The World's Rolling a Hard 6: Oil's Recovery and Look Ahead

April 26, 2021

We recently sent out our Q1 Quarterly Letter to our Limited Partners, which shared our thoughts on the global COVID recovery and oil’s rise. Despite a recent pause in the oil price rally, we believe it’s setting-up for another stage higher. Below is an excerpt of our letter . . .

At the Table

Hard 6. It’s a term in the game of craps, where a player rolls a “3” on a pair of six sided dice (3+3). It’s a high risk/high reward bet because the odds of rolling a hard 6 is only 3%, which is why if you bet a dollar, you’ll win seven. As improbable as it is, the world’s rolling a hard 6 right now because our scientists did. mRNA or adenovirus based vaccines were developed, clinically tested, manufactured, and disseminated at such record speeds/scale that the US/UK are nearly finished with their vaccination programs. EU and Asia are next, and should be blanketed by Q2 and Q3, respectively. A hard 6 is also what the IMF forecasts global GDP to grow by in 2021. It’s a blistering 2-3x above our normal ~2% average, but we’re far from normal as we emerge from a a global pandemic that shuttered the world’s economies.

We’re seeing it now though. That emergence. It’s on Facebook, Instagram and tweets. Look at us, we’re out and about. At the theme parks, cafes, and restaurants. We’re all congregating, laughing, reconnecting. What’s surprising to us isn’t that this would happen. We’ve been saying it would. What’s surprising to others is that it is happening. The US began moving in mid-March, and frankly even before clear evidence that the vaccines worked in “the real world.” As the data turned increasingly positive, we then saw material improvements in mobility across the US. Airline executives began touting higher reservation numbers, TSA passenger screenings at airports leapt, and hotels reported increasing occupancy; all of which occurred before vaccinations exceeded 50% of the population.

What did though were vaccinations for the highest risk groups (i.e., those >65 years old). Once that occurred, COVID data turned fantastic. What happens in the US won’t stay in the US. As we conclude our vaccinations, our vials/manufacturing capacity will snowball to others. EU and North American countries first, then Asia and emerging markets (“EM”) second. This snowball starts rolling in a matter of weeks. Increasing deliveries to the EU means that by June over half of its population should be vaccinated, but like the US, their recovery will come sooner. We believe by May, EU’s economic recovery will gather strength as their highest risk groups receive their doses. By July, Asia and the EMs will be up next, so by Q3, we’ll have made significant progress in corralling the disease.

Fortunately, efficacy is transcending politics here. As the vaccination program in the US accelerated, more people have opted to take it. Whether it’s the desire to travel, avoid social stigma, or experience normality, it matters not, higher vaccination rates equate to lower strains on our health care systems. We expect the same factors to play out in the EU and other parts of the world. For all our differences, we are all largely the same. We all want our lives back as soon as possible.

Which is to say we’ll get our lives back as we roll-out the vaccines in the coming quarters. All of it, meaning the good and “the bad.” Because if you can go to Disneyland, you can go to work. If you can fly for vacation, you can fly for business. So watch as the “work from home” experiment fades and business travel resumes. Business is all about relationships, inspiring, planning and executing requires some form of personal/physical connection. So as we recover socially, we’ll also recover economically. With the US on the mend, and EU and Asia by Q2 and Q3, the 6% global GDP growth (near 8% for the US) is looking increasingly likely. As a famous Admiral once said. “[s]ometimes you have to roll the hard six.” And we’re doing it.

An Oil Update

So picture this. These are some of the issues we’re seeing affect our energy thesis.

At the top is the pace and strength of our COVID recovery. Will demand come back, when will it come back, will behaviors have changed? It begins with that. After which, we then consider the other issues. We’ve been writing regularly about those for awhile now, and have shared our thoughts on the Substack page we sent out to everyone. Lately those pieces have addressed our COVID recovery, the impact of monetary and fiscal policies, global debt, inflation, climate change and politics.

Why? Because it’s all intertwined. We believe what we’re seeing today are the lingering consequences of the policies we adopted during the Great Financial Crisis (“GFC”) in 2008/2009. The GFC was a solvency crisis, one where banks and lending institutions held questionable assets on their balance sheets that became near worthless once the housing market collapsed. In response, governments worldwide recapitalized the banks, effectively “bailing out” companies and lenders. Ostensibly it was to preserve the lending system that our global economies rely on, but by bailing out the institutions and not the individuals, we began to see a political backlash. As the decade unfolded in the US, we saw globalization, offshoring, increasing income disparity and the erosion of the middle class further inflame populism in both parties (e.g., Tea Party, Occupy Wall Street, Portland riots, Trump/Sanders/Warren campaign, etc.). By our next crisis, the pump was primed. When the COVID liquidity crisis hit, we responded in this way . . .

“Eager to avoid the criticisms of the GFC and replace income lost due to the draconian public health measures, the federal government rained down money in the form of stimulus payments, PPP, unemployment benefits, grants and forgivable loans, which effectively bypassed commercial banks. Our current COVID response effectively

subserviates the central bank. Engaging in massive fiscal deficit spending means co- opting the Fed to print and fund whatever Congress and the White House decides.”

As we further noted . . .

“Said another way, we’re agnostic about which party is in control when it comes to spending. The political message from the electorate has been clear . . . Show Me the MONEY! Congress and the White House have dutifully obliged and showered funds on companies and voters to preserve jobs, protect livelihoods, and bolster individual finances. So regardless of who is in control (Trump/Republicans or Biden/Democrats), the fiscal largesse has been the same. We the People . . . Get the Money.”

Eventually the fiscal-led stimulus means that the historic increase in money supply will likely drive inflation higher because as the economy recovers, so will demand. Given the high savings rates and pent- up demand, our overall demand for goods and services will vault higher. Equally as important is that our free-spending ways are allowing us to fund moonshot projects that a few years ago would have been politically unfeasible. We’re now printing/allocating trillions in a global push to decarbonize and shift to green energy. The wholesale remake of our energy and transportation infrastructure creates a massive uplift in commodity consumption worldwide. Think of the need for metals, concrete, rare earth metals, etc. to build out solar power plants, wind farms, charging stations and electric vehicles. We’ll simply need more of everything.

The higher consumption is now running headfirst into a supply shortage. A supply shortage of nearly every commodity because another important consequence of the GFC was the suppression of interest rates by central banks. Commodity producers, who have one of the lowest margin businesses (after all they produce commodities with no pricing power), grew their businesses after the GFC by borrowing heavily at low rates and cranking up volume. It happened in oil, mining, and materials. The overproduction inevitably led to a supply/demand imbalance and a price crash, which occurred in 2015/2016. Since then we’ve been slowly recovering, as the industries repaired balance sheets and those too weak declared bankruptcy. When COVID hit last year, the already weakened industries were then decimated as demand evaporated. Supplies shrank dramatically. Now we’re expecting commodities to snap back and satisfy our increasing appetites? It can, but assuredly we’ll all have to start paying more. The “transitory” inflation central bankers keep talking about? They keep using that word, we do not think it means what they think it means.

Oil

For us, energy consumption will increase. Our COVID recovery coupled with the global stimulus and infrastructure spending largesse means our energy intensity is increasing. In many countries, we’re collectively shunning public transportation for our own vehicles. As for our energy supplies? They’re effectively flat. OPEC+ is increasing, but merely keeping pace with rising demand. Everyone else is holding even though oil prices have risen. None more so than public E&P companies. Raising production materially would draw the ire of shareholders, at a time when anything fossil fuel related is being shunned by the governments and investors. As we decarbonize and address climate change, the winds have already shifted on fossil fuels, and the oxygen removed.

Where We Are

Today Brent prices hover above $60/barrel, almost unfathomable a year ago. After a robust January/ February, we’ve witnessed a pause in the oil rebound during March/April. Overall we can see that inventories worldwide are still in drawdown mode, and the trend is still intact despite the recent malaise. There’s some debate about how much crude inventories built-up during 2020 remain. Some research firms like Energy Aspects estimate 120M barrels, Morgan Stanley 200M barrels and Goldman Sachs closer to 300M barrels. Nonetheless, all of the firms anticipate excess stocks will be gone before year end.

While the overall trend is down, we can see that crude stored on land (i.e., the dark blue section called “landed crude”) is pretty flat and has been for a few months. We’ve seen this as well in our tracking data, but think there are a few reasons for the lull.

First, we’re in the middle of refinery maintenance season, that time of year when producers take their refineries offline for maintenance and upgrades, hence crude demand is lower. As is typical, this will subside beginning in May as refiners increase production in anticipation of the summer season. Energy Aspects projects that outages will decline from 11.5M to 8.4M, an increase of 3M bpd in the next month, once refinery maintenance ends.

Second, rising COVID cases in the EU and India have hampered demand recovery as health restrictions negatively impact travel. Even so, we believe EU restrictions will begin lifting in May as vaccination campaigns ramp because of increased vaccine supplies. Most EU member states are set to vaccinate 20% of their population by the end of April (almost all those whom are older than 60 and in the highest risk cohorts), and that’s generally been the demarcation line for seeing improving COVID numbers. Consequently, EU’s situation should improve by June as more than 200M doses are planned for delivery in the coming 3 months. As for India, the second wave will need to break on its own, with the government ruling out a nationwide lockdown, the virus will be left to spread. Positive cases are exceeding 300K per day, but could quickly break lower. Data quality has always been an issue in India and as in all countries, uncounted/undetected infections vastly outnumber the tested. Without a nationwide lockdown, cases will spread uncontrollably until saturation. For oil, consumption will stay high. Prior to the second wave, demand had already recovered close to 2019 levels even with COVID’s lingering presence. We expect a ~10% demand hit (~500K bpd for the next few months). India’s full COVID recovery will have to wait until late-Q3.

Lastly, we believe destocking is distorting the inventory picture. What’s flat isn’t really flat as oil inventories are repositioning from storage hubs to tanks closer to consumers and refiners. In addition, previously opaque/hard to track inventories are also landing onshore (i.e., Iranian oil). In the first instance, destocking in storage hubs like the Saldanha Bay (South Africa) and the Caribbean indicate that the last vestiges of 2020’s COVID inventory builds are now in the process of winding down.

In the second, supplies that were previously shunned (i.e., sanctioned Iranian and Venezuelan oil) are now returning to the market.

Iran

Since Biden’s inauguration, Iran has been aggressively marketing its barrels, wagering that the new administration won’t strictly enforce Trump’s sanctions. It’s proven to be a prescient bet as China’s refineries have gorged on Iranian barrels, buying and storing as much as it can. China’s pivot came at the expense of Brazil, Angola and Russia, but the 10-15% discount from spot prices was too tempting to pass- up, and besides it has the added benefit of flouting US geopolitical power. Note, however, that these are sales from Iranian inventories. Iran isn’t producing much more at the moment, it’s exporting more from storage. Iranian exports have increased from an average of 0.5M bpd in 2020 to 1.5M bpd in March, whereas production has increased by only 0.2M bpd during this period.

The reduction of Iranian inventories, however, means that if the US / Iran renegotiations on the JCPOA (i.e., the nuclear deal agreed to under the Obama administration, but shelved by the Trump administration) are successful, Iran’s reemergence as a global exporter shouldn’t bring with it a deluge of previously unsold inventories. We anticipate that the Iranian sanctions will be lifted soon. President Biden’s fast approaching his 100 day in office and will want a foreign policy win. Moreover, there’s a push to side-step the Iranian elections in June, which could complicate and delay future discussions.

Lifting Iranian sanctions means Iran should be able to increase production and export an additional 1-1.5M bpd as we finish out the year. This will be gradual, but for our models we’re assuming it’s immediate as initial exports can come from remaining stored inventories before production catches-up. The increase will coincide with OPEC+’s agreement to increase production from May to June by an average of 1M bpd (or a 2M bpd increase from April’s levels). So combined, we know extra barrels are coming onto the market shortly.

Really though, some of it (Iranian barrels) are already here, they’re just in the “shadows” because of the sanctions. Legitimizing the smuggled exports will help clear up the data gathering, but not necessarily increase barrels in the real world. In total, let’s call the increase from both Iran and OPEC+ ~2-2.5M bpd from May to July. Will the market be able to absorb such an increase? We think so. The rise in demand in Q2 should absorb the increase by the beginning of this summer. Much of this will depend on the US’ continuing recovery and EU’s vaccination program, but by May, US vaccinations will be complete, and by June, 50% of the EU should be vaccinated. For Q2, we have the following balances.

So we’re in a bit of a temporary lull. Like other recent headwinds though these things will fade as the tailwind of increasing demand gets stronger. We’ve already seen US gasoline consumption rise to near pre-pandemic levels, and we’re still not quite finished with our vaccination efforts. We expect EU to recovery quickly in the coming months, and Asia to springboard thereafter. We have demand rising 2M bpd in Q2, and continuing to rise into H2 2021.

By the summertime, we’ll be on our way to needing every barrel that producers can produce, and if what we’re seeing with rig counts is correct, suppliers will eventually struggle to keep pace. Long-tail projects sanctioned years ago have already come on-line and short-tail (shale) producers are wary of spending capital. Growth today is coming from private producers trying to game their production and reserves to attract a buyout offer. Everyone wants to exit, but the doors are few. For public producers, the only way to make money now on their stock is to bolster cash flows. Free cash flow is the only thing that matters today, which means capital discipline will hold. The investment environment has shifted.

Finally, while pundits contend that US rig counts are increasing (largely from private producers), the US accounts for only ~10% of global production. We can see above that the rig counts for OPEC and certain non-OPEC+ countries (blue and green lines), which is responsible for another 70% of global production have stayed flat.

Like all headwinds though, the three noted above will fade. China’s inventory balances have been flat as it swaps and sources just enough crude to meet demand while their refineries undergo maintenance. When China (or refineries worldwide for that matter) returns to full operations in Q2, it will either need to buy more crude from the market, or inventories will begin to draw. In turn, demand for the refined products (e.g., gas, diesel, jet, etc.) will improve as our COVID recovery improves. That’s wholly dependent on vaccine rollouts, but that pace is quickening already. The headwinds to our energy thesis will fade as the tailwinds of increasing vaccinations gather.

Parting Thoughts

Everyone’s making snap judgments these days. Reporters seeing rising COVID cases/variants and concluding that our recovery is in jeopardy. Public health officials declaring that there’s going to be an “impending doom,” when in fact things are turning out much better. Sure, we all have some recency bias, and we know that health officials have to play it safe so that everyone will. Yet, for all that, those views are just plain wrong. We are fantastically and amazingly still on track. In fact, we’re faster than on track. We’re well ahead of anyone’s schedule, including ours, and remember we forecasted that a vaccine would appear in a year. Now we’re well on our way to recovery. In some instances, our recovery may be too fast. We wrote this recently . . .

“[w]hat the market doesn’t know though is what we’ve done to our energy supplies. The assumption is that things will return to normal because we’ll return to normal. Yet, what’s happened to the energy sector in the past 11 months have been transformational. 11 months may not have changed our individual behaviors, but it’s been enough to change an industry.

A reckoning had to occur, and a reckoning did as the pandemic wiped the slate clean. E&P companies only had themselves to blame for the demise, as they entered the pandemic weakened after years of poor management decisions, a complete disregard for shareholder value, and a misplaced focus on growth over value. Faced with insolvency and a complete loss of lender/shareholder support, companies began changing (voluntarily or involuntarily), consolidating, slashing expenses, and taking “the pledge” to generate free cash flow and focus on shareholder returns via buybacks, debt reduction, and dividends (variable or not).

Externally, the overcapacity, bloated inventories, historically low oil prices, ESG mandates, and changing political landscape gave environmentalists an opening to shift the conversation and pivot our priorities. Armed with a presidential seal and potentially limitless funds, climate crusaders began touting the benefits of a green revolution if we only electrified and decarbonized our energy infrastructure. 2030, ’40, ’50, these were the years thrown out by companies, environmentalists, government officials, and the media for when we could achieve net-zero carbon emissions. Read the fine print though and many acknowledge that despite the pledges, for the foreseeable future, fossil fuel consumption will continue to climb higher until at least 2030. So even under the most optimistic scenario, we’re a decade away. Still, if you want people to change, you have to create a sense of urgency, and fine print has no place with fear.

11 months. 11 months to hammer home a green energy agenda while we’re consuming less, driving less, and using less. 11 months to convince the masses that an energy transition was easy if only we threw money at it; that an energy utopia was within reach because the technology to capture and store it have matured enough to replace our current unhealthy diet. The message couldn’t be further from the truth, but nevertheless the idea that “we have to change” and “we should change” morphed into “we’re able to change” and “we can change, quickly and painlessly.” A sensible message morphed into intentional obfuscation.

While 11 months were not enough to change our behavior, it was enough to hobble an entire industry. So as we revert to our old habits of traveling, socializing, entertaining, as we resume our higher-energy consuming lifestyles with our padded pocketbooks, we’re doing so with an industry ill-equipped to power our recovery. Years of underinvestment in long-lead projects, the impacts for which are beginning to be felt this year, are now compounded by capital scarcity, spending restraint, and the demands of green energy investments.

Said another way, by year-end we’ll have exhausted our global spare capacity . . . 11 months from now.

We will then be asking companies, national oil companies, and governments to quickly increase supplies, despite the knowledge that one day, very soon, after we slake our thirst, we’ll again shun your dirty resources. Still, despite our desire to change, we just need one more hit as we celebrate the twilight of oil”

We’re not making any snap judgments these days. We’re taking the recovery one step at a time, one quarter at a time. Yes, we believe we’re still on track, some weeks slower, others faster. Despite the negative news, the data is clearly showing that vaccines work (even against the new variants), they’re being manufactured, distributed and administered at an incredible speed, and that many are willing to be vaccinated. We’ve had a solid beginning to the year, and looking forward to building on it in the quarters to come. If we all begin moving again, a peek at our freeways already tells us that we are, then we’ll be fine. We’ve been predicting and writing that all of this would occur, and all of it is occurring faster than even we thought. It will continue. Momentum will pick-up here because pent-up demand is real. We’re seeing it in the US, UK and Israel, where vaccination programs are nearly complete.

So don’t let the headlines sway or fool you, or make snap judgments from the tidbits you’re hearing. Ponder things more to tease out what’s important. It’s something my daughter recently realized as we were driving and she wistfully made this remark while staring out the window . . .

Addy: I wish humans wouldn’t kill animals . . . 

Wife: . . . .

Me: . . . .

Addy: . . . except for cows.

Me: . . . . wait, what?

Addy: . . . . steaks. They’re SOOOO delicious.

No snap judgment here, because this is the recovery wave and we plan to ride it.