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Trough oil

21 January 2016 By Edward Chancellor

When the oil price climbed through the $100-a-barrel barrier back in early 2008, Goldman Sachs loudly proclaimed it was on its way to $200. Now that oil has sunk below $30, Morgan Stanley is suggesting the price could fall below $20. Such commentaries are fine examples of linear extrapolation. The world, however, is cyclical.

The old market adage that “the best cure for high prices is high prices” also works in reverse. During the boom phase of the commodity supercycle, rising investment pushed supply up and prices down. In similar fashion, today’s capital spending cuts by energy producers are setting the stage for the next bull market in oil.

The basic insight of so-called capital-cycle analysis is that demand forecasts are inherently unreliable – who knows how many cars the Chinese will be driving in 20 years time? Supply is much easier to predict. As independent investment strategist Russell Napier puts it, “investors spend 90 percent of their time thinking about demand and 10 percent thinking about supply. It should be the other way round.” This explains why investors and industry insiders have read the bull phase of the commodity cycle so badly. During the boom, they fantasized about the prospects of Chinese demand, while largely ignoring the massive increase in commodity supply.

Most investors espouse a belief in mean reversion – the notion that markets return to a stable equilibrium price – but they ignore how it comes about. Mean reversion largely operates through changes on the supply side. Rising output prices and profitability in most industries tend to elicit an investment response. In time, the increase in production serves to bring down prices. This process is even more pronounced in asset-heavy industries, such as miners of heavy stuff like iron ore, copper and zinc.

As oil and commodity prices soared during the last decade, there was a surge in investment. Total capital spending for European miners climbed from around $5 billion in 2002 to peaking at over $80 billion in 2013, according to broker AllianceBernstein. During the same time frame, European oil majors boosted their annual capital spending from $40 billion to $110 billion. This upswing in the capital cycle was evident in the record-high ratios of capital expenditure relative to depreciation for both mining and energy companies.

Since the summer of 2014, the oil price has fallen by more than 70 percent. The market for iron ore is down even more. Commodity suppliers have responded to the price collapse by slashing capex. Oil companies deferred spending around $380 billion in 2015, according to energy consultants Wood Mackenzie. This year, global mining companies are set to cut capital spending by around a quarter.

Given that oil and industrial metals markets have moved more or less in lockstep over the last decade, it’s easy to conclude they face similar prospects. After all, oil and most other commodities have been moving inversely with the U.S. dollar and have reacted adversely to Federal Reserve tightening. Both oil and basic materials, such as iron ore, are currently in excess supply. In both the energy and mining industries, cash-strapped operators are being forced to maintain production at ever lower prices in order to service their debts.

Yet an examination of industry-supply conditions suggests that the cycles for energy and basic materials are set to diverge. For a start, mining output has increased far more than oil production. Iron ore mining capacity has roughly tripled since 2002. By contrast, the International Energy Agency estimates that world oil production rose only 21 percent between 2002 and 2014. The greatest problem for the big oil drillers has not been the falling oil price, but their inability to replace low-cost reserves.

Current capex cuts are likely to have a relatively muted impact in the near-term on the future supply of industrial commodities. That’s because many of the new mines that have opened in recent years are extremely efficient. Large miners, such as BHP Billiton, whose Australian mines can make money at half the current iron ore price have made it clear that they will continue producing as long as they can cover their marginal costs. As BHP’s Chief Executive Andrew Mackenzie stated last year, “the lowest cost producer has the right to continue producing.” Rio Tinto, the world’s second-largest producer of iron ore, has announced that it will increase production this year.

The outlook for oil is rather different. While the marginal cost of production for the miners has fallen, it has climbed for the energy sector. Most of the increase in global oil production in recent years came from U.S. shale-oil producers. In aggregate, these businesses were unable to generate positive cash flow when oil was above $100 a barrel. As the oil price has collapsed, dozens of smaller American oil companies have declared bankruptcy and the flow of cheap funding for the industry dried up. Furthermore, the rate of decline in production from shale oil wells is extremely high. Recent cuts in maintenance spending and over-drilling to boost near-term production are also likely to reduce recoverable reserves of shale oil.

A back-of-the-envelope calculation by Emad Mostaque of Ecstrat, an independent emerging markets consultancy, demonstrates the potential impact that recent investment cuts may have on future oil supply. The industry’s capital spending per barrel of oil is around $25, says Mostaque. Based on this figure, last year’s $380 billion of cuts could reduce future oil supply by some 15 billion barrels. This amounts to just over 4 million barrels per day over the next ten years. Current excess supply in the oil market is estimated at less than 2 million barrels a day. Each year, the industry needs to replace some 5 million barrels of oil a day in order to maintain production. Given the industry’s current investment plans, future oil shortages are a near certainty.

The mining industry may have to wait longer for its cycle to turn, especially given its greater exposure to the tottering Chinese economy. The oil market, however, appears primed to demonstrate another market truism. Namely, that the best cure for low prices is low prices.


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