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

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.