A precursor to a Transocean ($RIG) write up - Part 1
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Let’s talk about oil before we talk about $RIG as without an outlook on the underlying commodity itself, then our analysis will be largely useless. As people who hangout in the discord (link here) know, I’m quite bullish on oil. I’ve explained why at various times but I figured why not write it out, why the recent dip hasn’t deterred me and what I see moving forward.
For most of our lives we’ve seen the demand for oil continuously grow with supply keeping up. Sure, we’ve seen it overshoot at both ends of the spectrum, reaching a high of $147/bbl in 2008, to going negative in 2020, oil has really seen it all. But I don’t think it’s seen a scenario like the one that is unfolding. See, the world has been fortunate enough to have extremely cheap energy ever since 2014. In 2014 we had two major factors contribute to low oil prices that had lasted until recently which were both primarily supply driven. The first is the U.S shale revolution. In the early 2000’s there was actually a really similar story to what’s being told today. In 2005 energy investment banker Matt Simmons published Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy. Simmons helped set off a fierce debate about whether Saudi Arabia (and the world as a whole) had reached a global peak in oil production. This thesis gained traction over the next three years, as oil prices surged past $100/bbl and helped push the world into recession. The U.S needed something to change.
Fracking had been around since the 1940’s and had been used to promote higher production rates from wells. Fracking involves pumping water, chemicals and a proppant (like sand) down an oil or gas well under high pressure to break open channels (fractures) in the reservoir rock trapping the deposit. Oil and gas do not travel easily through certain reservoir types, which is why they need to be fractured. The proppant is designed to hold those channels open, allowing the oil or natural gas to flow. Then a man by the name of George Mitchell came and combined fracking with horizontal drilling. By doing this it enabled economic oil and gas production for the first time from shale formations across the U.S.
As breakeven prices continued to head lower, production increased. Incentivized by high oil prices, U.S production grew at the fastest pace in U.S history over the 7 years from 2008-2015. On top of this, we had unexpected demand starting to fall. China accounted for 70% of the increase in global oil consumption from 2000-2014. As such, initially strong forecasts for Chinese growth followed by repeated downward revisions likely contributed to the excess oil supply. Companies would have invested in projects right as oil price and demand was peaking, only for those projects to come online as demand was declining.
In the above chart we can see supply outpaced demand right around Q2 of 2013 which coincides with GDP growth and forecasts in the chart below.
While the output increased in the U.S, so did it in other countries as well. Non-opec output rose by 1.4mbd in 2014 with much of the increase coming from Brazil and Canada, two higher cost producers trying to take advantage of elevated prices. The second factor is in November 2014 Opec refrained from cutting production, instead choosing to maintain production output even in the face of the U.S shale boom. This caught the markets by surprise and contributed to the price decline. Although it was a surprise to the markets, it shouldn’t have been as it aligned with the behavior of Saudi Arabia, the key player in any Opec agreement. A cut was unlikely, models have narrowed down the conditions for a cut to a numbered few:
The ability of other Opec members to raise their own output must be limited, so it can’t offset the effects of a Saudi cut
The ability of non-opec members to raise their output in response to a cut should be limited and understood
The shock facing the oil market must be considered temporary
These conditions were absent in November of 2014 until the September 2016 meeting where they finally lowered output. On the Opec side Iran was making process towards the removal of economic sanctions against its oil exports and Iraq was finally solving the infrastructure bottlenecks that had plagued it since 2003. Iraqi oil production had already increased by 0.7mbd between 2011 and 2014. On the non-Opec side, US shale was clearly changing the nature of the oil market but it wasn’t very well understood. Saudi Arabia seemed willing to allow prices to decline enough to slow down non-opec production growth. Had they understood the price level needed to manage the non-Opec curve, they might have behaved differently.