Ty’s Take 01-13-17

We are starting the New Year off with a Bang!!! While sales have come nowhere close to the volume we need, we at Five Star are definitely seeing a nice uptick. We think we started seeing it in November, but the holiday months make it difficult because we traditionally slow a bit. And while the uptick may not be enough to make us jump for joy, we are incredibly appreciative of the business we are getting from all of our friends!

                  So, as we start the New Year, it seems we have every indication that the downturn is, for at least the moment, abating and we will start down the road of restoring normalcy to our industry. Because the good news is aplenty. I’m going to summarize all that I have learned over the past few weeks – most of these topics are discussed in substantially more detail in the articles this week. If you want to know more about any given topic, it is in the other articles.

First, and most importantly, OPEC seems intent to honor their production cuts. According to at least one reliable source, Saudi Arabia has already fully implemented their cuts. In fact, another source says that both Kuwait and Saudi Arabia have cut more than their agreed amount – as an example to others. Wow! And it makes sense as we will discuss below. Russia and others are more likely to not actually take much, if any, affirmative actions to cut production but are likely to allow existing production to naturally curtail. I do suspect though that Saudi’s Mid-East allies will turn the tap off pretty quickly as well.

However, this is why most analysts seem to think that markets will not rebalance until Mid-2017 and traders, given their trading activity, seem to agree. The optimistic news is that objective evidence and surveys seem to concur that markets are tightening. The Dallas Fed Survey and Reuters Survey discussed in another article this week all indicate that leading energy professionals seem to be substantially more bullish on oil than they were even a few months ago (again, as I note of disclosure, I was asked to and did participate in the Reuters survey).

On the plus side for oil services, this week’s article about Industry Optimism backs up what we suspected: service pricing is going up. Energy Execs are reporting demands for 30% price increases from oilfield service companies. This is net positive for all of us. First, it probably means we will all have some ability to regain all of the dramatic pricing concessions we have given over the last few years. Second, and I think more importantly, it may temper the fury of American drilling that I fear. If America simply boasts production back to pre-downturn levels, we will be back in the same market condition – even with OPEC cuts. At this point, we need growth in world oil demand and a steady growth in U.S. production to make the market sustainable for any real length of time. Natural factors were likely to temper America’s immediate growth anyway (ex: rigs that no longer work because they have been sitting too long), but structural pricing changes may hamper that growth in the short term but be positive long term.

Other positive notes include recent news that tankers are now moving from prior markets and shifting to carry North Sea production to Asia. While this may be speculators getting ready to take advantage of market conditions, it does seem to indicate at least a belief that OPEC will adhere to its agreements thereby creating a vacuum for additional crude in Asian markets that OPEC was attempting to dominate.

But a word of caution. OPEC cuts are much more difficult in reality than they are on paper. Few producers have the ability that the Saudis have, to simply flip a switch. And, the devil is in the details. In an excellent analysis in Business Insider by Elena Holodny, we learn there is a bit of a catch with the OPEC cuts – not all barrels are created equal. As you all now there is light crude and heavy crude, sweet crude and sour crude. Light sweet is generally preferred as it requires less refining. OPEC’s production cuts, combined with expected output growth from the U.S. and Russia suggests that lighter, sweeter crude will more heavily enter the market, whereas a bulk of the OPEC cuts will come from countries that tend to produce medium and heavy oil. And this might be problematic because global oil demand is centered on growth from only a few countries which tend to have refining capabilities geared towards running medium and heavier crude. This means that cuts to light, sweet crude have incrementally more impact for inventory balances that cuts to medium to heavy crude.   Now, the Saudis can theoretically offset this problem by cutting from their production of either light or extra light oil (about 78% of their total production). I mainly point this out to say this: OPEC production cuts are more complicated than just the number of barrels.

And given where we are with the OPEC cuts, I think it is reasonable to believe markets will reach balance. Interestingly, OPEC’s historical compliance with production cuts is around 60% and has been as high as 80%. Based on current market thinking, compliance as low as 50% will probably be acceptable – but 80% would get the job done.

So, as we enter 2017, I am optimistic that we are at the early stages of recovery, and that recovery may happen faster than we originally predicted. While our business is still down substantially over 2014 levels, right now I will take what we can get. The interesting question is: how much more will we recover, and how long will it last? Rather than give you all the details, I will direct you to a fascinating article on historical boom/bust cycles and oil price volatility written by John Kemp of Reuters. Mr. Kemp explains why oil goes through boom/bust cycles and why those are largely unable to be controlled. Nevertheless, Mr. Kemp notes that experience shows us that instability will characterize the recovery as well – and I fully expect that to be true this time around.

Let’s hope that OPEC cuts as promised, the recovery continues, and we all start to feel the benefits sooner rather than later. Here’s to 2017!!!

By: Ty Chapman

Five Star Metals, Inc.

Raising the Bar for Customer Service and Quality

Twitter: @FSM_TY

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