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Slippery ground

Why the recent spike in oil prices may not be sustainable

Slippery ground

The theory behind cycles goes something like this: starting with low prices (say, in the oil sector), which is a commodity, you reach a point where many players in the industry are not able to service debt. As a result fresh debt is not available. Given low stock prices, neither is equity. So overall supply is stagnant to falling, as marginal players who have eroded equity are forced out of business. We saw this recently in oil (with high-cost shale and deep-sea players), steel (the recent high-cost greenfield projects) and sugar (where capacity below 10,000 tonnes of cane per day became unviable). The same thing is happening in paper and shipping but in slow motion.

As the old saying goes, if money stops coming in through the balance sheet (in the form of debt or equity), it will come through the P&L account (in the form of higher prices and operating margins). That is, if there is a capacity shrinkage/stagnation in the industry, incremental demand will push up prices. Hence, the popular saying, lower prices cure lower prices - the principle behind commodity cycles.

This is being used to explain the current uptick in oil prices, presenting it as a cyclical upturn rather than a correction in a structural downturn. Lower oil prices result in higher consumption demand, especially price sensitive latent demand. And oil exploration has been largely suspended, except in the shale sub sector, leading to a paucity of new oil finds. But is that the end of the story or just a chapter in a longer story?

The first structural downturn in oil prices was when the cost of improving drill bits started to decide the marginal cost of world oil production, i.e., the causa proxima was shale oil, which saw a steep decline in the cost of oil production, from $85 per barrel to the current $50 to $65, mainly driven by advances in drilling technology. While in the earlier 'Big Oil' dominated world, the cost of drilling oil was mainly driven by the cost of finding (and getting to) it, the new shale oil discoveries were in geopolitically safe US, so there was no premium to finding and getting to the oil. Thereafter, as the cost of drill bits fell, and flexible drilling arms became the norm, you could 'drive' through rock to get at small puddles of oil lying in patches in shale rock. This brought down the cost of drilling and transporting oil. This cost curve is still declining. There are scenarios that talk of $28 as the average cost of shale oil by 2020.

The body blow was struck when shale-oil production reached a tipping point, about 9.25 million barrels per day (bpd), a critical mass that was more than Saudi Arabia's ability to 'swing' its production to balance supply, keeping prices in the $80-120 range. From a prognosis of $150-200, and 'peak oil', we came crashing down some 50 per cent and all those scare scenarios are now part of fiction.

The new 'bullish consensus' is that low prices cure oil prices and that the cycle has turned. This is flawed, and ignores the fact that the cost of oil production is now a function of technical improvements in drilling processes, and that a 20 per cent improvement in shale production (baseline 10 million bpd) can balance the entire increase in global oil consumption (currently 1.6 million bpd, about 2 per cent).

For intrepid investors, who are looking for an alternate to the current Indian bull market, there is a hedge available in playing this 'lower for longer' side of the story. And it goes something like this: not only is shale getting a new life (gross capex is reviving, and there is a whole new generation of flexible drilling technology) but this is short-gestation capex, not like the long views that are taken by oil companies in deep sea or geopolitically sensitive areas. Most important, the next big thing is already round the corner - electric cars and solar, which have shortened the life cycle of any traditional oil investment.

The key thing to play for is when electric-car conversion will reach a tipping point of 10 per cent adoption, after which the electrification of world transportation will start to drive prices at the margin. The recent order for 10,000 electric cars by the government is just a first domino; it will be accompanied by a flurry of electric models by end-2018.

The so-called oil bull market is capped at $65, the price at which unlimited supplies will come onstream, with a relatively short gestation period of 12-18 months. And this itself is going to follow the falling cost curve of the shale-oil industry, say, about $10 per year. Watch the carry, if the short-term bullishness is giving you 18-24 per cent annualised, you have a very safe strategy that will deliver excellent returns over a three- to five-year period. It's a beautiful way to play a current position in the Indian equities market.

So oil will top out at $65, maximum one-day upside of $85 if it hits a frenzied bull movement (possibly in the middle of some temporary geopolitical disruption, like the Kurdish lines being closed by Turkey). On average, it will be somewhere between $50 and $60, say, $55 as the mean.

You should try to get an average selling price of $60, and then let carry take care of the rest. And bet on $30 as the price of oil. The immediate cap is set by the cost curve of shale oil and its scalability, which is now well above any incremental demand that is triggered by 'lower prices'. Not only will this short-term demand uptick taper off, the incremental supply from shale (which will now be achieved by de-bottlenecking of existing investments) will more than meet any shortfall.

The joker in the pack, as always, is geopolitical disruptions like the blockage of Kurdish pipelines by Turkey (about 5,50,000 bpd, about 5 per cent of shale capacity). These will create short-term spikes, which a trader has to survive, so don't bet the ranch.

The black swan that this consensus has not taken into account is how fast solar will start impacting the the conversion of transportation to electric cars and how quickly this will start impacting the price of oil at the margin. I suspect this will happen when EVs start to account for about 10 per cent of car population, from less than 1 per cent now. This is still at the stage of early adoption, when issues of battery storage, refuelling and speed/power/range will be bedevilling the adoption rates. High oil prices, should they happen, will only accelerate early adoption of EVs, something the trader should bet on.

To bet on this hypothesis, you must believe in the big trend of zero-cost energy and its implications for the structure of the world economy. The energy industry contributes about 12 per cent to world GDP, steadily falling from 20 per cent in the 70s. Energy usage will grow faster than the energy industry will decline, provided the structural shifts happen in the poorest regions of the world. In this, India is headed in the right direction, with government policy driving almost all its incremental financial firepower into the solarification of India's hinterland.

Yes, there will be hiccups, and nothing in the current pull-back of oil prices was unpredictable. Low prices do cure low prices in the short run. In the long run, all the factors that are driving oil into the 'lower for longer' zone are intact. In fact, they are accelerating. The fact that oil exploration is not picking up is evidence of the long-term view. The current jump in oil prices is a short-term blip, a spike with a long valley ahead and can be traded with some trepidation.

The author teaches, trades and writes at spandiya.blogspot.com.