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This New Category Publishes Analytical work from Guest contributors on Marco Market Analysis. Macro analysis is in depth work that connects the dots between markets with what is happening in the economy or specific Macro trends in the Equity Commodity or Currency markets in India and Around then world. These come from people with skin in the game and whose work is found to be worth sharing with the intent of giving readers a fresh perspective of the affairs impacting the market. These are not recommendations to trade but will add great Value and Knowledge to your Decision Making Process.

DIVINE COMEDY

DIVINE COMEDY 

by Shashwat Panda

 

The author is a Partner at Pureheart Capital. Opinions expressed are personal. 

The language used is intentionally colorful because the world already has more than enough bloodless annual reports to wallow in. Those objecting need to get out in the sun more often. 

It has been roughly a year since I started writing these investment commentaries. It endeavors to be a sporadically timed, tongue-in-cheek take on a critical juncture in our shared financial history. A chronicle in and of its times, tracking the market hive-mind as it remorsefully and lethargically shifts from a profoundly deflationary to a predominantly inflationary zeitgeist. 

These turning points are important, infrequent and misunderstood. These points also provide enormous opportunities for accumulation or destruction of capital, in turn giving birth to trends that last decades and define the new epoch. These notes are my modest attempts at contemplating the unthinkable. Calling it “The Journal of Existential Dread” would have been more apt, but the name was already copyrighted by Divine Comedy Inc. and the board of directors (the Father, the Son and the Holy Ghost) refused to let it go.

The first note, written in June 2016 (Pre-Brexit) and rather pompously titled “Lessons of History”, made the case for a bottom in commodities and top in the developed economy bond markets. The second note, written in April 2017 and titled “Dollar Doldrums”, made the case for a peak in the USD bull market (DXY). (Please mail in to request for copies). Both stand the test of time fairly well. 

This is now the third note in the series, where I examine these nascent inflationary trends as they develop and challenge the deflationary psychosis that currently holds sway in the markets. We examine the prevalent narratives, especially from the perspective of what could go wrong. Because as Father Murphy taught us, whatever can, eventually will. 

We return to the subject of the dollar and the interest rates, but first we discuss Mr. Inflation itself – Crude oil. 

AN ENIGMA WRAPPED IN A RIDDLE SHROUDED IN MYSTERY  

Over the last few years, the crude market has been a battlefield. US Shale plays have become the global swing producer, dethroning Saudi Arabia. Demand has been weak, production stable and inventories high. OPEC jawboning hasn’t worked, neither have the production cuts. 

In the last few months, both Shell and Rosneft have mentioned separately that oil price will be lower for longer, and that they are preparing for it. “Oil God” Andy Hall has thrown in the towel and shut down his fund. News on the whole has been stunningly downbeat, and bearishness so thick, you could cut it with a knife.

Yet the WTI oil futures started the year at $54, dropped to $42 and are trading around $50 per barrel as we type this. What gives?

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Source: Bloomberg, WTI Crude 

 

Now I have a confession to make. In the early half of the noughties, I wasted a lot of time at an institution of some repute, waiting for some sense to accidentally get knocked into me. Of course it was futile exercise. Of course they eventually chucked me out. I was on the street but with two parting gifts: a Bachelors in Mechanical Engineering and a Masters in “Thermal & Fluids Engineering” (The ladies love it!). And I have been skeptical of “the miracle of shale oil” ever since. 

The dilemma is this: to get the conventional “OPEC” oil, you have to dig a hole in the ground, then utilize huge pumps to get the oil out. Sometimes you also have to push in some water to pump up the crude but hey, what’s pumping a few million barrels of water amongst friends? The Energy returned on energy invested, EROI, is about 8 - 10x now (it was 100x at the turn of the last century).

Shale oil is completely different. Conceptually, you take a bit of shale rock and slap it hard till it pukes its guts out, and then you lap up ooze. Practically, you use high pressure water & sand solution as a fracking agent, apply heat to the shale bed AND employ an “ice wall” around the whole shindig to avoid contamination of the ground water. And after all this effort, 85% of the fluid you pump out, is water again. Fun! 

The process is highly energy intensive. Shell estimated that best case EROI for Shale oil is about 4x, in reality you would be very lucky to get 3x. How does this process compete with literally putting straws in the ground?

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Source: Wikipedia

Another burning question to ponder this hour is: why does Shale remain predominantly a US phenomenon? Geology is an obvious limitation, but nowhere in the world is the formation similar or better? This is not a “new” technology despite all the hype. The first shale patent was granted in 1684. The current process was devised back in 1970s. To my untrained eye, it looks like US has 3 sticky advantages: Property rights, free money (via QE) and cheap alternative energy sources. 

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Source: EIA, as of 2014 only 4 countries were producing commercial volumes from shale formations 

The first two advantages are fairly obvious, but still do not explain why China is not yet a big shale oil power (All land belongs to the government and money is basically free for the SOEs. They can easily pay for the technology as it predominantly exists in the private domain). 

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Source: EIA, Share of US Electricity generation as of 2016 

As discussed before, Shale oil basically converts one form of energy (Electricity) to another (Light Sweet Crude) which is worth much more in the global markets. Basically shale gas, which is cheap, abundant and difficult to transport, is first converted to electricity, then to oil which is liquid, easy to handle and also was relatively expensive till 2015 happened. 

But as they say, a cure for low prices is low prices. US production of natural gas has flatlined along with higher prices. The price action in the market looks bullish. A sea change is at hand, Mortimer!   

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Source: Bloomberg, US Natural Gas Production volume & price 

With low crude prices and high debt levels, the shale companies have all the incentive to dig at the juiciest spots first. They also probably under-report the costs, and over-state the “technological edge” in order to feed the techno-centric narrative of this epoch and raise more capital from Investors. 

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Source: Bloomberg, Gross margin for Schlumberger  

Yet another overlooked point is that the oil servicing companies have massively cut pricing due to reduction in oil capex & exploration and corresponding reduction in capacity utilization. Gross margins for oil servicing bellwether Schlumberger is lowest

ever.  All factors put together indicate that the low is in for the production cost on shale oil. This is it folks, this is all there is. 

I then came across a few pieces written by Russell Clark of Horseman Capital on the American Shale industry. It is well worth a read:

  1. 1.https://www.horsemancapital.com/marketviews/russell-clark/2017/05/the-capitaldestructive-nature-of-the-us-shale-industry
  2. 2.https://www.horsemancapital.com/marketviews/russell-clark/2017/07/the-end-of-thetexas-tea-party

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Source: EIA monthly reports, US Shale oil production by Region 

To summarize their thinking:

  • Shale drillers reacted to low oil prices by limiting oil extraction to only the best areas, while also maximizing new well extraction in these areas by increasing the number of wells per rig, and drilling much longer pipes (laterals) 
  • The biggest cost for the producers is now land cost, not the cost of the rigs. Land values have shot up in line with the production potential
  • Since more than 50% of production is extracted in first 18 months, the companies constantly need to raise capital due to high depreciation rates
  • The Shale oil production is increasingly dominated by key areas in the Permian basin. Permian rigs are now 50% of all rigs 
  • High decline rates also mean that to increase the aggregate production, the companies need to keep drilling new wells faster than the legacy decline 
  • There are signs that productivity gains in the Permian are becoming more difficult to attain. EIA is projecting a decline in productivity over next few months 
  • Texas Railroad Commission data on operating wells is showing a historically unusual drop in the number of operating wells in the Permian counties
  • The unusual drop in operating wells has happened at a time when the number of completed wells has been increasing. This suggests that a large number of legacy wells are no longer producing oil
  • They suspect that frac-hits (new wells interfering with legacy wells) are causing decline rates to accelerate and costs to increase, hence reducing the number of operating wells

My takeaway from these articles is that all the juicy spots in the Permian basin already seem to have been thoroughly dug up like Swiss cheese and that the oil production is set to decline irrespective of the price. (On August 2 2017, Pioneer Natural Resources, a prominent shale oil producer in Permian Basin, reduced its 2017 crude growth target to 17-18% from the previous forecast of 24-28% and the stock crashed 16%.) The other shale plays are either geologically not attractive enough at this price (Eagle Ford) or, have already seen their best days (Bakken). 

Since Permian is where all the production growth has come from for the last two years, US oil production is about to decline. 

This has profound implications for both US interest rates and the US dollar.

BEST LAID PLANS OF MICE & MEN 

In 2012, IEA projected forward the production of Shale Oil in the US and estimated that it would peak by 2020. The technology has improved since then, but as with all the natural systems, the improvement is incremental not exponential. Unless there is a completely new way of doing things, there exist natural limit to incremental innovation (The whole shale "revolution" is an incremental evolution, predicated on high oil prices). 

Similarly, as long as Tesla is dependent on the Lithium Ion battery technology, they will never be able to achieve the energy density they desire. Natural systems and chemical reactions don't scale exponentially. 

Also, extractive technologies do not create more reserves, they just accelerate the rate of extraction so you burn through your reserves faster. It is quite possible that we will hit the production plateau a few years before 2020, as projected. 

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Source: EIA 2012 report 

Also due to the “shale revolution”, the conventional producers of Crude Oil have drastically cut their capital expenditure and exploration spending. In the previous years, a down year in capex implied a 100% rally in Crude oil in the subsequent years due to a fall in production volume. But previously, we had never had two consecutive down years in capex, so clearly we are not in Kansas anymore. Timing remains uncertain, but we might be looking at a massive decline in conventional oil production just as shale production is also about to decline. 

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Source: EIA 2016 report 

Usually the oil futures market is liquid up to 6 Months forward. It has already been 6 months from higher oil prices at the beginning of the year. The aggregate hedged book should be rolling off, and this would depress future production, unless crude rises significantly and the hedges are rolled back on.

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Source: Bloomberg, WTI Option Skew  

If the Horseman Capital prediction for lower production from Permian field comes to pass, then we are looking at an extraordinarily mispriced scenario for crude oil going forward. 

The markets, forward looking as they are, should start discounting the 2020 tightness in the crude market by 2018. I would not be surprised if the WTI crude refuses to break below $42. If it does break the trading range on the upside, I would expect an acceleration in prices to the underside of the previous resistance line which is at $80. 

At the very least, downside is limited as the USD strength, which aided the previous oil crash, has all but dissipated. 

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Source: Bloomberg, WTI Crude & Bloomberg Dollar Index Inverted

I have not even discussed the real black-swans: instability in Venezuela, possible war in the Korean Peninsula, the Qatar pivot and the redrawing of political alliances in the middle-east.  Odds are high that we have seen the intermediate lows in the crude market.  

 

WHO’S SCARED OF A CRUDE RALLY? 

It is the dirty secret of the bond markets that 5Y-5Y forward inflation breakeven rate (Market expectation of the rate of inflation 5 years from now, for the subsequent 5 years) has a very high correlation with current commodity prices. 


This has always flummoxed the Macro-mavens. They portend that the bond markets tend to “over-interpret” the current price trend of commodities. 

My contention is that it is better to over-interpret a living-breathing market price than bash your head against “hedonically adjusted” price estimates of “owner’s equivalent rent”. The market can do much, much worse than using the current commodity prices.

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Source: Bloomberg, WTI Crude & 5Y / 5Y Forward Inflation breakeven rates

The crude price has about 50% correlation with 5Y-5Y inflation forwards, as does copper. Both are indicating steeper curves and higher long dated treasury rates going forward. 

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Source: Bloomberg, Copper & 5Y / 5Y Forward Inflation breakeven rates

 

DIVINE COMEDY

As I noted in my previous note “Dollar Doldrums”, the dollar bulls have one argument going for them: that the supply of dollars outside America is shrinking. There are many regulatory and economic reasons for the same which I will not get into here. My counter argument has been that most of it had already been priced into the market after years of strongly trending prices. The price action since then supports this thesis.

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Source: Bloomberg, Bloomberg Broad Dollar Index  

The standard narrative has been that shrinkage in the US current account deficit due to the “shale revolution” reduces the supply of dollars that flow into the global economy. If our expectation of a shrinking US oil production is correct, this trend is about to reverse. As an important leg of the bullish argument breaks, the USD market might be horribly mispriced still.

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Source: Bloomberg, US Current Account Balance as a % of GDP  

WILL IT BE A GENERATIONAL TOP, IF EVERYBODY KNOWS IT’S A GENERATIONAL TOP?

At the risk of putting my foot in my mouth, I contend that a generational top in the USD was ushered in with the Trump election. There are many reasons: fundamental, technical and geopolitical which I shall hold on to for another note, if the view proves plays out further. 

The psychology of the market is extremely interesting. There have been many lines in the sand recently when it comes to the DXY. When I published my note back in April, there was an expectation of a bottom at 98. The bulls then regrouped around 96. I was then then told “I don’t expect it, but if dollar falls beyond 94, I will change my mind.” 94 then come and went changing zilch. Now I hear that 92 “has to, has to” hold. 

Many of the fellow bears at the top have now turned bullish and expecting a countertrend rally. The bulls are looking at the commitment of traders (COT) data to convince themselves of their contrarian stance.  COT data usually works as a contrarian given that the markets are “normal” (2015-16). But the markets were not “normal” in 2014 when dollar was getting repriced, they are not “normal” now with the carry trades unwinding. The investment / trade flows will overwhelm COTs every single time. 

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Source: Bloomberg, DXY dollar index   

This reminds me of the following anecdote published by 13D Research

We frequently tell the story of the late David Bostian. He was a brilliant strategist and a very good friend. On August 12, 1982, with the Dow at 776.92 — the exact low of the long U.S. equity bear market — he turned bullish, forecasting Dow 3,000 by 1987. One of the great U.S. investors, a client of Bostian’s, gave him money to invest in the bull market that he so wisely predicted. Unfortunately, and against our advice, Bostian bet on corrections against the primary trend, and lost it all.” 

Because the market has reacted with such stubbornness and disbelief, my assessment of the probability of success on this rather bold call has inched up to better than even at the moment. 

92 looks like the last good support. Since most market participants expect a bounce from this level, it will probably not hold. Most of the decline so far has been fairly orderly, and we need an emotional exhaustion phase before the prices can find an intermediate bottom (my guess: 84–86 range). But my recommendation remains that you sell the rallies and the bounces, as the larger trend has changed for good. 

 

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