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Oil & Antibiotics

Source: Nasdaq

We caught a falling knife last fall when we bought DBO, an exchange-traded fund1 linked to the price of oil, for our strategies in mid-September. Our thesis was that the summer's near 15% drop in oil prices didn't make sense given the increased risks to oil production/ exportation in major oil producing countries such as Russia (Ukraine-related sanctions), Iran (potential new sanctions if nuclear negotiations failed), Iraq (ISIS attacks) and Libya (civil war), and the potential for a US-driven acceleration in global oil demand. By early November we had suffered a low double-digit loss in DBO, so we reevaluated the position, admitted that our thesis was wrong and sold out. We concluded that the Saudis, the "swing producer," wanted lower oil prices. Sure enough, the Saudis confirmed our conclusion later that month at the 166th meeting of the Organization of the Petroleum Exporting Countries (OPEC) in Vienna by resisting all calls for production cuts.

Oil is now some $30 cheaper per barrel than when we bailed out in November, but we still have no appetite to be long the commodity. Although we feel that current prices have undershot levels justified by long-term supply and demand, we believe the Saudis have strong short-term strategic motivations that will continue to pressure oil prices over the coming year, maybe longer.

Being among the largest and lowest cost producers of oil, Saudi Arabia has traditionally played the role of swing producer, able to change supply-demand balances and set price by adjusting its production rate. The Saudis perhaps got a little greedy by letting prices run above $75 per barrel for much of the last 10 years. This naturally incentivized consumers to use less oil (e.g. individuals bought smaller and more efficient vehicles, airlines bought more efficient planes) and to find substitutes and alternatives (e.g. solar, wind, gas), and incentivized producers to find new oil sources (e.g. tight oil/fracking, oil sands, deep sea).


Source: Deutsche Bank


The US has led the charge in developing new sources of oil. The chart on the left from Deutsche Bank shows the dramatic increase in US oil production, most of it coming from hydraulic fracking operations in shale oil formations such as North Dakota's Bakken and Texas's Eagle Ford. The US alone has added over 4m barrels/day to global production over the last six years. On a pre-recession oil consumption base of 86.7m barrels/day (2007), US hydraulic fracking has changed the game for OPEC and the rest of the oil market.

Source: International Energy Agency

The chart on the right shows how OPEC initially reacted to the new supply of non-OPEC oil, most of which was from the US - it cut aggregate production by over 1m barrels/day during 2013 and 2014 in an effort to maintain the balance of supply and demand at high prices.

OPEC appeared to initially underestimate the destructive effects of high oil prices on demand and their constructive effects on new supply. It appears that sometime last summer the alarm bells finally sounded in Riyadh, a realization that they were on a treadmill of production (and revenue) cuts if it and OPEC maintained its policy of high prices.

To cure their ills, the Saudis need to maim their new foes - the high cost operators developing US shale oil formations, Canadian oil sand deposits and deepwater fields off Brazil, and the high cost/high tech developments that dented new oil demand, such as solar, wind, LED bulbs and electric cars. The medicine, or antibiotics if you will, would have to be low oil prices. And like with antibiotics, it would be unwise for the Saudis, and the rest of OPEC, to stop midway through taking the prescription. A temporary price drop will only work to build resilience and resistance in the new foes, helping them to lower their cost structures and to develop more resilient funding structures. The Saudis need to bankrupt as many of these foes as possible and this will take some time. As shown in the above chart, OPEC opened up the taps in September, led by Saudi Arabia and other like-minded (and Sunni- controlled) Gulf states.

Below is a chart that shows all-in costs of various oil producers. The new sources from the Americas, mostly unconventional (hydraulic fracking, oil sands, deepwater), are higher in cost and thus the most vulnerable to low oil prices (currently $48). But this chart includes all-in costs, including upfront development costs. We imagine that production from the Americas will continue to grow throughout most of 2015 as many unconventional operations near production, or currently in production, will still generate positive cashflow at these price levels. What will be affected immediately are new exploration and drilling projects - actions that won't affect supply until later in 2015 or even 2016.

Source: Unit Credit, 9DEC14

It's a similar story on the demand side. Just because oil has suddenly halved doesn't mean there will be a sudden spike in oil usage. It takes time for drivers to buy larger and less fuel efficient vehicles (the average car in the US is 11.4 years old, indicating that less than 10% of all cars on the road were bought within the last year) and airlines to lower their airfares (little sign of that yet). And with deflation risks spreading around the world, we know that consumers aren't in a mood to buy more things just because they're a little cheaper.

The price drop will be painful for the Saudis, but their very low oil production costs and their large financial reserves allow them to go for years without making significant cuts in government spending. This is not true of other OPEC members like Venezuela, Iran (Saudi Arabia's archenemy) and Nigeria, non-OPEC conventional oil countries like Russia, and most importantly, the new high cost oil developers and substitutes.

Net-net, we're skeptical that we will see a "dead cat bounce" in oil prices anytime soon. We think the Saudis are committed to flooding the market with oil, that high-cost supplies will take some time to exit and that demand growth will be slow to respond. This hypothesis jives with other instances of other sudden price collapses as shown below in this chart from Credit Suisse. We are only six months into this oil bear market.

Source: Credit Suisse, 20NOV14

Source: The Wall Street Journal

The Wall Street Journal ran an article earlier this week (the graphic to the right is from this article) that analyzed the similarities and differences between today's oil glut and the one that began in 1985. I remember the initial price collapse and muted recovery well as my parents were living in Saudi Arabia at the time and I was soon to move to Houston for university. Excluding from the temporary spike in prices triggered by Iraq's invasion of Kuwait in 1990, oil prices didn't recover to early 1985 nominal prices until about 2000. Believe me, those 15 years were difficult for both Saudi Arabia and Houston.

So in summary, we're not anxious to go long oil, even after the more than halving in prices since last summer. We think that oil could bounce around at these price levels for months and even years - the prescribed course of antibiotics is a long one for the swing producer in the market, Saudi Arabia.

For AlphaGlider, the actionable investment opportunities from sub-$50 oil come from reasonably priced economies and companies that are net purchasers of oil. The top of this list is Europe which is a major net importer of oil. Operating at low to mid-cycle margins and trading on reasonable valuations, European companies stand to surprise on the earnings front. We are also constructive on European companies due to recent euro depreciation and the likelihood of the European Central Bank (ECB) initiating a major quantitative easing program, perhaps as soon as next week.


1Mutual funds, exchange-traded funds and exchange-traded notes are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.