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Energy

OPEC’s Next Mistake

Energy, Sin categoría

The OPEC meeting has failed, again. The decision to cut production was announced months ago as a great triumph because it included countries outside the organization. And it was a mistake. The result, several months after the largest production cut in history, could not be further from what the organization expected. Oil inventories in the OECD rose to five-year highs, the United States also recorded record levels of crude oil in storage despite a healthy demand, growing by more than a million barrels a day in annualized terms. However, oil prices remained far below those levels desired by OPEC, and especially its more wasteful members, Venezuela in particular.
Why? OPEC has underestimated the reaction of new technologies and independent producers. The cut by OPEC has been the biggest gift to shale in a long time. The US achieved a production growth that has surprised the most optimistic, and the country is closer to energy independence. That the US imports less and stores more, affects oil prices in several ways. On the one hand, US producers have done their homework and increased their efficiency and reduced costs by more than 40%, which has allowed them to be competitive at $45 a barrel. This makes the price of oil lose strength in the face of evidence that the market is better supplied and more diversified than expected.

There is another very important effect. The “oil weapon” mentioned by Chavez years ago has run out of gunpowder. With the drastic reduction of US oil imports, the geopolitical premium historically added to the price of oil due to the US dependence on politically unstable countries, disappears.
Evidence from recent years shows us that the success of the American energy revolution, carried out without any support from the Obama Administration, is twofold. The dream of energy independence of the world’s largest energy consumer is ever closer, and the combination of shale, renewables, coal and natural gas, has been an essential factor in competitiveness, growth, employment and has destroyed the power of OPEC to manipulate the price of oil.
The big mistake

With this meeting, the cartel shows that its control over the price of the barrel in the medium term is non-existent. Worse, if they continue with this policy, the response of alternative technologies will accelerate. The great error of OPEC has been to think that lowering prices would displace alternative technologies and the inexorable advance of efficiency, but the suicidal movement puts at risk OPEC’s role as the most reliable, competitive and flexible supplier. Throwing themselves into unnecessary cuts, they sent a dangerous message to their customers: it was worthwhile to continue to advance with disruptive technologies.

None – I repeat, not one – of the OPEC countries is losing money with the current prices.

None of the OPEC countries is losing money with the current prices. The production and development cost of all members is massively below the current oil price (average total costs $20 a barrel), but member states had become accustomed to financing unproductive subsidies and political spending, to squander their oil revenues. So, despite having costs well below $20 a barrel on average, almost no OPEC country balances its budget at these prices. Between $20 and the $100 some would like to see, there are hundreds of billions of dollars in political spending and subsidies.
I am sorry, because I have had the honor of attending several OPEC meetings and I value the principles that have always informed its policy: to defend an adequate supply and a price that is good for consumers and producers, to be a reliable and safe supplier. We mentioned it in the book The Energy World Is Flat (Wiley), the decision to manipulate the market will only make the market respond more quickly.

Today, OPEC is faced with the devil’s alternative. If it continues to limit production, the response of efficient operators in different technologies will accelerate, and if it recovers production levels prior to the cuts, it will not be able to finance the excessive expenditure to which the member countries have become accustomed.

OPEC’s response should only be one. Demonstrate that they are the most efficient and reliable operators and that their governments can stop irresponsible spending. Only in this way will these countries, full of wonderful opportunities, remain relevant and prosperous.

“Low” oil prices are a blessing in disguise to producers, even if they do not believe it. It is the shock they need to wake up from the nightmare of the petrostate, that wastes billions of oil revenues and thinks it will go on eternally. Disruptive technologies are here to stay and have only one future: brilliant.

 

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Published in Expansion.

Picture courtesy of Google, BP.

OPEC strategy has backfired. And it could get worse

Energy, Global Economy, On the cover, Sin categoría

Nervousness is palpable ahead of the next OPEC meeting in Vienna. The cut in production agreed with some countries such as Russia has been an absolute failure. Not only OPEC has failed to raise the price of oil, but the market share of their main producing countries has been reduced.

If anyone would have told Saudi Arabia that the deal would push the price of oil to its lowest level in six months, increase its main rival’s market share, and strengthen the fracking industry in the US, they would not have believed it. And that is exactly what has happened. No one can say I did not warn them.

Iran expects to increase production capacity by 3 million barrels a day according to the Shana news agency and official sources. Iraq remains at record levels, exporting 3.2 million barrels per day.

In the United States, shale alone has boosted production to 5.2 million barrels a day in May, 700,000 more than at the end of 2016. Between the increase in output of Iran, Iraq and the United States, they cover almost all of the cut agreed.

Iranian and Iraqi barrels are of the highest quality and very low cost, while US production costs have been brutally reduced. BP, in its earnings presentation, commented that its production in deep waters in the Gulf of Mexico can compete without problems with a shale production that already has a break-even price of c$45 a barrel. Thanks to efficiency and cost reduction, production in the Gulf of Mexico has also skyrocketed, bringing total US production to 9.3 million barrels per day, the highest level since 2015.

The OPEC cut has been the biggest gift to independent producers who have improved efficiency. It has allowed them to generate better returns at low prices, and increase market share.

Meanwhile, Saudi Arabia is the only country that has exceeded its commitment – as always – and delivers the biggest cut of all.

The price of oil is suffering because production is increasingly diversified and, as such, the geopolitical premium we attach to crude prices disappears and the ability to control prices of OPEC diminishes. Not only that, but inventories are at a five-year high, and have increased in the US by 10% since the OPEC cut, 30% above the average of the last five years.

The mistake of inflationists with the price of oil is threefold:

  • To think that the reduction of investments will generate a boom in prices in the medium term. Not only is capex growing at an annualized 8%, but they forget that the “reduction” came after a spending bubble in the easy money decade that led to a huge productive overcapacity of close to 30%. Investments in exploration and production multiplied in ten years to more than $1.2 trillion per annum, fueled by inflated commodity prices – in dollars – due to monetary policy and estimates of science fiction-style Chinese  growth, with no fundamental justification and based on bubble expectations. Today, those massive investments have become sunk costs and work just to generate cash. What we call “energy broadband” in The Energy World Is Flat (Wiley).
  • Ignoring efficiency and technological substitution, which are unstoppable and withdraw each year, according to the IEA, up to 2 million barrels a day of potential demand. Many think that OPEC cuts will work as demand grows. Let us not forget that, as soon as the demand begins to work better -and it is not bad- OPEC will start to “cheat” on those cuts, as it has always done, since there are no individual quotas and, when there are, many ignore them . To give you an idea, the average “cheat” in OPEC cuts since 1980 is between 450 and 800,000 barrels a day.
  • The lower the price, the more efficient the system. Global service companies have shown in their results this quarter that they can lower prices by 40-45% and still make money and grow.

OPEC strategy has backfired. But it can get worse. If consumer nations continue to perceive that the cartel is not a reliable, flexible and efficient supplier, and that its aim is to raise prices at any cost, the policies to reduce energy dependence will accelerate, just as solar and wind are becoming more competitive and electric vehicles are a reality. OPEC does not have a cost or profitability problem. All countries are making very positive returns at $45-50 a barrel. Those that are not making money is because they have massive cross-subsidies and political spending, not high production and development costs.

Many will tell you that “in the medium term” the market will balance … And they said the same thing two years ago, a year ago, six months ago… But they ignore that balancing does not necessarily mean price inflation. Because the technology, substitution and diversification revolution is much faster than the interventionist decisions of central planners.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google

 

Tesla vs GM. Value or Bubble?

Energy

Surely you have read the headlines. “Tesla is worth more than Ford,” “Tesla surpasses General Motors in market value”. The question is, are we in front of a bubble or a reality? A little of both.

Let’s start with the reality. The electric car, as we explained in ” The Energy World Is Flat” (Wiley) is an unstoppable alternative and part of the process of flattening the world of energy and using less oil. There is no doubt that the future of transportation will come from a combination of electric, alternative and hybrid vehicles.

Global electric vehicle sales totaled 222,000 units in 2016, and growth – while positive – has proven to be well below the overly optimistic market estimates. How does this affect Tesla?

Let us forget arguments like “it’s a good company”, “it’s a new paradigm” or “it grows a lot” and go to the data.

Tesla has sold, in 2016, about 77,000 vehicles. To give you an idea, the Renault-Nissan Alliance alliance  sold more than 94,000 electric cars.

Tesla’s revenues are around $ 7 billion, which means it trades at more than 6.5 times sales, and an enterprise value of eight times its sales, 164 times its EBITDA (Earnings before Interest, Tax, Depreciation and Amortization). That is, it discounts that sales and profits will multiply exponentially without resorting to more debt or sell new shares.

In 2016, Tesla reported a loss of $725 million, and has only recorded two quarters of clean positive results. Along the way, it has carried out capital increases and convertible bond issuances at almost $ 1 billion a year, increasing its debt to 12.3 times its EBITDA. Tesla does not pay dividends, of course. All in its valuation comes from expectations of growth.

If we compare it with General Motors, revenue is about $166 billion, which means that it trades at about 0.3 times sales (enterprise value is 0.24 times sales, since it has no debt, and 1.9 times its EBITDA). A net positive result of $9.9 billion, and a dividend yield of 4.4%.

General Motors generates $7.3 billion in free cash flow, a Free Cash Flow Yield of 13.3%. Tesla consumes $1 billion of cash a quarter, and its working capital requirements lead to the increased debt.

Since all the difference between one and the other come from estimates of the future, we must analyze what that future costs and its probability.

The reality is that the race for the electric cars market is not a matter of innovation or ideology, but of the ability to manufacture and sell them massively, in addition to offering them at a competitive price.

If our analysis is who will reach one million electric vehicles sold and what is needed to achieve it, we will not be surprised to see that Tesla will need at least three further capital increases similar to those already made, or a disproportionate increase in debt. As its shares are at historic highs, the best way to finance Tesla’s growth will be issuing new equity. You can, therefore, expect that demand for new shares to be greater or not.

The reality is that the investment to reach that same million electric vehicles in General Motors does not suppose neither an increase of debt nor impact in its dividend or a significant reduction in its enormous free cash flow. Of course, with more than nine million cars sold, General Motors has a manufacturing, development, sales and after-sales network that is already operational and can be adapted to new technologies with very little investment. In the case of Renault-Nissan, also with more than nine million cars sold, the burden to reach massive electric car sales is also very low. Therefore, the technological or innovation premium may seems exaggerated in Tesla while it is discounted at zero in its competitors. Interesting, because that “premium” needs capital, a lot, to become tangible sales.

The most optimistic estimates of investment in capacity for Tesla are $5 billion over the next few years, and others exceed $8 billion, which will continue to burn cash.

Many expect Tesla will be sold to one of those conglomerates that deserve to trade at such low multiples. What investors should analyze is whether that acquisition will be made before or after the day of reckoning. Betting on the “greater fool” theory is always dangerous.

Make no mistake. Tesla surely deserves a premium to the sector, just as any focused, innovative company deserves higher multiples than integrated conglomerates. The question is, what premium? And how much will it cost investors in capital increases?

The achievement of its objectives, to justify such multiples, may require almost 20% of its market capitalization in new equity, and estimates a 100% success rate.

We are faced with a case where the market seems to discount the perfect future in a stock that, moreover, has neither the cash nor the balance sheet to undertake it, while the markets values negatively that same business in its established incumbent competitors, which can massively develop electric vehicles without blinking.

No, it’s not the same as Apple or Amazon, Netflix or Google. Tesla’s multiples need, anyway you look at it, a massive capital investment to turn the idea into reality. Another completely different thing is whether shareholders accept such risk. While other technology companies have a much higher return on capital employed, their investment needs are much lower to get the estimated sales into reality. One thing is technology and another, cars.

Tesla’s shares can continue to rise, of course. Euphoria and fear are essential market factors. But what investors must analyze is whether the euphoria discounts a perfect scenario, and whether the market is willing to participate in the following capital increases and dilutions that are necessary to undertake the expansion of the company.

If it is a credible scenario, it is worth that Tesla uses the current environment to clear the balance sheet concerns. Working capital can be a big risk.

In investment it is essential to differentiate technology from business model, and not fall into quasi-religious faith arguments when it comes to buying a stock.

Do you remember the solar stocks trading at a premium on future installations? Hundreds of bankruptcies later, the mirage has dissipated. And what about the wind manufacturers and developers discounting the “pipeline“of estimated projects? Gone. Do you remember the valuations of technology stocks discounting earnings on future emails? Goodbye.

The bankruptcy of ‘bubbles’ in solar, technology, financials, oil and gas or wind has always been due to two common factors. Excess debt and impossible expectations.

We have to be careful not to confuse a technology and its support, from an emotional or ideological point of view, with a stock and a business model.

Tesla is and should be smarter than all of its competitors and use its valuation to strengthen its balance sheet. I would love to see them succeed, not defend a bubble.

 

Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

Image courtesy Google Images

Op-Ed at CNBC: “Cut and dried? Oil prices are entering a bearish trend despite supply deal”

Energy, Global Economy, On the cover, Sin categoría

Oil prices have entered a bearish trend despite short-term bounces, supply cuts and improved demand estimates.

The lateral range of $50-$55 a barrel was recently broken, with the new long-term support level for Brent edging closer to $45-$47 rather than $50 a barrel. With money managers’ net length exposure to crude prices at the highest level in months, the risks for oil prices seem tilted to the downside.

There are various reasons for this trend.

The supply cut deal struck between members of the oil-producing cartel OPEC and non-members is ineffective and under question. We read everywhere that compliance is 90 percent, but Saudi Arabia is, in reality, the only member that is reducing output by a lot more than agreed according to OPEC figures (130,000 barrels per day cut above its agreed production), while Russia is at almost at a third (118,000 b/d versus the agreed 300,000 b/d).

Meanwhile Emirates, Kuwait, Venezuela, Algeria and others are between 50 percent and 60 percent compliance on the agreed cuts. Only Angola is cutting more than announced. This reliance on Saudi Arabia doing all the work is dangerous. Saudi Arabia has already announced it will increase output above 10 million barrels per day in February.

 

Iran keeps pumping out oil at record levels and Iraq is increasing its output to multiyear highs. Oil exports from Iran in February reached 3 million b/d, a level not seen since 1979. According to the International Energy Agency, Iraq will increase its output to 5.4 million b/d by 2022. Similarly, Iran is expected to boost production to reach 4.15 million b/d in 2022. These barrels are of high quality and abundant, as reserves have been underdeveloped for years.

Additionally, U.S. production is rising faster than expected. U.S. oil production has increased by 400,000 b/d from the lows, according to the IEA, surprising consensus that thought that shale would not recover before Brent reached $65 a barrel. Shale breakeven is now at the high $30s-low $40 a barrel level, and OPEC has underestimated the strengthening balance sheets and improvement of efficiency seen in U.S. companies. The U.S. is on track to deliver a 1 million barrels per day increase in production from December 2016 to December 2017, according to IEA estimates. This is before any tax cuts from the new administration, which would lower the breakeven price even further.

Despite cuts, inventories remain elevated. At 66 days of supply, OECD inventories are at a six-year high compared to 55 days in January 2011, and 287 million barrels above the five-year average. U.S. crude inventories are close to record highs as well, as shown in the Energy Information Administration (EIA) data.

The main element that analysts skip is that the so-called “lack of investment” is just the burst of a bubble. While many point to capex cuts as the driver of a new super-cycle, few seem to understand that the increase seen in oil and gas investments from 2004 to 2013 was created by the bubble of low interest rates and perception of ever-rising oil prices, not by demand. Capex multiplied in real terms to more than $1 trillion per annum in a decade of excess, creating a structural overcapacity.

While demand growth has been healthy year-to-date, consensus estimates seem too optimistic. International agencies get used to correlations of growth and oil demand that simply do not work and have been broken for years. Efficiency, technology and substitution continue to improve exponentially. This technology and substitution did not stop due to low oil prices, as OPEC expected. Solar, wind, electric vehicles and other alternatives continue to thrive despite lower fossil fuel prices.

Let us also remember that a stronger U.S. dollar and the Trump administration’s “America First” policy destroy the geopolitical premium attached to the oil price. The U.S. can become fully energy independent by 2019, and a monetary policy that finally normalizes rates and supports a strong dollar has an impact on the price of a barrel, which trades U.S. dollars.

The fact that oil prices remain in a bearish trend despite the largest cut in history and money managers’ net long exposure to crude at 10-month highs, shows us that the market is not only very well supplied. It remains oversupplied. Bulls maintain that the market will be balanced in six months. They said the same six months ago.

OPEC and oil producers should focus on being a competitive, flexible and reliable suppliers. Further cuts will only weaken their position.

Daniel Lacalle is a PhD, economist and fund manager, author of “Life In the Financial Markets” and (with D Parilla) “The Energy World Is Flat”. You can follow Daniel on Twitter @dlacalle_IA