Why Bears Will Win The Oil Price War

Oil prices may have had an impressive rally this year – until last week – but the longer-term trend looks downbeat. “Deflationary forces are gathering momentum,” Morgan Stanley analysts wrote in a new report.

The most recent jump in prices through mid-May came largely as a result of geopolitical riskand supply outages. Rising tensions in the Middle East and disruptions in places like Venezuela and Iran are showing no signs of going away anytime soon. These geopolitical factors will keep some upward pressure on oil prices for the next few quarters.

However, in the background, there are several variables that could exert deflationary pressure on the oil market. Morgan Stanley has noted that U.S. shale is slowing, “but with 200 [billion] barrels of resource with breakevens in the $40-45/bbl range, there is an increasingly credible scenario that shale could grow >1 mb/d per year out to 2025.” Moreover, oil producers are turning to a variety of digital technologies, robotics and automation that could keep costs in check. That’s good for individual oil companies, the investment bank argues, but in the aggregate, it puts a lid on crude prices.

Morgan Stanley drew parallels to copper and aluminum markets. In the past, oil was like copper in that producing the next project became more and more expensive. Scarcity meant higher prices and the tendency for companies to venture into ever riskier frontiers. On the other hand, shale is more like aluminum, the bank says – the resource itself is abundant, so costs are more determined by the industrial process that comes after extraction. As a result, as technology improves, costs fall. Aluminum prices have steadily declined over the last century while copper has been more volatile and cyclical.

Because of shale’s increasingly important role in the global market for crude oil, the entire oil market may begin to resemble what has occurred with aluminum. In other words, there is a cap on oil prices in the medium-term, Morgan Stanley argues. That leaves little room for OPEC+ to add production; the group may have to maintain its output curtailments for years to come.

Depressed prices mean that investment outside of North America could dwindle. That’s bad news for companies working outside of the U.S. and Canada and also negative for oilfield service companies. “For the majors and the E&Ps, their place on the cost curves would be more critical than ever,” Morgan Stanley warned. “Ongoing focus on cost and capital efficiency would remain a key priority.”

On top of this, as other governments try to compete for capital with North America, tax rates on the energy industry could fall, Morgan Stanley said. That also could act as yet another deflationary force.

This narrative is a rather optimistic take on U.S. shale, and not one that everyone agrees with. For instance, it’s not clear that breakeven prices have really fallen all that much. There is evidence that the breakeven in the Permian has been right at about $50 per barrel for several years, barely budging despite a lot of hype about cost-savings.

Meanwhile, a recent report from the Post Carbon Institute argues that the intensification of drilling, and the fast ramp up in production, merely front-loads production and does very little to increase the ultimate amount of oil recovered. The faster the industry drills out the best acreage, the faster the resource becomes picked over. Drillers will be forced into non-core areas, where costs are higher and recover rates are less attractive.

Morgan Stanley acknowledges risks to its forecast. For instance, geopolitics cannot simply be discounted as a phenomenon that will go away. Indeed, politics and upheaval have characterized the oil industry since its inception.

In addition, the bank is assuming “that the US E&P industry will continue to overcome key operational bottlenecks relatively quickly and without major impact on break-evens,” the bank said. “Perhaps sweet spot exhaustion, parent/child interference, rising gas or water cuts, crude quality issues, the capacity of the refining system to absorb large quantities of light crude, etc., will eventually slow production growth from the potential that we currently estimate,” the bank conceded in a rather long list of caveats.

On the demand side, there are also deflationary forces taking hold. Weaker demand could cap oil prices as well. Morgan Stanley points out that demand has grown at a roughly 1.3-mb/d rate for the last few years, but that rate of consumption could fall to 0.8 mb/d by the mid-2020s. This too is the subject of a great deal of debate – some see demand slowing even faster, while a large number of other analysts see demand remaining rather strong through the decade and into the 2030s. If demand does not slow, the oil market will need much more supply, and the deflationary thesis could be undercut somewhat.

Regardless of whether one agrees with Morgan Stanley’s deflationary thesis, one argument does ring true: Whatever happens in the U.S. shale industry – and more specifically, how the Permian boom unfolds in the next few years – will go a long way in determining the trajectory for the rest of the global oil market.

Beijing "Seriously Considering" Rare-Earth Export Ban

Following what was a mostly quiet holiday weekend for trade-war-related rhetoric (other than a dollop of trade-deal optimism offer by President Trump, little was said by either side), Beijing has started the holiday-shortened week by reiterating threats to embrace what we have described as a 'nuclear' option: restricting exports of rare earth metals to the US.

Global Times editor Hu Xijin, who has emerged as one of the most influential Communist Party mouthpieces since President Trump increased tariffs on $200 billion in Chinese goods, tweeted that China is "seriously considering restricting rare earths exports to the US."

There are signs that these warnings should be taken seriously: One week ago, President Xi and Vice Premier Liu He, China's top trade negotiator, visited a rare earth metals mine in Jiangxi province. Rare earths, which are vital for the manufacture of everything from microchips to batteries, to LED displays to night-vision goggles, have been excluded from US tariffs.

Though other Chinese officials have denied that export curbs were being considered, Xi's visit was widely viewed as a symbolic warning. Seven out of every 10 tons of rare earth metals mined last year were produced by Chinese mines. One analyst warned that Xi's visit was intended to send "a strong message" to the US.

Beijing is limited in its ability to retaliate against Washington's tariffs by the fact that there simply aren't enough American-made goods flowing into the Chinese market. Because of these limits, it's widely suspected that Beijing will find other ways to retaliate. Though they are more plentiful than precious metals like gold and platinum, rare earths can be expensive to refine and extract.

The tension has sparked a 30% increase in 'heavy rare earth' metals.

The prices of so-called heavy rare earths, which are used in batteries for electric vehicles and in defence applications, have risen 30 per cent this year, said Helen Lau, senior analyst and head of metals and mining research at Argonaut in Hong Kong.

"I think it is a little bit reckless, from my point of view, for China to ban the export of rare earths to the US directly," Lau said. "There’s always some way to have a similar impact...Maybe we want to reduce exports to everyone. That is a likely scenario."

Even if Beijing doesn't follow through on these threats, some analysts suspect that, given their scarce supply, China might move to restrict their export to help meet domestic demand. Beijing has already slapped tariffs on rare earths mined in the US.

Lau said she believes China, regardless of the trade war, will ultimately move to reduce exports of rare earths to meet its own domestic demand.

"Everyone knows that China needs rare earths for its electric-vehicle industry," Lau said. "Electric-vehicle production is very strong – every single month it is growing in high double digits, and this year it has doubled from last year. The demand for rare earths is very strong."

According to the SCMP, June could be a critical make-or-break moment for the global rare earth metals trade, because that's when China is expected to set its mining quota for the second half of the year. The quota for the first half of the year was 60,000 tonnes, unchanged from the year prior.

There is precedent for a rare earth export ban: China briefly limited exports of rare earth materials to Japan back in 2010 after a Chinese trawler collided with Japanese patrol boats near a disputed island. Beijing also briefly imposed licenses, quotas and taxes on rare earth elements but removed many of them in 2014 after the US and Japan complained to the WTO.

To wean the US off its dependence on Beijing, one American chemicals company on Monday signed an MoU with an Australian mining firm to develop a rare earths mine in Hondo, Texas to help compensate for the "critical supply chain gap." And Japanese scientists recently announced the discovery of a massive cache of rare earths on the sea floor off the coast of Tokyo.

But whether these alternatives can be cultivated in time is very much in doubt. Still, Beijing is likely wary of resorting to an export ban since it would likely only work once. Once the option has been invoked once, analysts say, efforts to develop these alternative sources will likely accelerate.

Russia Aims To Exploit Africa's Energy Potential

Africa’s economic potential is enormous: the continent contains significant mineral and energy deposits, a young and growing population, and an underdeveloped energy sector desperately in need of investment. Approximately 640 million people, or two-thirds of the entire populace, don’t have access to electricity. According to the African Development Bank, energy poverty reduces GDP growth by 4 percent every year. Russia’s energy industry, in comparison, is booming. Its state-run nuclear energy company Rosatom has an order book of 34 reactors in 12 countries worth $300 billion. Recently, Moscow has set its eyes on Africa where most states have either already struck a deal with the Kremlin or are considering one.

Africa’s long march forward

Currently, only South Africa is operating a commercial nuclear power plant with plans on the table to expand capacity. Another ten states are in different stages of planning and negotiations including Algeria, Egypt, Ghana, Kenya, Namibia, Nigeria, Tanzania, Tunisia, Uganda, and Zambia.

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Energy poverty is a significant problem in the world’s least developed continent. The lack of access to a reliable and affordable source of energy is a severe impediment to economic development. Although the costs of renewables have decreased significantly over the years, technical and geographic limitations impede the rapid rollout of solar and wind energy. Also, Africa is urbanizing much quicker than the rest of the world where cities are expanding by 8 percent every year compared to 2 percent globally - which puts even more pressure on the existing energy systems.

The Russian deal is particularly appealing to countries lacking nuclear knowhow due to Moscow’s comprehensive offer regarding financing, construction, and operation of the facilities. Currently, Rosatom is experimenting with a contract known as ‘build-own-operate’ under which ownership of the plant remains in Russian hands while energy is sold to the host country. This new type of contract is appealing to several African states who lack the means to finance construction. In some instances, the mineral resources of host countries could function as a deposit for any liability comparable to Moscow’s ‘arms-for-platinum’ deal with Zimbabwe worth $3 billion.

The Russian deal is also attractive for countries lacking the necessary infrastructure because Moscow takes back nuclear waste which means that host countries don't have to worry about storage. From a security point of view, this could alleviate concerns regarding weapons production through plutonium reprocessing or threats from non-state actors.

Russia’s strategy

Moscow’s is reusing its successful Middle East strategy comprised of diplomacy, energy, and security.The Kremlin has presented itself as a ‘clean’ and honest broker lacking the colonial background of most Western countries. Africa’s relative instability and need for cheap energy makes it a good match for Russia which is looking to expand its global presence and find new markets for critical industries such as energy.

From Moscow’s perspective, sanctions and deteriorated relations with the West have increased the need to improve its relations with other parts of the world. Africa is not a new frontier for the Kremlin, which maintained diplomatic and military contact with the continent during the Cold War to counterbalance the U.S. This time, however, Moscow is not driven by ideology but by the need to increase influence and its position as a global power.

Nuclear energy is an obvious option as Russia is a global leader in nuclear technology. The country processes 7 percent of the world’s uranium production, 20 percent of uranium conversion, 45 percent of uranium enrichment, and 25 percent of the global nuclear power plant construction activities. Providing the necessary technology to Africa serves another purpose besides increasing influence and revenue for the state’s coffers. The continent is also home to some of the world’s largest uranium deposits in Malawi, Niger, and South Africa. Access to these resources is essential if Moscow’s wants to maintain its position globally.

A way forward or unnecessary risks?

Without a doubt, Africa is in desperate need of electricity to develop and industrialize. However, according to some critics, Russia's nuclear involvement in unstable countries could become a global security threat due to those countries’ weak institutions and unstable governments. Moscow’s nuclear strategy will be tested after the first power plants are completed in developing countries in Africa and Asia. The lifespan of these facilities spans decades and they require an adequate and comprehensive approach in order to provide electricity for millions that is both safe and reliable.

10 Illustrated Truths About Investing & The Markets

Over the last eighteen months, stocks have whipsawed within a massive trading range as “trade wars,” “tariffs,” and monetary policy actions from the Fed have lit up headlines. Despite the strong rally from the beginning of the year, investors are no better off today than they were at the beginning of 2018.

Does this mean the bull market is over? Or, is it just a pause before a continuation higher? Has the Federal Reserve figured out how to “end recessions?” Or, has the low interest rate environment over the last decade spurred another credit bubble?

Honestly, no one knows for sure where we are within the current cycle, but it is understood it will end.

As a portfolio manager, I must stay invested during rising markets as our clients need returns in order to meet their investment goals. However, I must also protect that capital from major drawdowns which inflict far greater damage to financial goals than temporary underperformance.

This is a point missed by most individuals who take on far greater risks than they realize when chasing markets higher. It is also why we spend the majority of our time pointing out the relevant risks to capital.

Pointing out risks, analyzing those risks, and developing an “odds based” approach based on those risks is what guides our asset protection strategies within our long-biased portfolios. While ignoring those risks may lead to great gains in the short-term, the long-term destruction of capital combined with lost time is irreparable.

This is why we write the way we do. It is our “homework” behind our investment management strategies. Here are ten thoughts about investing and markets to consider. (I have provided links to relevant articles for more in-depth explanations.)

1. Markets are cyclical.  Bull markets are a process. Bear markets are an event.

2. Diversification has become less beneficial as markets have become highly correlated.

3. Follow the trend of the market. Have a simple method to define the direction of the trend and follow it accordingly. Being a bull during a bearish trend doesn’t work well.

4. We will all be wrong from time to time. Staying wrong is problematic.

5. There is no “law” that says you have to remain “fully invested” at all times. Sometimes, cash is the best hedge against uncertainty.

6. Understanding the real meaning of “risk” and how to control it always leads to better outcomes. Professional gamblers know when “not to bet” on a losing hand.

7. No one is right all the time. However, there are basic investing rules. that if followed. tend to reduce the loss of capital associated with being wrong.

8. The markets are driven by the “herd” mentality which swings from optimism to pessimism driven by headlines and narratives. Excess optimism and excess pessimism denote the points where the most money is lost or made.

9. Valuations do matter.

10. Understanding the importance of “time” is critical to investing success. While capital can always be regained, the loss of time cannot. 

These are just reminders to keep you grounded in the reality of how money, and investing, REALLY work over the long-term. While it is easy to get lost in the excitement of the moment, the brutal return to reality has always been a costly lesson to re-learn.