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

 

Video: Outlook for the Euro, Oil and Stocks after the French Elections

Global Economy, Media, On the cover, Sin categoría

In this short video, I explain our view of the EUR/USD short-term, why oil remains subdued despite OPEC cuts and the earnings season so far, with implications on stock markets.

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 Tressis

 

Euro vs US Dollar. Time to sell?

Global Economy, On the cover, Sin categoría

After the French elections, the euphoria over the euro/dollar exchange rate is more than likely to dissipate. The revaluation of the European currency has been supported by consecutive political catalysts, which have supported the Eurozone project, and the trade surplus supports the euro versus the main currencies with which it trades.

Once political news have passed, and focusing exclusively on fundamentals, supply and demand should prevail. There are several challenges:

– The global demand for euros decreases . The latest figures from the Bank of International Settlements (BIS) show total cross-border transactions in US dollars of $ 13.9 trillion, increasing by $60 billion in the third quarter of 2016. In turn, transactions in euros fell by $160 billion, to a total $8.1 trillion.

– Supply of euros rises. We are in a dangerous time. For the first time in history, central banks are increasing money supply by more than $200 billion a month without any crisis or recession. Of that figure, the European Central Bank is almost a third. At the close of this article, this enormous monetary expansion has already generated 1.2 trillion euros of excessive liquidity.

Confidence in an export model and the trade surplus of the European Union, which makes the reserves of foreign currency of the Eurozone grow steadily, have been the main factors behind the relative strength of the euro. It shows that the European economy is more solid than some inflationists would like it to be.

The evidence that devaluation does not favor exports is clear in the Eurozone. Since the launch of the ECB program, the euro has weakened almost 23% against the US dollar and yet export growth has slowed significantly. In fact, the most sustained increase in exports has been between countries of the euro area itself, that is to say, with no currency effect, while growth in exports to non-euro countries has weakened considerably. However, inflationary alchemists will continue to tell you that devaluing supports exports.

We must not forget the challenge of supply and demand, and of excess liquidity. The European Central Bank is almost 200 bps behind the curve and should be raising rates already. In addition, with such an amount of excess liquidity, which increased by more than €1 trillion since the repurchase program was launched, it is urgent to drain that excess and stop increasing the ECB current balance sheet. There is enough liquidity in the system to continue supporting bond issuances.

It is more than likely that the supply of US dollars will be contained, through the normalization of the US monetary policy, where the Federal Reserve also lags far behind the curve by almost 300 basis points, while global demand of the US currency increases, mainly from emerging countries. While demand for dollars is growing above supply, the reverse is true of demand for euros versus supply.

Therefore, apart from political catalysts, markets are facing a few years in which the euro is more than likely to lose momentum with respect to the US dollar.

We must pay attention to the risk of loss of confidence in the European currency if excessive liquidity continues to rise while money supply is increased. The last thing the EU would wants is to lose the status of the euro as a reserve currency. It must leave alchemist experiments behind and aim to strengthen the demand for euros in global transactions.

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 Images

Are European Earnings Improving?

Global Economy, On the cover, Sin categoría

Investors in European stocks seems to breathe a sigh of relief. After many quarters in which the only thing they have seen were downward revisions in profit estimates, this earnings season seems to be positive. At the moment 15% of the European market capitalization, about 115 companies, has publishede, and this is on track to be the best results season in eight years. Net Income point to a 20% growth in the first quarter, compared to the previous year. The downward trend of the last eight years seems to be reversed.

The European investor has been clinging to the “value” argument as a last resort for many years. Anyone has heard it several times. “Europe is very cheap” … and disappointment ensued.

This “valuation” argument, repeated over and over again, hid the fundamental difference between the European stock market, plagued by low-growth and low-return-high-debt conglomerates, without a strong shareholder remuneration policy, compared to the opposite in the US. While in the United States, companies were posting single-to-double-digit earnings growth, increasing dividends and share buybacks in the face of excess liquidity, Europe continued with no growth, dividends paid with shares and more debt.

The interesting thing is that the consensus, for the first time in years, is revising upwards its earnings estimates

But that is changing. The average debt of the European stock market has not fallen much, that is true, but that is due to the disproportionate weight of banks and energy. What is interesting is that consensus, for the first time in years, is revising upwards its estimates, even if it is a meager 1%, but in the past fourteen years, the average downward revision of estimates in the first three months of the year was 5%.

However, markets have reacted cautiously. The positive reaction to good results has been on average an outperformance of 1% to the broad market, while poor results have been penalized with a 5% underperformance. This shows the level of caution from investors, who see companies still very timid in their guidance and outlook. Indeed, Eurostoxx 600 companies’ guidance for annual profits has not improved significantly.

We should not forget that a very important part of the positive surprise of the earnings season comes from the so-called base effect. What does that mean? That a large part of the earnings increase comes from the comparison with abnormally weak periods. In the energy sector earnings beats have come from commodity prices, while in Financial, lower provisions and a slight increase in inflation explain 90% of the positive surprise.

Investors’ caution is justified because, despite improved estimates, neither margins nor cash generation are improving significantly.

It is not clear that we are facing the end of the earnings recession we discussed here, but a base-effect rebound. In any case, this rebound may justify a floor to valuations. At least a scenario of steady downgrades in estimates seems to have been almost ruled out.

Investor caution is justified because margins are not increasing significantly

The great challenges of the large European stocks remain. Overcapacity has not been reduced – it has increased in the industrial sector in particular – and low margins and high indebtedness continue to weigh on multinationals’ multiples. Many of them are still in the process of digesting the binge of high-priced acquisitions made between 2004 and 2007. To this, we must add the eternal soap-opera of political risks and the increase in tax burden.

We cannot say that the earnings recession has ended, but it is worth noting that it seems that the European companies are beginning to breathe.

Daniel Lacalle is a PhD in Economics and 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 Images