Ty's Take For Week Ending September 16, 2016

          First, I’m happy to be back from visiting our supply chain and writing The Five Star Standard. Thank you to several of our readers who were kind enough to email me while I was away and tell me how much they missed reading our Newsletter. This takes a lot of work each week, but your support makes it worth it.

As you all probably saw, Oil markets while I was away were a bit of a wild ride. Last week, API reported a massive draw of 12 million barrels from U.S. stockpiles which sent oil dramatically higher. However, markets quickly retreated after traders figured out that the draw had more to do with import tanker delays as a result of a storm rather than increased demand.

          So let me talk about where I think things are going and let me try to ferret out the key points from the two major articles in this week’s Five Star Standard.

The first bit of news that happened in the last few weeks, and can be summarized collectively, is the change in projections reported in the Monthly Reports issued by the EIA, OPEC, and IEA. On September 13, 2016, the International Energy Agency (IEA), which advises oil-consuming countries on their energy policy, and OPEC revised their forecast, in ways that implicate a slower than previous expected recovery. The IEA stated that a sharp slowdown in oil demand growth, coupled with ballooning inventories and rising supply means that markets will remain oversupplied at least through the first half of 2017. These comments follow a bearish outlook from OPEC who pointed to a larger surplus next year due to new fields in non-member countries and U.S. shale drillers proving more resilient than expected in the face of cheap crude. Additionally, the EIA changed its projection from market balance at the end of this year, to middle of next year. These comments, as well as a general market expectation of U.S. monetary tightening before the end of the year, seem to indicate both supply and demand issues holding down the price of oil.

          I believe these revised forecasts by the major agencies are disconcerting for us and they all generally seem to have some collective themes running through them. First, most of the major agencies have now acknowledged (and are a bit bewildered by) the resilience of U.S. production. While these agencies and commentators forecast strong supply losses from U.S. given the steep decline rates of U.S. shale wells, producers have become resilient and are expertly squeezing more and more barrels out of each play. While this occurrence has been well known and thoroughly discussed, I think there is finally a begrudging acceptance. Second, I believe that everyone is concerned that we are on the verge of another global economic slowdown at a time where the U.S. Federal Reserve is lying in wait to increase interest rates and restrict access to capital – which is obviously negative for the price of oil. So these two factors combined (along with contributing factors, such as increasing rig counts) seem to be dominating the changing projections.

          And of course the OPEC freeze. We have been talking about the OPEC freeze since the Saudi energy minister first insinuated (not even stated) that in some universe (this one or a parallel one that everyone who wants to believe there is going to be a magical freeze lives in) there might be a freeze. Really OPEC and Russia?. If you read our prior articles, you know how cynical I am that OPEC will agree to a freeze and even more cynical that they will actually adhere to their own production quotas. But then, if you read the article this week (OPEC Output Freezes Update )you might very well walk away with the opinion that a freeze is imminent. And with good reason: OPEC gives just enough of a hint that there might be (which coincidentally added about 10% to the value of a barrel – gee – I see a pattern emerging) to give you hope. However, if you read the article provided in the link I gave you at the end of our article that provides a contrary view, I remain skeptical that a freeze is even really being contemplated. Not one minister has given a truly clear indication that a production freeze is actually imminent, and indeed, when the actual quotes by the various OPEC players are read quite literally, makes it seem as if no one is really contemplating a freeze. But markets love volatility so traders can make money, and journalists love to publish articles. So any news of a possible freeze is met with great fanfare and quick publication – even if you can just imply one.

But Ty, you ask. Where are we now?

          Based on the convergence of supply and demand that was predicted to occur later this year, I felt when writing earlier editions of The Five Star Standard as though we would see inventory draws become more regular in 2016Q4. However, all three major agencies (EIA, OPEC, IEA) seem to agree now that is unlikely. And even once we do see inventory draws that will not necessarily spur production. Furthermore, it was my strong hope that we would begin to see more recovery for oil markets before 2016Q4, but I am beginning to have doubts. Big oil generally sets E&P budgets for the following year in the last quarter of the preceding year. My strong hope was that the great minds that control these budgets would see the turnaround and make some positive decisions for 2017.

          Nevertheless, I do not fear that all is lost. First and foremost, drilling efficiency allows many producers to be profitable at substantially lower oil prices (See prior editions of The Five Star Standard for more specifics on the radically changed and reduced cost structure oil companies have found since the downturn). That alone will allow drillers to confidently put some wells into production even at lower oil prices once they see some consistent movement of existing inventory / more convergence of supply/demand. Second, we have already seen some increases in the rig count based on $40+ barrel oil. That makes sense. Many drillers have a large inventory of DUCS (Drilled, Uncompleted wells) which means they have already sunk a substantial cost into producing the well but are not reaping any benefits. Completing those wells may make sense as refinery margins are squeezed (as they have been) and big, integrated oil struggles for cash flow. Ditto with non-integrated producers: at some point you are drill or die. And finally, all of the predictions are somewhat predicated on slowing demand because of concerns of a global economic slowdown. Of course, the U.S. Presidential election will have a substantial impact, and I believe there is some market volatility over concerns raised by the major candidates. That slowdown may not occur.

          And, as outlined above, I do not believe we should expect a great deal from the much touted informal OPEC meeting slated to occur later this month. Frankly, I see little incentive for OPEC to freeze production, much less curtail it. There are simply too many headwinds at this point. But OPEC surprised the world when they allowed unlimited production to continue, and indeed, increased production. They are certainly capable of doing it again.

All of this leads me to my prior conclusion, oil markets will recover and therefore the services sector will recover. I strongly suspect we will see a continued gradual rise in rig counts and business for the service sector will correspondingly increase.

          However, I think my major revision now is that I believed in past editions that recovery would begin more in Q4 this year. Now I’m not so sure. The negative forecast revisions are disconcerting, but overall play into the “middle-for-longer” philosophy expressed by most major executives for the big companies (oil and service). But instead of being on the middle part of the middle for longer, I now think we will be on the lower part of the middle-for-longer curve through Q1 of 2017 with only a small marginal increase in our business. But of course, these are only my opinions, and if EIA, OPEC, and IEA can all change their opinions rather dramatically (and I assure you – they not only have a lot more data than me, but also a lot smarter people analyzing it), I reserve the right to change mine.

Finally, for all my friends who take the time to read this: on a happy note, my beautiful girlfriend Gabi foolishly agreed to marry me – so now she’s my beautiful fiancé and I at least have something to be happy about even during this horrible market. While we wait for markets to recover (look for a big indication of where markets are headed in the 2 months following the U.S. Presidential election), I hope everyone finds something to be happy about!

Again, thank you all for your friendship and business. Until next week!

Cheers,

Ty

By: Ty Chapman

Five Star Metals, Inc.

Raising the Bar for Customer Service and Quality

Twitter: @FSM_TY

Please like us on Facebook!