Posted by on May 22, 2017 4:50 pm
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Categories: Backwardation Business Central Banks Contango Economy Goldman Market Share Normal backwardation OECD OPEC Organization of Petroleum-Exporting Countries Peak oil Petroleum Petroleum industry Petroleum politics Price of oil Private Equity Saudi Arabia US Federal Reserve white house World oil market chronology from

Increasingly some of the more prominent sellside analysts appear to be picking and choosing ideas from their competitors. Earlier, it was JPM echoing Goldman’s reco when it cut its 10Y yield forecast. Now, in a note previewing the outcome of this week’s OPEC meeting and proposing a way forward for OPEC, Goldman’s Damien Couravlin adopted the “backwardation” idea presented last week by Morgan Stanley’s Francisco Blanch.

As a reminder, Blanch’s latest thesis on oil market dynamics, is that “OPEC’s goal for the oil market is not a specific price level, but reaching backwardation“, (which is also why he does not believe that OPEC will proceed with deeper cuts as this would likely mean ceding more market share to U.S. shale production).

Fast forward to Monday, when Goldman’s energy strategist Damien Couravlin effectively cribbed the whole note by writing that while “oil prices are rebounding with stock draws and greater certainty on an extension of the production cuts” and a “9 month extension would normalize OECD inventories by early 2018” he warns that he sees “risks for a renewed surplus later next year if OPEC and Russia’s production rises to their expanding capacity and shale grows at an unbridled rate.”

How can OPEC avoid this boom-bust cycle again and achieve both fiscal stability and rising revenue through oil market share gains? He argument is that “only sustained backwardation can restrain access to the large pools of private equity and HY credit capital.”

We believe that low deferred prices can achieve this by (1) increasing the opportunity cost of shale’s capital providers to hedge out their oil price exposure, (2) lowering expected equity valuation and (3) increasing expected leverage levels. Costs will also play a role in setting shale’s growth path but we do not forecast sufficient inflation at this point to achieve the required slowdown next year.

In other words, Goldman observes that curtailing access to capital is required to slow shale grow, and is urging OPEC to eliminate the biggest loophole that has allowed shale to keep producing despite lower prices, namely the contango that has allowed US producers to not only hedge production at affordable prices but to continue expanding production even as OPEC nations have been forced to limit their own output, ceding market share to US producers. 

How can OPEC achieve this? Goldman’s answer is that the bank believes “that OPEC and Russia should (1) extend/increase the cuts until stocks have normalized, (2) express the goal of growing future production, and (3) gradually ramp up production to grow market share but keep stocks stable and backwardation in place.”

Goldman concedes that “achieving this will be difficult, but we see templates in both OPEC’s modus operandi of the 1990s of managed but flagged growth and the rationalization of shale growth in US gas, both with backwardation.”

The bank also highlights one major risk to its thesis: that cheap, mostly junk-rated credit will remain abundant, allowing shale to continue expanding production regardless of the fundamentals: “while oil hedge ratios are low for 2018, the main risk to this view is that funding markets remain resilient to lower deferred prices, with little HY debt maturing in the coming years.

What does all of the above mean for OPEC’s announcement on Thursday? Under such a proposed framework, “we believe that OPEC should announce a decisive cut on May 25, as normalizing stocks is a required first step (likely a 9 month extension).” Such an announcement would have a two-fold impact on oil prices: first, when it comes to Goldman’s near-term price target, the firm says that its year end Brent spot price forecast remains at $57/bbl. Things change when going beyond the 2017: here Goldman for the first time adds a significant caveat:

“we now forecast that deferred prices will need to decline with 1- to 2-yr WTI forwards of $45/bbl. This leaves us expecting high total returns for being long oil, delivered through backwardation, but recommending that producers increase their hedge coverage. If backwardation is not achieved, however, we see risks that prices fall sharply next year as OPEC reverts to growing market share through volumes.”

Just to recap, here is Goldman’s summary of what it dubs “OPEC’s dilemma”:

Herein lies the OPEC dilemma – a return to production capacity in 2018 to grow market share would lead to a sharp collapse in prices. This would extend the tug of war between OPEC and shale with the former ramping up production in 2015-2016 and 2018 but shale growing sharply in 2013-14 and 2017.

This dilemma is well illustrated with Saudi Arabia. While the Kingdom reduced its fiscal deficit in 1Q17, its roll back of austerity measures necessitates higher oil revenues in 2018 to prevent renewed large deficits. While further cuts in 2018 to support oil prices near $60/bbl would guarantee such higher fiscal revenues, this strategy would prove self-defeating longer term as high cost producers globally would ramp up activity at such prices, reducing Saudi’s long-term revenues. In turn, we do not believe that Saudi’s spare production capacity is large enough to be able to grow volumes sufficiently in 2018 to offset a sustainable decline in prices to $45/bbl and keep oil revenues at 2017 levels.

How can OPEC therefore achieve both fiscal stability and rising revenues through market share gains? We believe that the answer to this question is backwardation as low deferred prices can restrain access to capital for higher cost producers such as shale. Furthermore, backwardation maximizes low cost producers’ revenues relative to higher cost producers that hedge, as they instead sell all their production at spot prices.

Finally, we will note that the irony embedded of Goldman’s latest analysis is two-fold: on one hand the bank has to come up with a comprehensive strategy to bypass the liquidity gusher unleashed by the Fed and other global central banks. One issue with the Goldman analysis is that while it may be absolutely correct, and that backwardation will likely impair the fundamental profile of US shale producers, all that would result in is higher yields for corporate issuers which in turn would lead to an oversubscribed, bidding frenzy as the buyside rushes to allocate “other people’s money” in distressed names. As such, Goldman’s assumption of an efficient capital allocation process in a time when there is $18 trillion in excess liquidity is almost certainly wrong.

Funding aside, what is also ironic is that a US investment bank, one which effectively controls the White House, is tasked with conceptualizing a scenario which leads to a Saudi “victory” in the war with shale, an outcome which would result in thousands of lost US jobs, even as Saudi state revenues recover, and save the kingdom from its recent near budgetary death experience. It begs the question: if push comes to shove, will the Goldman Trump White House pick the side of the US shale industry, or that of Saudi Arabia, which this weekend announced intentions to purchase $350 billion in US arms over the next decade. Unfortunately, the answer is not self-evident.

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