016. Things looked bleak for the nascent U.S. shale industry.

We should remember, of course, that there were other factors at play than OPEC’s campaign against shale oil. Russia continued to produce more than 10 million barrels a day throughout this period, while of course the U.S. was partly a victim of its own shale extraction success, seeing production increase dramatically in the first half of this decade. Figure 1 shows the impact of OPEC’s moves on the U.S. oil industry, with the rig count – an indication of new drilling activity – falling to its lowest level since 1999.

Figure 1: US oil production and rig count

Source: Bloomberg, June 2017. US Oil Rig Count – Baker Hughes (BAKEOIL index), US Oil Production – US Energy Information Administration (EIA).

Initially, as one would expect, U.S. production did stall, and in November 2016, confident that they had seen off the shale threat, OPEC, encouraged by Khalid al-Falih, the new Saudi oil minister, began to cut production in the hope of shoring up prices. Just now, Saudi Arabia has a particular interest in rising oil prices, given that late-2018 will see the long-awaited flotation of its state oil business, Saudi Aramco. It’s likely to be the biggest company in the world when it launches, with valuation estimates ranging from USD500bn to well north of USD1tr. One of the key components of the final price secured will be estimates for oil prices going forward.

And so here’s a new conundrum for OPEC, and an extraordinary lesson in the strength of the capitalist system. As Figure 1 shows, U.S. production anticipating new highs to be reached in the coming months. While OPEC was congratulating itself on the slow-down in U.S. exploration, oil companies in the States were working hard to improve the productivity of existing fields. Shale producers made extraordinary technological improvements to well design, which lowered their per-barrel break-even costs. According to JP Morgan’s estimates, the oil price needed to earn a 15% pre-tax rate of return at the wellhead in certain parts of the U.S. has fallen by 40% in just the past year, from USD48.95 to USD29.32.

For the U.S. shale industry, 2014 and 2015 were a trial by fire. Between the beginning of 2015 and mid-2016, 90 companies filed for bankruptcy, more than in the telecoms bust of 2001.

Over USD65bn of debt was affected, with the largest filings coming from Sandridge Energy, which owed USD8.3bn, and Linn Energy, which owed USD6.1bn. The sector de-levered dramatically during its period of stress, and those companies that survived are now leaner and nimbler. Looking specifically at the Permian Basin area of West Texas and New Mexico, we can see with clarity the impact of these productivity improvements. This area has been responsible for more than 50% of new activity since the slump, and production per rig has more than tripled here since 2014.

Figure 2: Oil production per rig in Permian Basin

Source: US Energy Information Administration (EIA), May 2017.

Technological advancements, intelligent management decisions and rigorous cost cutting have thus made the previously marginally economical shale oil business globally competitive, and this poses a potentially major problem for Saudi Arabia as the Saudi Aramco IPO nears.

It’s not only, though, that this is a notable, and very American, tale of corporate ingenuity overcoming seemingly impossible odds. The reason that we are watching oil so closely is that previous reflation trades have been scuppered by surging oil prices leading to overheating and an eventual crash – just look at the 1970s. As we weigh the sustainability of the current reflation trade, the possibility that oil prices could be maintained at the currently lower levels through technological innovation sends a potentially strong signal regarding the future health of the global economy. Conversely, if we were to see slowing global growth and continued acceleration in U.S. shale oil production, things could begin to feel eerily reminiscent of 2014. In this case deflationary alarm bells would start ringing loudly. Whichever way it goes, we believe it’s worth keeping a very close eye on oil over the coming months.