Whereas OPEC + has been 94% compliant,, the price of Brent recovered nicely in May from $29 to $37 , may be a bit too quickly as the price of WTI followed and is coming near what we think is the average operating break even for shale of $ 36 per barrel. This has triggered a word of caution from Russia about the next OPEC + meeting to be held this week. Russia would like cuts to come down from the 9.7 million barrels a day to the 7 million agreed as early as July . This is important for Russia as the large part of oil production is done during summer months and not in winter . It will be interesting to follow the OPEC+ meeting this week and a difference on cuts between Saudi Arabia and Russia may happen. We see a 20% probability of another fiasco as Russia has no incentive to throw a life line to US Shale. -Indeed, shale oil production has fallen very fast and it would be silly for the World oil equilibrium to stop the work now that OPEC + may become a much less volatile price setter than the 6000 greedy wildcatters of Texas and Oklahoma .
The Permian basin has probably seen its output reduced from 5 million barrels a day to a low of 3.8 million and the number of rigs as measured by Baker Hughes is continuing its free fall. Most of the production cuts today, though is the result of voluntary shut down by shale drillers given a WTI much lower than operating break even and given the pressures of the financial markets ,with over 280 Billion $ to refinance by 2022 , the whole industry which has produced $1 of free cash flow has only been able to tap $ 7 billion from the Junk bond market . A yearly 6000 wells have to be drilled to maintain production flattish. .With a rig count in free fall, the lack of exploration in March/April/May will be reflected in Q4 production which we expect to be at least 40% than last year . The worst is thus to come for shale oil and it is unlikely that its output recovers its 2019 level before 2023 at the earliest.
We spoke to correspondents in mainland China last week . The domestic consumption is recovering with domestic flights at 60% of normal and road traffic at 90% . Chinese consumption of oil should be flat yoy in spite of COVID 19 and up 400,000 barrels next year . As we speak, 127 VLCCs are heading to China and Saudi Arabia has been exporting 2 million barrels a day to China for the last two months. Road traffic recovery is happening everywhere . Diesel consumption was down 20% in April in the USA but only 6% in May whilst gasoline demand which was down 40% in April was only down 20% in May. If this trend continues, the expensive floating storage could easily turn in reversal and with the cuts, oil on water , still a legacy of April, could start to slow. The rebound in tanker rates last week of 35% is in our opinion temporary. The Contango trade has largely disappeared . Our recommendation to switch from Tankers to Refineries late April(See Graph) has been very timely . Refineries had a big bounce in the USA since the lows in March but most stocks still present a lot of value . Both refinery run and the crack spread have still to improve but the 2019 levels could be seen as early as mid 2021 . The sector trades on an attractive 9% free cash flow yield assuming a 90% run rate in June 2021 .
We saw this week FLEX LNG and HOEGH reporting. The picture for LNG shipping is still quite hectic but the valuations are also rock bottom. The on going trade war is doing no good for the ton mile equation. Many cargoes from the USA to China have been cancelled as the Henry Hub /JKM spread does not justify any trade and China is now after Australia, the nicknamed “US Kangaroo dog” . The Australian LNG trade with China is at risk and Russia should benefit . The business of FSRU seems to have found a bottom though with gas now cheaper than coal and lignite, triggering a massive switch. For a few coastal countries, FSRUs are the solution and HOEGH LNG is seeing a revival of the market . It was about time . Although we are long term bulls of gas as one of the least polluting fossil fuels , it is going to take time to reflect the value of the trade . The switch Coal to Gas is speeding up and the new extensions of Qatar and Mozambique should favour the LNG shipping trade but the market is largely dead at the moment .
It is interesting to notice though, that the Brent rally is not only helping the finances of oil producers but also their currencies . The Real, the Rubble, the Canadian Dollar, the Mexican Peso and the Norwegian Krona have all rallied from their lows . A good signal for many of these countries which have a big pile of Sovereign $ debt lowering their credit risk. The help for the refinancing of the debt procured by these two linked trends should also help the future recovery of infrastructure works in these countries ,but probably not visible before mid 2021.
Another factor not helping shale in the long run is the amount of pollution it is generating . Deep offshore is the cleanest way ( as far as CO2 is concerned) to produce oil and Norway total emissions are only 10 million tons a year vs 133 for the USA and 111 for Canada as Shale and Tar sands are ecological disasters (Source Rystad) . The COVID 19 crisis and the ESG funds being more and more scrutinizing will be another hurdle for the shale oil recovery.
DISCLAIMER
This note has been prepared by Renaud Saleur, managing partner of VULCAIN ENERGY LLP and of ANACONDA INVEST SA and officer of KENDAR, thereafter designated as the Advisor. The Advisor is under contract with investment managers ( the Managers) and gives nonbinding advice to the Managers for the exclusive management of actively managed certificates, managed accounts or any other regulated collective investment schemes, thereafter, designated as the “Funds”. A structured product is therefore not a Fund for the clarity of this disclaimer. The Advisor does not give advice nor participate in the origination of any other financial products than the Funds and, in particular, the Advisor is never involved nor gives advice for the origination of structured products made from a basket of equities that may be mentioned in this letter and/or are part of the Funds. Consequently, the Advisor declines all responsibilities for any product created on the basis of the information contained in this document and/or for any product originated by taking any securities out of the context of the Funds. The Advisor does not give investment recommendation to the public, advice on commodities nor solicit the public to invest into any energy products.
