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

So far this year, the European energy sector (SXEP Index) is the worst performing one in the European stock market. Same with Energy vs the US all-time-high levels.

The fact that this situation happens while oil prices remain within the range of $ 50-55 a barrel, shows that the sector is very far from regaining momentum after a rather technical rebound seen in 2016.

We should not forget that the oil sector was already one of the worst performers in the stock market way before the oil price collapse. The reasons were obvious. Monstrous investment plans with very poor returns, disappointing growth, weak profitability and missing companies’ own targets, added to an unsustainable dividend yield even at $ 100 a barrel.

No, the problems of the oil sector do not come only from the price of oil or natural gas. It comes from the atrocious allocation of capital and the inexorable destruction of value of many conglomerates that hide under the “long-term strategy” excuse, and the detestable “integrated model” to mask a very low competitiveness and a poor identity of objectives with the suffering shareholder who, year after year, looks to the sky and hopes that “in the long-term” things will improve.

When prices are high, the sector embarks on questionable acquisitions and, when oil prices fall, it is the shareholder who suffers.

It all started many years ago. Already in the late 1990s, the vast majority of integrated oil companies forgot the historical principles of the sector.  They forgot ROCE (return on capital employed) as a fundamental measure to analyze investments, launched “diversification” strategies that have destroyed billions of market capitalization, began to relax their investment criteria … And the disaster was slowly brewing. A sector that generated 12% ROCE at $ 14 a barrel … went on to generate a lower profitability, 11%, at $ 130 (SXEP Index).

When I started working in the oil sector, planning was made using commodity prices that were much lower than the curve. Today, oil companies’ strategy departments are semi-religious centers dedicated to praying for the price of oil to rise, resorting to conspiracy theories and hopes of OPEC cuts, instead of planning at the low-end of the cycle, as the sector always did.

US companies learned this lesson years ago when they made strategic mistakes because they thought the price of natural gas “could not fall.” Acquisitions were made in the US that required $ 6/mmbtu. But natural gas prices plummeted to $ 2/mmbtu. A reality slap in the face that led companies to go back to basics. Put ROCE in the forefront of strategies and forget the mirage of high debt. Massive capital increases, cuts in capex and restructurings ensued.

Meanwhile, in Europe, big oil companies were launching a strategy of running to stand still. Adding debt, and investing in power and renewables.

To think that the problem of the European oil sector, of its lack of investment rigor and poor shareholder return, is going to be solved with higher crude prices, is to deny reality. Investments have already started to increase – an annualized 8% – even though balance sheets remain damaged and the enormous overcapacity created in the bubble period has not been reduced.

There are opportunities in the oil sector, but I fear they are not clearly defined in Europe. Any hint of hope in European conglomerate valuations requires an act of faith, while in the US, at least the investor has managers who are aligned with investors’ interests and better fundamentals.

If investors believe that oil prices will rise, there are better options in service companies that benefit from the return of investment plans or focused exploration and production companies, where one does not have to take believe in conglomerates. In any case, despite the OPEC “agreement”, crude oil does not easily move out of its lateral range, due to the obvious excess of supply.

The high dividend yield of integrated conglomerates is an indicator that should be carefully analyzed. When those dividends are unsustainable, paid with debt or, worse, with shares, a high dividend yield could be misleading.

I do not like oil conglomerates. They are value traps by the book. They always seem optically “cheap”, but their low multiples are justified by the atrocious profitability, lack of investment rigor and megalomaniac strategic decisions.

The two trends that do interest me are the return of capex, which benefits service companies, and the energy independence of the US, which benefits the focused North American producers. The rest, with all due respect, need to stop hiding under the long-term excuse, do their homework and carry out an exercise of self-criticism and restructuring after decades of empire-building with shareholders’ money. The electricity sector did it. The integrated oil sector, like many banks, continues to believe in unicorns.

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

Image courtesy Google.

The main guidelines that the Trump team have outlined for the United States energy policy can be summarized in two words: energy independence (read ). To declare “United States energy domination” a strategic priority, both in foreign and economic policy.

The key driver is to develop $50 trillion of untapped oil, shale and natural gas reserves as well as hundreds of years of clean coal reserves. Liberalizing licensing for exploration at the national level and cutting red tape, the goal of the Administration is to achieve and maintain total independence from imports of any type of hydrocarbon. With this policy, the US could almost double its proven reserves and produce 12 million barrels a day of oil by 2020.

This policy would help slash the trade deficit, create millions of jobs and at the same time, through competition, lower household and industry energy bills, increasing competitiveness and… cutting CO2 emissions thanks to carbon capture and efficiency development.

Eliminating subsidies to renewables is part of the plan. The sector does not need them anymore, and has the opportunity to show that it is true. The US Energy Administration estimates that the cost of solar in 2046 will remain three times higher than that of coal or nuclear. These estimates are criticized and questioned by the renewable industry, and this is a unique opportunity to prove it, benefitting consumers at the same time.

Nobody in the administration will prevent the development of renewable energies, quite the contrary. Just phase out subsidies that were already being slashed. Solar energy received more subsidies since 2008 than all the other technologies combined, $ 575,875 per thousand megawatts. But solar costs have dropped dramatically in the past three years and now it can compete in the same terms with any other technology, but also without unjustified government interference in the development of other technologies.

The US will review the federal tax incentives for renewables, an incentive that already was in gradual reduction until its disappearance. And no one will be forced to install any technology by law. Renewables will continue to grow and benefit, like all others, from lower taxes and opening up regulation, facilitating developments and reducing bureaucracy. In this respect, however, there are different views in different States of the Union; In some the promotion of renewables is fundamentally a political priority.

Some media say that Trump attacks renewables. Since when facilitating competition, reducing obstacles and eliminating subsidies that the sector itself says are not needed, means “attacking”? Let us not forget that the shale revolution happened during the Obama administration… Because it worked. And that hundreds of solar companies failed… Because they didn´t.

Removing legal barriers and bureaucracy that limits exploration and development of resources, while promoting energy competition without  federal restrictions is good news for customers and industries. This will certainly help solar and wind demonstrate their potential to compete in equal terms with others,… and the beneficiary will be the consumer.

The Department of Energy (DOE) has just published a Quadrennial Energy Review (QER), which reviews in detail the power system, from generation, centralized and distributed, to the end user, including an analysis of grids, distribution, storage, cybersecurity, and new business models. The DOE proposes a series of recommendations of action for the Government at federal level.

The main conclusions point to the strategic nature of the protection and development of the value of the electrical system, through its modernization and transformation, since the most important infrastructure in the United States depends on it.

The DOE indicates that the US electric sector faces significant challenges:

An aging infrastructure – which the administration seeks to modernize via private investment and fiscal incentives -, the change in the generation mix and the growth of the intermittent generation in a country where demand has been almost flat, thanks to efficiency, despite the increase in GDP.

The energy sector reduced its CO2 emissions thanks to the winning combination of shale, natural gas and renewables, and the relevance of nuclear power, which is 60% of the emissions-free generation in the US, is critical to continue improving. Clean coal technology, added to hydro, nuclear and natural gas, will add to renewables in a cleaner environment that does not cost the consumer dearly.

Faced with the challenges of energy independence, the modernization of the electricity grid is an essential element to tackle. But rapidly lifting unnecessary regulatory barriers and lowering taxes are critical to allow hydraulic power, renewables, clean coal and nuclear to contribute to a winning mix.

The most interesting thing about these measures is that infrastructure costs will not mean higher prices for consumers or increased tariffs. Modernization and decarbonization should be promoted from improving competition and unblocking legislative obstacles.

The United States, with its energy revolution, has achieved lower costs for consumers and industries and at the same time reducing emissions more than the EU. Household and industrial electricity prices on average are less than half the European mean, and CO2 emissions have fallen more with the development of shale gas in the US than with massive subsidies to renewables in the EU. Accelerating technological competition and eliminating perverse incentives will work.

All countries in Europe could learn from this policy. Putting competitiveness and free market as an essential element for technological improvement.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google Images

Article published in Spanish in @elespanol