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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

Video Interview: Secrets of a Fund Manager, Economist and Author

Global Economy, Interviews, Media, On the cover, Sin categoría

In this interview we explore my views on the economy, technology, Bitcoin, my forthcoming book “Escape from the Central Bank Trap” and many other things. I hope you like it.

Thanks for watching!

 

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

 

Deutsche Bank and the last opportunity

Sin categoría

Deutsche Bank has a new strategy. Unwind the old one.  And it might be the correct decision, as well as its last opportunity to overcome its challenges.

Now Deutsche Bank will make its third capital increase since 2013, a move it wanted desperately to avoid… But it was inevitable.

Details: €8bn capital increase, €2bn disposals and list a minority stake in its Asset Management business.

Based on 687.5 million shares issued, the dilution is 50% and the new shares are issued at a 40% discount to Friday’s close. This capital increase should bring the CET1 capital ratio to 13.4% before disposals. Disposals and other impacts would bring 2018 CET1 capital to 11.8% in 2018 according to consensus.

The question is: Will it be the last one?

The German bank’s shares have recovered dramatically in the past months thanks to the expectation of a new strategy and the improvement in inflation and growth in the EU. The main issue, when it comes to understanding risk, is to understand why the shares fell so heavily before – along with the rest of the European banking system -, even when we were told that banks were “very cheap”.

A few problems that the market identifies in Deutsche Bank, and that we have seen in Italian and Portuguese banks, are:

Capital deficits. An estimated capital requirement of €5.5 billion is expected to exceed €10 billion including the costs of recent fines and the harsh reality that the sale of some non-core assets is likely to be at a price below the book value. Divestments have been delayed and capital requirements became more relevant as the business base deteriorated with negative real interest rates – which depressed the bank margins -, and weak global macro outlooks.

Lower revenues. Deutsche Bank generates almost 50% of its revenues from NII (net interest income on loans). With real rates falling worldwide and more than 25% of the world’s GDP in negative yield territory, the risk to the bank’s income outlook was very relevant.

Costs rise. Even with the cost reduction plans carried out and the efficiency programmes, costs skyrocketed (45% from 2011 to 2015) and revenues did not grow (1% over the same period). The cost-to-revenue ratio remains very worrying. It has soared from 72% in the second quarter of 2014 to 79% in 2015 and is estimated to be 80% in 2017.

Low profitability. A problem for the whole European banking system. But with a core capital requirement of 13%, consensus estimates that Deutsche Bank may not generate profitability above its cost of capital at least until 2018. By 2017, a ROTE (return on tangible assets) of less than 5 % and a return on total assets (ROA) close to 0%.

DEUTSCHE IS NOT LEHMAN

Scaremongers try to call this a “Lehman” moment. But there are many elements that differentiate Deutsche Bank from Lehman Brothers, for example:

  • Non-Performing Loans are not at a worrying level (1.9%, less than 3% in the worst of consensus estimates), and well below the Italian or Portuguese banks, for example.
  • The exposure to derivatives, which is constantly discussed in the media, is enormous – nine times its tangible assets – but it has been that way for many years, it has been falling and we must remember that the risk in derivatives is generated when these are very concentrated in an asset that collapses. Deutsche’s derivatives exposure is very diversified and well managed.
  • Deutsche Bank does not deny its imbalances, and has been increasing core capital and reinforcing its balance sheet for several years. This is a big difference with Lehman. Also, Deutsche has none of the massive exposure to a single risk that the failed US investment bank had.

… But all these problems were already known – or at least feared. What changed last year?

Welcome to the CoCos (Contingent Convertible Bonds). These were very popular bonds issued during the years of Draghi’s “whatever it takes” bubble. These are bonds issued by banks which rating agencies give up to 50% consideration as capital because the coupon can be eliminated if the capital requirements of the issuing bank demand it. These CoCos paid an attractive interest and many investors started to buy it as a “bargain” in the hunt for yield. They were so popular that yields fell from 7% to 4% in very little time. For many investors, buying these contingent convertible bonds had “no risk” and they received a 4-6% coupon because the risk of eliminating the coupon was perceived as very low.

In 2016, the risk that Deutsche Bank would not pay some of the maturities on these bonds generated a domino effect: the stock collapsed, the CDS soared and the alarms went off. It did not happen, and maturities were paid, but the elephant in the room -capital risk- became evident.

The idea that you can stop paying a bond without having an impact on the stock and the bank is – as it always has been – a ridiculous one, and we are seeing a second wave of risk, if confidence continues to deteriorate. Therefore, a real capital increase was inevitable.

This contingent convertible bond solution was a fake and dangerous way to deny the need for aggressive capital increases. It highlighted the balance sheet fragility while putting at risk the entire market cap of the bank due to loss of confidence.

Will Deutsche Bank fall? It is very unlikely. This urgent recapitalization comes as the right answer to a problem that cannot be disguised with empty words and apparently intelligent financial engineering ideas.

But the problems of the European banks remain.

Total banking assets in Europe exceed 300% of the Eurozone’s GDP. At the peak of the crisis, in the US, they did not reach 80%.

Non-Performing Loans in the Eurozone remain above €900 billion.

An erroneous policy of kicking the can further via ultra low rates and high liquidity has made it difficult for banks to recover and strengthen their balance sheet, and monetary policy has made the efforts almost a race to stand still. All divestments and increases in share count were offset by weakening profitability and poor credit demand.

The policy of financial repression in the European Union, has weakened banks, rather than allowing them to strengthen. Despite huge provisions and capital increases, the recovery of the financial sector has been much slower than desirable.

If the ECB persists in denying the problem, it is only going to perpetuate it. It is urgent to put recapitalization mechanisms that do not generate systemic risk, instead of bubble patches like the CoCo bonds.

The mistake of this period is twofold: to compareDeutsche Bank with Lehman, while denying the devastating effects of financial repression in the sector. Laughing at the first undeniable exaggeration, policy makers have ignored the urgent measures needed to solve the second reality.

Today’s capital increase is a step in the right direction. But it needs much more. Put profitability back on the map, really reduce costs and make a detailed roadmap of objectives for investors to rebuild their trust.

Deutsche Bank has a unique opportunity to solve its problems for once and for all. It will require much more than a capital increase. Or it will not be the last one.

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 Oil Sector Underperformance Goes Beyond Oil Prices

Energy, Global Economy, On the cover, Sin categoría

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.