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Submitted by Jeffrey Snider via Alhambra Investment Partners,

Part 1 here…

The entire point of leveraged positions is the margin of safety. That is true on both sides of that equation, as for the provider and the borrower/user. In the most famous examples of collapse, from AIG to LTCM losses were never really the issue. None of them could withstand instead collateral calls to their liquidity reserves. As noted last week, AIG’s “toxic waste” positions ended up registering some $20 billion profits to the Federal Reserve and the government via its (illegal) Maiden Lane SIV’s. AIG just could not withstand the liquidity demands brought about by increasing calculated volatility.

Another famous episode offers the same interpretation while providing some further insight into the world of leverage and liquidity as it exists now. Orange County went into bankruptcy with assets that were all still money good. The county’s investment fund, run by Robert Citron, was holding paper from mostly government agencies and even UST’s. Out of the nearly $20 billion in the fund close to its demise, $16.7 billion was UST’s, agency fixed rate bonds, agency floating rate bonds, CD’s and commercial paper. The problem was the combination of the floating rate FNMA’s and that the fund was increasingly leveraged as Citron’s bets were further imperiled.

Throughout the early 1990’s, Orange County’s fund was handsomely beating every benchmark. So much so that municipalities throughout the county were beating down Citron’s door in order to invest in his magic; some cities, such as Irvine, even borrowed through bond offerings just to make available cash to put in. S&P, as the bankruptcy transcript tells, even conditioned its highest investment rating on Irvine’s bonds such that they were placed in Citron’s “care.”

The manner of the outperformance was as it usually is in modern wholesale finance; available and easy leverage of all kinds and all forms. In this specific instance, Citron was building the fund’s bond portfolio not for general coupon returns but so that they were available for reverse repos. When the interest rate environment was in his favor, the Orange County fund was leveraged less than 2 to 1; when it started turning against, that was when the leverage piled up as almost a gambler’s view of doubling down to “make it back.”

As it turned out, even though Citron’s broker Merrill Lynch had warned him about both the increasing volatility risk of an increasingly homogenous portfolio and that interest rates might rise, Citron continued on his course regardless of the advice (and Merrill kept selling securities to him and funding those positions). Later grand jury proceedings even found evidence that Mr. Citron was using a “mailorder astrologer and a psychic for interest rate predictions.” He was, starting in 1994, quite wrong with those predictions.

Still, the fact that rates had gone up even sharply did not alone produce catastrophe; there were no losses to book based on credit defaults or skipped coupons in any of the underlying. The “inverse floaters” at the center of the controversy were simply designed as a mechanism for FNMA to reduce or hedge its own funding costs in the event of conditions just the kind produced by the Fed’s rate hikes in 1994.

The inverse floating rate notes integral to Citron’s strategy for leveraged outperformance were agency coupon bonds that reset them regularly by LIBOR. In December 1993, the fund held approximately $100 million inverse FNMA floaters maturing in 1998, offered in reverse repo to Credit Suisse First Boston as collateral on $100 million funding (I haven’t seen anywhere descriptions of any haircuts, so it may just be or have been assumed 1 to 1). That was not the full extent of the leverage, as the bonds were repledged to total something like 3 to 1 leverage in other funded positions. All told, there were about $800 million in FNMA floaters that spearheaded the fall from grace.

The coupon of the floaters varied inversely to the volatility of LIBOR. The coupon rate is set as the initial payment rate minus some LIBOR spread, meaning that any increase in LIBOR reduces the coupon payments. For FNMA, it is funding protection; for Orange County and Citron, the bonds paid typically a much higher initial rate and in some cases might increase (up to a preset ceiling). The lowest possible rate was, conversely, 0%.

Because of this structure, the convexity of the bond is enormous, particularly when compared to the change in value of any fixed rate investment. In January 1993, the coupon on the FNMA 1998’s was 8.25%, but by 1994 the coupon rate was cut all the way to 2.3% and perhaps, via volatility calculations, on its way to zero. That didn’t mean that the bonds would default as they were agency paper, only that the current value of them would fall precipitously with the reset coupons being so far below the “market” interest rate.

If there had been no leverage involved, Citron’s run as something of a “guru” would have ended but at least not in a prison sentence; it would have continued in underperformance but absent loss as at maturity, in every underlying bond, principal would have been returned in full. As it was, given the repos, the current values of the securities pledged as collateral matters more than whether those prices actually mean credit losses or not. The more “sensitive” to changes in prices the larger the adjustments that will be made as volatility rises. For Orange County, the floaters that were pledged in reverse repos meant collateral calls and then eventually collateral seizure when prior demands for additional collateral were not met. Bankruptcy was the only means to stop the seizures (it was alleged), and even then banks viewed it within their rights to liquidate what they could at current (depressed) prices.

Thus the huge losses for Orange County were really produced because the fund could no longer fund itself; once liquidated, the assets were about $1.64 billion less than total liabilities including the nearly 3 to leverage employed near the end. For the overall fund of $20 some billion, even then $1.64 billion isn’t huge except that the underlying “equity” was just $8 billion.

It is not just a tale of woe and a lesson about the nature of leverage, it speaks to the nature of the whole idea of wholesale finance. Banking is no longer about lending and boring loans, it is about leveraged spreads and leveraged capital and leveraged capacity. When leverage is plentiful and in all types, there is great profit on all sides; from those doing the “investing” to those providing the funding and the advice. That is what built the eurodollar system before August 2007, the idea of plentiful leverage not just in repos and funding, but also in capital ratios and regulatory leverage provided by accounting rules (gain-on-sale for one) and math-as-money. The major conduit through which it all flowed was proprietary trading, where banks would mingle all sides of the leverage equations – as “investors” holding securities (in warehousing) and then testing the line of what might count as “hedging” those positions (which so often drew into outright speculation).

With all these avenues for profit available, it was simply accepted (and modeled in ridiculously low volatility) that it would continue forever and ever. And if recession were to result and interrupt the leverage festival, it was assumed the “Greenspan put” would work enough to keep it mild and temporary as was the case in 2001 (stocks may have suffered, but even the credit cycle did not interrupt the mortgage boom and eurodollar “hot money” pushing into every EM with access to the global financial network). It was the fatal flaw in the whole thing, assuming little or no volatility.

Without free flowing leverage on all sides, money dealing profits simply dried up. Banks have tried to make the most of it in the various QE’s and intermittent circumstances, but for the most part the world as it existed before 2008 just cannot be rebuilt. Again, it wasn’t losses so much as math (recalculated, post-crisis, volatility and “capital” efficiency that systemically sapped leverage capacity especially as reinforced by the events of 2011). It was, like Citron’s game, all an illusion based upon “perfect” circumstances that will never be repeated. It might have been possible had a real recovery started after the Great Recession was over, given enough time of a full and robust fundamental rebound, but as I wrote yesterday, that, too, was an illusion predicated on the lie of orthodox economics and the Phillips Curve view of economic potential.

Without leverage there is no money dealing, and without money dealing there will only be increasing volatility (leading to less leverage and so on). Some banks, such as UBS and Wells Fargo, worked that out early on; others, like Deutsche, Credit Suisse and Goldman Sachs, saw the potential rebirth of pre-crisis wholesale in Bernanke’s/Yellen’s fairy tale ending for QE and ZIRP. Like Citron’s psychically-derived interest rate forecasts, it was just a terrible idea and all the more so as leverage conditions have only worsened and worsened.

The difference now is, obviously, that EM debt and US corporate junk (including leveraged loans) are the center of the current and gathering liquidity storm. We might likely never know exactly what those banks have been doing, but through examples like AIG and Orange County we can see the destructive capacity and potential of volatility no matter if ever the credit cycle truly blasts apart this time – it is never losses that do it; it is illiquidity and lack of margin of safety. In the case of these particular banks though, there is a ready feedback that plays directly into quickening the process – they are both leveraged in their holdings and activities but also suppliers into those “dollar” conduits. It’s as if Orange County were not just reverse repo counterparty borrowing cash for its own portfolios but also then providing a good part of that cash or financial resources to the next guy. That is really what scared the Fed and the Treasury in 2008 into TBTF; which, of course, has only gotten worse over the intervening years.

I think that explains somewhat the trajectory of the eurodollar decay past the panic; that initially leverage restraint (including and especially collateral shortage) as compared to pre-crisis meant the downward baseline to begin with. Since 2013, increased volatility has only quickened that pace in the same manner as we have seen in all sorts of prior episodes. Again, some firms instead doubled down and are being undressed especially recently, which will only make it all the more difficult further on.

Restoring the eurodollar system as it was just wasn’t possible. That is why the collapse in oil and commodities is especially relevant as a signal about leverage and hidden liquidity capacity that otherwise goes unnoticed. The “thing” that made the eurodollar appear to work and work so well (at least as it was rapidly expanding to ridiculous proportions, in both quantitative and qualitative terms) were these artificial channels of leverage flow and capacity; the same kinds of ideas and “products” that made Robert Citron a hero are no different than what eurodollar banks had been up to all throughout their structures before the final reckoning in 2008. That might be the most important point about unwieldy and unconstrained leverage, that there is always an endpoint and then the cleanup.

Unfortunately, we remain stuck in the cleanup phase so long as economists and their ability to direct policy continue to suggest the Great Recession was anything other than systemic revelation along these lines; a permanent rift between what was and what can be. It is and was never about oil; only now that oil projects volatility into the dying days of eurodollar leverage.

via Zero Hedge http://ift.tt/1KemVSO Tyler Durden

UBS’ chief global credit strategist Matthew Mish has been on a roll lately. After first revealing “how the investment grade dominos will fall” in mid January (an analysis which was followed by another leg lower in IG bond prices), and then two weeks later instead of focusing on products, Mish analyzed sectors and explained “What’s The Next ‘Energy’ Sector In Credit Markets“, today he tries to put it all together and as he himself puts it, “the inquiries we have received are increasingly from investors across all asset classes and regions, and lines of questioning evolve in many directions. But the genesis of the debate comes down to three questions: first, why is the sell-off happening; second, when does it end; and third, what can slow or speed up the process?“

We are certain that these are the questions asked by every single credit investor, so without further ado, here are Mish’s answers.

What is the clearing level for $1tn in stressed credit?

First, why are HY credit markets wilting? For non-credit investors the simple analogy is a balloon. The air going into the balloon was essentially inflows into credit funds. Our prior work suggests inflows have been driven by three factors: quantitative easing, credit losses and past performance. From 2010-2014 the environment was extraordinary; at its peak, the Fed was buying roughly $1tn annually in fixed income securities, crowding investors into corporate credit; defaults were low as capital markets were accessible and earnings were expanding, and prior HY returns were unprecedented. The money poured in, and credit funds put that cash to work. However, that mirage has faded; the Fed is tightening policy, defaults are rising due to commodity price declines and excessive leverage, and past performance has been negative. Outflows are triggering forced selling across real money and hedge funds.

However, the problem is not simply technical. The root cause is fundamental in nature. During that period of euphoria, credit portfolio managers were essentially forced to buy the market. The inflows were too robust. In that environment, fundamental credit analysis became secondary. Clients had yield targets to achieve, and with central banks pushing interest rates towards zero those that bought high grade credit in prior decades bought high yield; those who purchased high yield previously bought triple Cs. Unfortunately, investors were being compensated in a fairly linear fashion across IG, HY and CCCs. Later in this period a few hundred basis points was the yield differential between IG versus HY and HY versus CCCs (Figure 1). But realized defaults increase at an exponential rate when one moves from IG (Aa, A, Baa) to HY (Ba, B, Caa, Figure 2).

* * *

Second, when does the credit sell-off end? Unfortunately, we believe the answer to this question is complicated – complicated in that traditional models may not provide a perfect guide. Models always work better in than out-ofsample, but model risks increase when there is a structural or paradigm shift. In the current environment, there are at least two possibilities. First, the level of dispersion in US high yield between commodity and non-commodity industries is quite extreme by historical standards. Second, the lower quality segment of the high yield (and all leveraged credit markets) is undergoing a structural shift in that the proverbial balloon is no longer inflating, but deflating. Capital is wounded and illiquidity is complicating an exit as the saying goes ‘fool me once, shame on you; fool me twice, shame on me’. A new marginal buyer is needed. And the overwhelming majority of potential new buyers we speak with are fundamentally pricing lower quality risk through the cycle (or restructuring process) and under the assumption this debt is illiquid.

In our 2016 US high yield outlook we posited there is one central question that will dictate the outlook for high yield: will credit markets be able to absorb refinancing needs of almost $1tn stressed and distressed credit. And we continue to believe this should be THE debate in the market. In our view, if the lower quality rung of the market cannot stabilize the balance of risks is for contagion to spread further. So what is the clearing level for what we believe is upwards of $750 – 1tn in stressed credit? First, investors will require compensation for loss risks; cohorts of triple Cs typically experience 5yr cumulative default rates of 55 – 65% near the end of the cycle, implying half of the universe defaults before the end of year 5 and no longer pay coupons. Assuming recovery rates of 35% an investor should require roughly 12% yield to compensate for loss risks alone. What about mark-to-market and liquidity risks? While triple C bonds are trading on average in the low $60s, investors will likely need to stomach a further decline later in the cycle. Historically, triple C prices bottomed in the $40 – 50 range, so potential MTM declines could be significant (Figure 3).

Further, although our prior analysis assumes hold-to-maturity, investors will need to be compensated for the fact that illiquidity may prevent them from selling when needed. Bottom line, our conversations with investors suggest yields in the 20 – 25% context could be attractive enough to draw in marginal capital – although several investors noted that is reasonable for triple C risk excluding commodities. In short, we’re not there yet.

* * *

Third, what reverses or speeds up the process? We would reiterate the primary drivers of fund flows are credit fundamentals and central bank policy. Higher commodity prices would ease, albeit not remove, default concerns. Better-than-expected earnings could also help sustain excess leverage on corporate balance sheets. And aggressive monetary policy – that which could conceivably push investors back into lower rated credit – could extend the cycle. And the reverse is also true in both cases.

via Zero Hedge http://ift.tt/1SKKRQM Tyler Durden

He hope we are not the only ones who find it oddly confusing that moments after the WSJ reported that the UAE, supposedly speaking on behalf of the Saudis, said OPEC is “ready to cooperate on a production cut”, the very same WSJ writes that the “story may be bogus.”

From the WSJ:

Look, the OPEC thing may turn out to be bogus. Lord knows we’ve heard that line too many times to count, and oil’s at $26/barrel. Even if it is bogus, though, the episode illustrates one thing: there is still a sizable contingent of operators out there just waiting for an excuse to pounce on equities.

 

In other words, we still are not near capitulation.

Yes, it may very well be bogus, and no, it has nothing to do with operators pouncing, and everything to do with the latest violent short squeeze, one which was accelerated by frontrunning algos which swept away all the offers for minutes, sending the Nasdaq briefly into the green.

 

The WSJ also adds the following walkback:

It’s not that I think somebody planted a rumor, mind you. I’m not saying the news is wrong or that it’s being misreported. I just think that we hear this kind of talk out of OPEC a lot.

 

“We’ve heard this chatter enough times over the past month so take it with a grain of salt,” said Lindsey Group’s Peter Boockvar.

 

They have a notorious history of “agreeing” on cuts and quotas, and then going behind each other’s back and doing whatever is best for individual states.

 

It’s best to wait until OPEC actually does something on this front, and then to wait and see if they honor it. In other words, we’re a long way away from anything really happening here.

We expect the Saudis to chime in momentarily and explain how everyone got punked by the latest “OPEC headline” for the 6th time.

via Zero Hedge http://ift.tt/1mvjaN2 Tyler Durden

The last time front-month crude oil traded at these levels ($26.12) was May 2003 as WTI Crude has collapsed over 22% in the last 2 weeks – the biggest drop since Lehman in 2008. Goldman’s “teens” are getting closer…

 

 

With credit risk already at record highs – and getting higher – we suspect the moment of Chapter 7 truth is getting closer.

via Zero Hedge http://ift.tt/1SKHs4q Tyler Durden

“Forget it.”

That’s Turkish ambassador to the EU Selim Yenel’s message to Europe in response to a Dutch plan that would resettle 250,000 refugees per year directly from Turkey if Ankara can manage to close off the Aegean sea route to Greece.

Turkey is of course a key chokepoint for migrants fleeing Syria and the situation is expected to worsen materially going forward as Hezbollah and Russia advance on Aleppo, the country’s second-largest city where the opposition is making what amounts to a last stand against Moscow’s air force and Hassan Nasrallah’s advancing army. This was the scene at the border last week:

“If Turkey is not engaged, not committed and doesn’t start to deliver … it will be very difficult to manage the situation,” Dimitris Avramopoulos, the EU commissioner in charge of migration said. “If they really want, they can do the job on the ground.”

Not so, says Yenel.

“It’s unacceptable and it’s not feasible,” he said, deriding the Dutch plan. Effectively, the EU wants Turkey to let in the all of the refugees fleeing Aleppo ahead of what will likely be a direct assault on the city in the coming weeks, but as The Guardian notes, Brussels is simultaneously “demanding that Ankara close the western and northern routes to Europe.”

“We’re surprised that the Europeans should say we should open the borders to Syrians from Aleppo when we’ve been doing that for five years,” Yenel said. “It is all unfolding, another tsunami. How are we going to cope?” he asked, reflecting the exasperation Turks are experiencing after sheltering some 3 million Syrians, triple the number of total refugees German took in last year.

“Avramopoulos unveiled new plans to force Turkey and Greece to take asylum seekers back from the rest of Europe,” The Guardian goes on to write. “But the scheme would not apply to Syrians, who are virtually assured of successful asylum claims in the EU, and perhaps also Iraqis and Afghans.”

Substantially all of those entering Greece via the Aegean Sea route are either Syrian, Afghan, or Iraqi. Athens has been threatened with expulsion from Schengen if it can’t bring its procedures for coping with the migrant flows in line with European “norms” – whatever that means.

All of this comes as leaked documents reveal Erdogan effectively blackmailed the EU last year by promising to “send refugees in buses” into Europe if Brussels didn’t hand over billions and as NATO sends ships to the Aegean to deter people smugglers from moving refugees from Turkey to the shores of Greece.

Obviously, the NATO mission doesn’t exactly sound like it’s compatible with the compassionate, open-door policy Europe is keen on projecting, but as Jens Stoltenberg will tell you, it’s not about “stopping or pushing back refugee boats,” it’s about obtaining “critical information and surveillance to help counter human trafficking.”

“The decision marks the security alliance’s first intervention in Europe’s migrant crisis,” BBC writes. US defence secretary Ashton Carter says it’s critical that NATO target the “criminal syndicate that is exploiting these poor people.”

Of course if Ash Carter was really concerned about those “poor people,” perhaps he should consider not bombing the countries from which they are fleeing. Say what you will about Saddam, Assad, and the Taliban, but Iraqis, Syrians, and Afghans weren’t running for their lives to Western Europe by the millions prior to American interventions in their countries’ affairs.  

via Zero Hedge http://ift.tt/1TeZ8oi Tyler Durden

Submitted by Arthur Berman via OilPrice.com,

An OPEC production cut is unlikely until U.S. production declines by about another million barrels per day (mmbpd). OPEC won’t cut because it would accomplish nothing beyond a short-term increase in price. Carefully placed comments by OPEC and Russian oil ministers about the possibility of production cuts achieve almost the same price increase as an actual cut.

Bad News About The Oil Over-Supply from IEA and EIA

The International Energy Agency (IEA) and U.S. Energy Information Administration (EIA) shook the markets yesterday with news that the world’s over-supply of oil has gotten worse rather than better in recent months. IEA data shows that the global liquids over-supply increased in the 4th quarter of 2015 to 2.24 million barrels per day (mmbpd) from 1.62 mmbpd in the 3rd quarter (Figure 1).

Figure 1. IEA world liquids market balance (supply minus demand). Source: IEA and Labyrinth Consulting Services, Inc.

(click image to enlarge)

Supply increased 70,000 bpd and demand decreased 550,000 bpd for a net increase in over-supply of 620,000 bpd. The sharp decline in demand is perhaps the most troubling aspect of IEA’s report. The agency forecasts tepid demand growth of only 1.17 mmbpd in 2016 compared with 1.61 mmbpd in 2015. The weak global economy is the culprit.

EIA’s monthly data showed the same trend. Over-supply in January increased to 2.01 mmbpd from 1.35 mmbpd in December, a 650,000 bpd net change (Figure 2). Supply fell by 370,000 bpd but consumption dropped by a stunning 1.02 mmbpd.

Figure 2. EIA world liquids market balance (supply minus consumption). Source: EIA and Labyrinth Consulting Services, Inc.

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The January 2016 Oil Price Head-Fake

Recent comments about a possible OPEC cut were largely responsible for the late January “head-fake” increase in oil prices (Figure 3). WTI futures increased 27 percent from $26.55 to $33.62 per barrel between January 20 and 29. As hopes for a production cut faded, prices fell 8 percent last week and have fallen below $28.00 as reality regains control of market expectations.

Figure 3. NYMEX WTI futures prices, October 2015-February 2016. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.

(Click image to enlarge)

There were, of course, other factors that boosted oil prices for that brief period. These included the usual questionably substantial suspects: a lower-than-expected build in U.S. crude oil inventories, sharp declines in U.S. land rig counts, and a weaker U.S. dollar on expectation that the Federal Reserve Board may slow planned interest-rate increases. What happens in the U.S. continues to drive oil markets.

Oil markets reflect a psychological conflict among investors between reality and hope. The reality is that the world is over-supplied with oil. The hope is that oil prices will increase without resolving that fundamental problem.

An OPEC production cut fulfills that hope. Deus ex machina.

Blame It On OPEC

Many believe that OPEC caused the global oil-price collapse by failing to rescue prices in its role as swing producer. This narrative also contends that OPEC and Saudi Arabia are producing at maximum capacity to destroy U.S. shale producers. The data do not support this narrative.

January 2016 Saudi crude oil production (9.95 mmbpd) increased slightly from December (9.90 mmbpd) but has declined since the August 2015 peak of 10.25 mmbpd (Figure 4).

Figure 4. Saudi Arabia crude oil production and change in production since January 2008. Source: EIA and Labyrinth Consulting Services, Inc.

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Total OPEC crude oil production in January production was 31.61 mmbpd, almost half-a-million barrels per day less than in July (32.09 mmbpd) and only somewhat more than its 4-year average of 31.28 mmbpd.

Figure 5. Total OPEC crude oil production. Source: EIA and Labyrinth Consulting Services, Inc.

(click image to enlarge)

OPEC crude oil production since the Financial Crisis in 2008 has been remarkably balanced (Figure 6). Overall, increases by Iraq (+2.35 mmbpd) and Saudi Arabia (+0.6 mmbpd) have largely offset decreases by Iran (-1.0 mmpbd due to sanctions) and Libya (-1.4 mmbpd due to civil war). Renewed export by Iran with the lifting of sanctions is part of what pulls the oil market back to reality after its flights of sentiment-based hope.

Figure 6. OPEC crude oil production compared to January 2008 production levels (minus Indonesia). Source: EIA and Labyrinth Consulting Services, Inc.

(Click image to enlarge)

Although it appears unlikely that Libya will resolve its civil unrest any time soon, renewed Libyan production and export is a sobering factor to ponder.

OPEC and Saudi Arabia increased production aggressively from March through August of 2015. Since then, however, production has declined to near average levels for 2012-2016.

The United States and Non-OPEC Are The Problem

OPEC did not cause the oil over-supply in early 2014. Over-production by the United States and other non-OPEC countries caused the problem. This is still the case.

The U.S. is responsible for more than 70 percent of the increase in non-OPEC liquids production since January 2014 (Figure 7). Brazil and Canada along with China and Russia account for the rest.

Figure 7. Non-OPEC liquids production compared to January 2014 production levels. Source: EIA and Labyrinth Consulting Services, Inc.

(Click image to enlarge)

Until the structure of non-OPEC production decreases, there is little that OPEC can do to remedy low prices. Cuts by OPEC might temporarily increase prices but this would lead to more over-production outside of OPEC that would further collapse world oil prices later on.

Why U.S. Production Has Not Declined More

U.S. crude oil production has only declined by approximately 570,000 bpd from its peak of 9.69 mmbpd in April 2014 to 9.13 mmbpd in January 2016–about 60,000 bpd each month (Figure 8).

Figure 8. U.S. crude oil production and forecast. Source: EIA and Labyrinth Consulting Services, Inc.

(Click image to enlarge)

EIA forecasts that production will fall another 820,000 bpd (about 100 kbpd each month) to 8.31 mmbpd by September 2016 before increasing again. The forecast provides hope that the oil market may balance later in 2016 or in 2017 but history to date suggests that it is probably optimistic.

Tight oil production in the U.S. has not declined nearly as much as many anticipated based on falling rig counts. Most explanations invoke increases in drilling and completion efficiency but I believe the truth lies in the continued availability of external capital to fund drilling of an ever-increasing number of producing wells until quite recently.

In the Bakken, Eagle Ford and Permian basin plays, the number of producing wells has declined or flattened in the last reporting months of October or November 2015. The plays are different and so are the patterns for production decline. Nevertheless, the decrease in new producing wells suggests that either capital is less available or that companies are choosing to drill and complete fewer wells.

Reporting in the Bakken is better than in the other plays. Bakken production only declined 51,000 bpd between the December 2014 and November 2015, the last reported data from the North Dakota Department of Mineral Resources (Figure 9).

Figure 9. Bakken production and number of producing wells. Source: North Dakota Dept. of Mineral Resources and Labyrinth Consulting Services, Inc.

(Click image to enlarge)

Over the same period, the horizontal rig count fell by 111, from 173 to 62 rigs. Yet, the number of producing wells increased by 943, from 12,134 to 13,077 (the number of wells waiting on completion (WOC) increased by 219 from 750 to 969).

As long as more wells were added each month, production continued to increase. The number of producing wells only began to decline in October 2015. Each completed well cost approximately $8 million so capital spending did not decrease until then despite fairy tales about ever-increasing efficiency.

The resilience of tight oil production in the Bakken, therefore, reflected the continued availability of external capital to fund more drilling and completion. The impact of reduced capital is apparently a recent phenomenon in the Bakken.

The Eagle Ford and Permian basin plays show similar patterns of flattening rates of well completions in recent months. Eagle Ford production has declined 183,000 bpd since March 2015 while Permian basin production may just be peaking.

It is too early to draw concrete conclusions from the tight oil play data presented here but, in a way, that is the point. Production has only begun to decline because external capital was available until late 2015 despite low oil prices. If companies are forced to rely increasingly on cash flow for new drilling then, U.S. production should decline sharply. If, on the other hand, the recent $2 billion in equity raised by Permian basin operators becomes more the norm in 2016 then, production declines will be more modest.

The U.S. Crude Oil Storage Problem

There is little chance that oil prices will increase beyond the head-fakes and sentiment-driven price cycles of the past year until U.S. crude oil storage begins to decrease. Oil stocks are currently 154 million barrels more than the 5-year average and 131 million barrels more than the 5-year maximum (Figure 10).

Figure 10. U.S. crude oil stocks. Source: EIA and Labyrinth Consulting Services, Inc.

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The Cushing, Oklahoma pricing hub and nearby Gulf Coast storage facilities make up almost 70 percent of U.S. working storage capacity. These crucial storage areas are currently at 85 percent of capacity (Figure 11).

Figure 11. Cushing and Gulf Coast crude oil storage. Source: EIA and Labyrinth Consulting Services, Inc.

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Although the correlation between Gulf Coast and Cushing storage utilization, and WTI oil price is not perfect, it is as good as any single price indicator (Figure 12).

Figure 12. Cushing and Gulf Coast Storage Capacity and WTI oil price. Source: EIA and Labyrinth Consulting Services, Inc.

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Despite considerable hype about 3 billion barrels of oil in storage around the world, Matt Mushalik has shown that OECD storage is only about 300 million barrels above the 5-year average based on IEA data. More than half of those 300 million barrels are in U.S. storage so, again, the U.S. drives the world oil market.

As long as storage volumes remain above 80 percent of capacity, oil prices will be depressed. Until U.S. oil production declines substantially, storage will remain near capacity. No OPEC production cut will be able to offset this powerful market factor for long.

Saudi Arabia Is Not Going Broke

Euan Mearns has presented a compelling case that OPEC made a gigantic blunder by letting oil prices fall below $40 per barrel for the sake of market share. I believe, however, that there is more at stake than market share.

The capital providers who enable high-cost oil projects are the market-share target of Saudi Arabia’s gambit. Oil sands are the primary focus because these have gigantic reserves. Deep-water and tight oil are secondary objectives because their reserves are smaller and shorter lived.

OPEC’s larger objective is to postpone the end of the Oil Age as far into the future as possible. This is accomplished by an extended period of low oil prices that puts renewable energy at a price disadvantage to oil and gas, and slows the climate change-based flight from fossil energy. It is further achieved by stimulating the global economy through low energy prices that may in turn increase oil demand.

The commercial present and future for the Saudis and their Gulf State comrades depend on oil. They take the long view that near-term losses are justified by longer-term gains.

I am not defending their stratagem but merely trying to understand it.

The press has been focused on the imminent financial demise of Saudi Arabia as a result of their production and price strategy. Although the strain on the Kingdom is considerable, I do not believe that these criticisms are completely realistic.

Saudi Arabia’s year-end 2015 foreign reserve accounts totaled $636 billion, an amount almost equal to its cash reserves in 2012 when Brent prices averaged $112 per barrel (Figure 13).

Figure 13. Saudi Arabia international reserve assets. Source: Saudi Arabia Monetary Agency and Labyrinth Consulting Services, Inc.

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Its estimated cash reserves through 2017 of $443 billion are still above or nearly equal to levels from 2007 through 2010 and exceed the current accounts of all countries except Switzerland shown in Figure 14 (China ($3513 billion) and Japan ($1233 billion), not shown in the figure, are higher than Saudi Arabia).

Figure 14. International reserves and foreign currency liquidity. Source: International Monetary Fund and Labyrinth Consulting Services, Inc.

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The Way Forward

Oil prices will not increase or stop falling until the current 2 mmbpd over-supply is consistently reduced for a period of many months. I do not expect a formal OPEC production cut until that happens. That means that U.S. production and storage inventories must fall. That may happen in 2016 if EIA’s forecast shown in Figure 8 is close to correct.

There are some considerable wild cards that might keep the world mired in over-supply and low oil prices beyond 2016. Renewed supply from Iran and Libya are the most obvious candidates. Continued supply of external capital to U.S. tight oil production is a second important wild card. The weak global economy and associated oil demand below the forecasted range of 1.2 mmbpd of annual growth represent other important uncertainties.

Without a meaningful forward reduction of U.S. oil production of around 1 mmbpd, an OPEC cut would only have a limited, short-term effect on prices. The focus going forward must be on the source of the problem. That is the United States and not OPEC.

via Zero Hedge http://ift.tt/1TeZ87M Tyler Durden