Shale Oil: Another Layer of US Power

Summary There’s scarcely a reason to point out how geopolitically important energy is. Energy, particularly oil, is a source of geopolitical power. Every country needs it, but only some countries have the resources to procure it themselves. Some countries have enough of it that they can profit from its export, and others have so much that they rely on it almost exclusively to fuel their economies. Saudi Arabia and Russia are two such countries. They spend a lot of money on social services, and they can afford to do so as long as oil revenue keeps flowing in. In times of prosperity, they can, through OPEC, bully other countries into doing their bidding and even dictate the direction of markets. But when oil prices are low, as they are now, they simply don’t have as much money to pacify their populations or exert influence abroad. Pressure on their governments builds. Simple supply and demand helps to explain why prices are low. When prices bottomed out a few years ago, most oil producers, including Saudi Arabia and Russia, were expected to cut production to normalize prices. Instead, they kept production high to increase their market share, thinking (incorrectly) that they would capitalize when prices rebounded. But perhaps a more important reason supply is so high, despite recent efforts by OPEC and Russia to cut production, is that the United States has exceeded expectations on how much oil it could bring to market. With the continued use of hydraulic fracturing and other related technologies, the United States is now believed to have more recoverable oil reserves than any other country in the world, and it is reaping the benefits of its newfound status. Geopolitical Futures doesn’t forecast commodity prices, so we make no attempt to do so here. But the following report will outline a trend that has emerged over the past several years, one that will maintain downward pressure on prices and thus alter the global geopolitical landscape: affordable shale oil drilling in the United States. Introduction Saudi Arabia and Russia are geopolitically important countries. What happens to Saudi Arabia affects the regional balance of the Middle East, and what happens to Russia affects Europe, East Asia and beyond. Their importance is due in no small part to their vast energy reserves, which are their primary source of government revenue. They create a high standard of living to which their populations are accustomed, pay state employees and give the government gravity on the global stage. Since so much depends on energy, oil prices are more than just financially important. In Saudi Arabia, oil revenue has enabled the government to create patronage networks public and private alike. It has also enabled Riyadh to be the de facto leader of the Middle East. Without oil revenue, the government could not fund its Sunni Arab proxy groups in the battle for regional control, finance the war in Yemen or even maintain social stability. The story is much the same in Russia. Financial reserves have dwindled. Russia is considering cutting defense spending in the coming years (something it rarely does) and is struggling to finance state pensions. Now that its Reserve Fund is being depleted, Moscow will have to switch over to its National Wealth Fund, which has a little over $70 billion but which is, for various reasons, much more difficult to tap into. OPEC, which Saudi Arabia essentially leads, has so much recoverable oil that it has been able to more or less control oil prices by adjusting production levels, sometimes in concert with Russia. But that is no longer the case. By some estimates, the United States has surpassed Saudi Arabia in recoverable oil reserves as advancements in hydraulic fracturing and horizontal drilling have enabled producers to access areas previously not thought posible.   A Deep History Hydraulic fracturing, more commonly referred to as fracking, is a process by which oil deposits found in shale rock formations are extracted. Shale oil, also called tight oil, is enmeshed in shale rock, which is located thousands of feet beneath the Earth’s surface and is generally less permeable than other rock types, making deposits more difficult to access – difficult, but not impossible. Once producers drill down far enough to reach the shale deposits, they inject a solution made mostly of water (hence hydraulic) at high speeds to break apart the rock (hence fracturing), creating fissures through which oil can flow. Included in the solution are certain chemicals that assist in the extraction process and a kind of sand that keeps the fissures open once the fracturing is complete. (The process can also be used for natural gas, and its effect on natural gas prices is similar, but for the purposes of this report we will focus on oil.) Though fracking has become more of a household term in recent years, it’s hardly a new technology. It dates back to the mid-19th century, when a man named Col. Edward Roberts devised a way to lower an explosive device through a pipe in an oil well that had already been drilled. Some of the wells in which this technique was used were thereafter 1,000 percent more productive (that’s not a typo). Roberts’ explosive device was eventually replaced by another explosive, nitroglycerine. Even though nitroglycerine was used as late as the 1990s, companies began to experiment with using more inert materials as early as the 1930s. In 1949, Halliburton became the first company to fracture a well with wáter.   (click to enlarge)   It was also in the 1990s that producers began to combine fracking with a separate process known as horizontal drilling, which allows a well to be drilled vertically, then, when the drill hits the desired sedimentary layer, it is turned to drill parallel to the layer. In 1991, a well was successfully horizontally drilled and fractured for the first time, and in 1998 the first profitable horizontally fractured well was completed. The supply of U.S. shale gas, and later shale oil, has increased ever since. The United States has benefited from the shale revolution more than any other country. Not only does it have extensive shale formations, but most of its wells are located entirely within its territory, so producers don’t have to compete for jurisdiction or share their profits. (Brazil and Paraguay, for example, have overlapping oil interests that have sparked debate over ownership and sovereignty.) Still, the shale revolution is not exclusively American. Canada has some shale plays in operation, and from 2020 to 2040, Russia and Argentina are expected to tap into their shale oil reserves.   (click to enlarge)   (click to enlarge)   In the meantime, the United States is likely to become a net energy exporter in 2017, according to some estimates from the U.S. Energy Information Administration. This is no small development; energy independence has been a strategic objective of Washington’s for some time. Shale oil has given it the means to achieve its goal.   Peculiar Economics Energy independence, however, depends on the peculiar economics of the shale industry. Drilling for shale oil costs less per project than, say, deep-water drilling. There are two general types of costs: capital costs and operating costs. Capital costs are the investment required to drill and complete the well and build the facilities onsite to manage it. Operating costs are the ongoing costs after the well has been drilled. These are measured either in dollar per thousand cubic feet or in dollar per barrel. The total well cost – the entire amount of investment required to set up a new well, including land, permits, drilling and completion – varies by location but runs consistently in the low millions of dollars. A report by the EIA estimated that the average completion cost per well is around $5 million to $9 million, depending on the location of the deposits. Some companies, however, are able to drill and complete wells much more cheaply; Chesapeake Energy was able to complete wells in the Mississippi Lime in northern Oklahoma for $2.8 million per well in 2015. According to the EIA, drilling accounts for 30-40 percent of all capital costs. Completion costs, which include the actual fracking process, account for 55-70 percent. Facilities costs, which include erecting onsite buildings as well as road construction to transport oil away from the site, account for 7-8 percent of well costs. The same EIA report analyzed well completion costs across a number of companies and locations and determined that average costs, in terms of dollar per barrel of oil equivalent – an approximation of energy released by burning one barrel of oil – declined 7-22 percent from 2014 to 2015 and 25-30 percent from 2012 to 2015. Importantly, some wells are drilled but not completed when funds dry up or when oil prices dictate that the well is no longer economically viable for the time being. In this scenario, the oil driller has effectively used the low permeability of the sedimentary layer to store oil until it’s ready to frack the deposits. Once the oil starts to flow, operating costs tend to vary. Gathering, processing and transporting can range from $2.25 to $5 per barrel for oil or higher, depending on how far it needs to be transported. Water disposal can range from $1 to $8 per barrel. Other general and administrative expenses range from $1 to $4 per barrel. New drilling techniques can expedite the completion process and thus drive costs down further. Several years ago, a new well might have taken 3-4 weeks to drill. Now it can take as few as 7-10 days. Not only does this cut down on the overall costs of producing a barrel of oil, it also gives producers flexibility to respond to higher prices and to expand their operations. In fact, now that so many shale plays are known to produce, exploration is less risky, so companies are more willing to operate there. Since capital and operating costs are so varied, there is no single break-even price for shale oil. But if we average wells by location, we can get a sense of which prices generate profit and which do not.   (click to enlarge)   Wood Mackenzie, an energy research and consulting firm, estimates that 60 percent of all crude reserves that are economically viable at $60 per barrel or less are located in U.S. shale reserves. This figure is different for every well, of course – some are unprofitable even at $46.88 – but it is notably lower than the break-even price just a few years ago, around $80-$100 per barrel.   (click to enlarge)   In fact, break-even prices are down at most shale locations. This is partly because of lower costs and partly because of higher yield enabled by newer technologies. And while total rig count has declined significantly, production has remained stable.   (click to enlarge)   What complicates things is that technological innovation raised some absolute costs of drilling even as it yielded more oil from wells. Consider fracking sand. Producers eventually figured out that if they injected the wells with a hydraulic solution that contained more sand than the previous solutions did, their wells yielded more oil. The solution was then adopted throughout the industry. This increased the demand and therefore the price for sand. The price of labor has risen too. When oil prices declined from mid-2014 to early 2016, many shale sites were left uncompleted and their crews laid off. When prices rebounded to the $40-$50 range, as many as 400,000 workers returned to complete the wells. But since the demand for labor was widespread, companies were forced to offer more competitive wages to attract skilled personnel back to their sites. And then there are the vendors who provide goods to drilling companies. When prices bottomed out in 2015, vendors sold their wares at low margins – the only way companies could afford them. If the price of oil rises in the next 1-3 years, vendors will raise their prices in kind, knowing that their customers can foot the bill. These short-term gains, however, will be modest at best. Some analysts believe the inflation rate of input costs could reach 10-20 percent. Drilling companies also have to pay for the land on which they operate. Some of the richer shale territories such as the Permian Basin charge a high price because they are in such high demand. The Trump administration has pledged to make it easier for companies to drill for oil, and if that is the case, it’s reasonable to assume there may be more land available for shale exploration in the future. Costly though these factors may be, they are ultimately short-term risks for energy companies. The industry would continue to innovate even if, all things equal, oil prices increased. In fact, wells have been pretty productive independently of price trends. Higher prices will keep the drillers drilling until oversupply drives prices down again. No Reason Not To And therein lie the geopolitical consequences of the shale revolution. In Russia and Saudi Arabia, it’s still much cheaper to drill for conventional oil than for shale oil. Each can produce a barrel for about $10-$15. With oil priced at $50, the government in Riyadh will make more money off a single barrel than a shale oil driller will for the foreseeable future. This explains why, even when prices fell so dramatically from 2014 to 2016, OPEC could afford to maintain high levels of production. Its members (and Russia) thought that if they kept prices low and captured market share, they could outlast U.S. shale producers who could, in theory, no longer afford to operate. It was a sensible strategy at the time. The problem is it didn’t work. OPEC didn’t expect shale oil drillers to lower their costs as much as they did, nor did it anticipate how quickly they could complete unfinished projects. A shale oil driller in the United States, moreover, doesn’t need to be more profitable than Saudi Arabia to drill new wells; the driller just needs to fetch a sufficient return on invested capital. When prices are low, drillers simply forgo exploration and concentrate on the completed wells that produce enough oil to justify their existence.   (click to enlarge)   The number of drilled but incomplete wells has grown over the past few months.   When oil prices reach the upper end of the $40-$60 per barrel range, these wells will begin to produce, bringing even more oil onto the market. This is a foreboding prospect for countries like Saudi Arabia and Russia that depend so heavily on hydrocarbons. Sure, they can produce oil more cheaply than their U.S. counterparts, but rampant government expenditures make their fiscal break-even point – the price at which their budget is not running a deficit – much higher. The International Monetary Fund estimates that oil will need to cost $78-$80 per barrel in the next two years for the government in Riyadh to break even on its fiscal budget. Russia’s break-even point is lower at $68 per barrel, but it’s still higher than current prices. Short of that, the two countries will have to run budget deficits – which deplete their fiscal reserves – to continue the social spending programs that earn them the support of their people.   (click to enlarge)   For Russia, that means cutting state pension plans on which more than 90 percent of its citizens depend for their retirement. For Saudi Arabia, that means cutting benefits for state employees who have grown accustomed to a comfortable lifestyle. It is in both cases a recipe for social discontent – something both governments are keenly aware of. U.S. shale producers, meanwhile, are now profitable at levels below the fiscal break-even points of Russia and Saudi Arabia. They have no reason not to drill more. So even if prices climb high enough for Riyadh and Moscow to break even, it is unlikely that they will stay there for long, since high prices encourage shale producers to drill more. In light of this dynamic, the United States is uniquely positioned to be energy independent – or at least less dependent on oil imports – something it has wanted to be for decades. Contemporary U.S. power is built on two layers: its military might and its relative independence on exports at a time of stagnant global demand. Energy independence would give it a third layer, making it only more powerful. The agility of its oil sector to respond to market forces is simply more than Russia and Saudi Arabia can bring to bear. Conclusion OPEC’s strategy – gaining market share to put shale drillers out of business – has failed. Shale oil producers have proved capable of reducing their per barrel costs and competing on the global market at price points that would have been unimaginable just a few years ago. If OPEC (or Russia) raised prices by cutting production, they would make shale producers only more profitable. If they kept prices low by raising production, they would only spur more innovation by shale oil producers. Geopolitics is rarely a zero-sum game. But in the case of shale oil, what’s good for the U.S. is bad for its rivals.

Fed sides with reflationists as bond battle resumes

US central bank sticks to view that inflation will quicken as bond market scepticism intensifies

by: John Authers

The oldest conflict in world markets has resumed. Politics has generated excitement for the last 12 months or so, as has the notion that reflation is at last here after years of post-crisis deflationary malaise.

But this week, the outline of an old conflict has grown clear once more. The bond market is again battling central banks. And deflationists — who believe that the western world is stuck in low growth and low or negative inflation — have resumed with vigour a battle they appeared to have lost to the reflationists, who believe that the world is at last emerging from the morass.

It has not been a long respite; six months ago, the market abandoned its hostilities with the Federal Reserve after persistently betting that the central bank would not have the nerve to follow through on its own forecasts that it would raise rates — and generally winning.

Donald Trump managed to bring harmony where there had been discord, bringing everyone to believe that reflation was at hand. As the year started, the Fed predicted three rate rises this year and the market — as measured by Fed Funds futures — broadly agreed. Bond yields steadily rose to take account of the likely inflation and rate rises to come.

But that accord has now broken down. The Fed’s monetary policy-setting committee met on Wednesday, raised rates to 1.25 per cent as expected, and left its projections for the future path of rates intact. Infamously published in the form of a dot plot, they show that Fed governors are guiding the market towards one more rate rise this year about as directly as they possibly could. That is what half of them expect, while a quarter think they will raise twice, and a quarter think they will stand pat.

But despite this very clear steer, the market is positioned for something else. The Fed Funds futures market suggests another 2017 rate rise is less than a 50-50 shot, while falling bond yields imply radical dissent. At face value, two-year yields, which are now above the Fed’s target rate, imply that we are unlikely to see as much as one rate rise over the next two years.

How is this possible? In part this is a regression to old behaviour. Traders had several profitable years betting against the Fed’s dots, which persistently and incorrectly signalled that the central bank was ready to tighten.

But it is perhaps more about a straight disagreement over incoming economic data, on which the Fed says it is dependent. The biggest fall in US bond yields this week came hours before the Fed’s announcement, with the release of US inflation data. Inflation, notably core inflation excluding food and fuel prices, fell. So did retail sales. Growth in average annual real wages slowed, to 0.6 per cent — labour is indeed managing to get a slightly better deal out of capital, after inflation, but not to the extent that would make anyone worry about inflation or brace for a great increase in consumption.

Added to all this, oil prices dropped to a fresh low for the year, meaning that headline inflation — which matters most to politicians and consumers, if not central bankers — will fall further compared with previous expectations.

This latest data package looks like a convincing argument that the great Reflation Trade, ignited by China early last year and given extra fuel by the strong surveys of economic confidence that followed the US election, can now be consigned to the dustbin of history. We should all go back to worrying about deflation.

But that would be premature. Other central banks, and not just the Fed, see a reason to worry about inflation. In the UK, the Bank of England staged its own shock by revealing that three of the eight members of its rate-setting committee voted to raise rates at its latest meeting. They are worried by UK inflation, which is rising in the wake of last year’s depreciation of sterling.

The problem for the BoE is that sterling’s plunge last year has helped guide the UK economy through the aftershocks from the Brexit referendum. Higher rates would attract funds back to the UK, push up the pound (which is what happened on Thursday), and render British exports less competitive at a time of high political uncertainty.

In the US the labour market remains strong, which, according to a long-used economic theory known as the Phillips Curve, implies that inflation should be rising. Surveys of businesses still suggest renewed enthusiasm to invest, while corporate revenues are impressive. And in the eurozone, growth has startled almost everyone, after years of malaise. These are not consistent with another deflation scare.

But for now the wisdom of crowds, captured by the collective judgment of the market, is that the data once more point to deflationary forces. The wisdom of the Federal Reserve still disagrees. We are back yet again to a battle between inflationists and deflationists. Just when you thought it was safe to go back into inflation-linked bonds, the question returns. And as before, no question is more important in the world of markets.

Brexit Is Dead

A Wave of Anger Crashes over Britain

An Editorial by Thomas Hüetlin

 
British Prime Minister Theresa May


Europe used to have a fearful respect of the Tories. But those days have long since passed. Now, the weakened party may have accidentally killed off Brexit -- a pet project that most party leaders didn't want in the first place.

Once upon a time, under the leadership of Margaret Thatcher, the Tories filled all of Europe with trepidation. French President François Mitterrand complained to his psychologist that he was plagued by nightmares caused by the British leader and German Chancellor Helmut Kohl, as unclassified British documents revealed in late 2016, once preferred to chow down on a cream pie in Salzburg than meet with the British prime minister.

Many in the UK thought a bit of fear was a good thing. Fear sounded like respect and influence -- and, more than anything, like good deals. But now, after two catastrophic elections in less than a year, that is over. Completely.

"The country looks ridiculous," the Financial Times -- not exactly a leftist mouthpiece -- wrote recently. Indeed, the party of Winston Churchill and Margaret Thatcher has turned into a gaggle of high rollers and unwitting clowns.

First came Boris Johnson, who vociferously supported Brexit last year to show his boss, Prime Minister David Cameron, what an outstanding orator he was even though he, Johnson, didn't really want Brexit. They both went all in, and the country lost.

And now we have Theresa May, who didn't really want Brexit either, but decided after last summer's referendum to throw her support behind leaving the European Union if it meant that she could become prime minister.

"The lady's not for turning," is one of the more famous quotes uttered by Margaret Thatcher.

But her heirs currently leading the Tories are now turning so quickly that many observers aren't just getting dizzy. They are becoming nauseous.

Incompetently Cool and Calculating

Great Britain may be an island, but economically it is the most interconnected country in Europe: The financial center in London, the country's carmakers, what's left of British industry and even the country's infrastructure. France delivers electricity, water sanitation facilities in southern England belong to Germans and large airports such as Heathrow are owned by Spaniards. One quarter of the doctors who keep afloat the NHS -- Britain's comparatively deficient health care system -- come from the Continent.

The promise of Brexit was steeped in ideology from the very beginning, a fairy tale based on dark chauvinism. The Spanish Armada, Napoleon, Hitler and now the Polish plumbers who allegedly push down wages -- when in reality they ensured that, after decades of lukewarmly dripping showers, the country's bathrooms gradually returned to functionality. Brexit was never a particularly good idea.

Now, following the most recent election, Brexit is defunct. That, at least, is what a member of Theresa May's cabinet intimated last weekend. "In practical terms, Brexit is dead," an unnamed minister told the Financial Times.

If she weren't so incompetently cool and calculating, one could almost pity Theresa May. Even as her supposed allies begin sharpening their knives at home, Brexit negotiations are set to begin in Brussels next week. And she also has to find time for a bit of begging at the door of a former party to the civil conflict in Northern Ireland known as the Troubles, the Ulster Unionist Party, so that she can have them sign a coalition agreement. Anything at all would be fine, as long as she can continue to govern.

It won't be a hard Brexit. The best case is a soft Brexit, which would mean that the UK could remain a part of the common market, but that the government would have to accept immigration from Europe and regulations from Brussels -- without having a vote in the EU. To paraphrase May, this would indeed be a bad deal, but still better than no deal at all -- the scenario she threatened when she still had a comfortable majority in the House of Commons.

Investors hate nothing more than uncertainty, but that is exactly what experts are predicting for Britain in the coming years. Uncertainty combined with stunted growth, less trade, higher taxes and worse national health care.

As things look now, last week's election was only the first wave of anger that is currently breaking over the country. The worse the times get, the more powerful it will become. And in a few years, it is almost certain that there will be a government interested in rejoining the EU.

Which is possible, but the conditions offered are almost sure to be worse.

Read This, Spike That

How Tech Dependent Is This Stock Market?

While several well-known tech names have led the market lately, their dominance is overstated.

By John Kimelman          
 

Getty Images/iStockphoto

 

 

One argument cited for why the bull market in stocks is in danger is the seeming narrowness of the recent gains.

As a recent report by Goldman Sachs pointed out, just five tech stocks – Facebook (ticker: FB), AppleAAPL in Your Value Your Change Short position (AAPL), Amazon.comAMZN in Your Value Your Change Short position (AMZN), Microsoft (MSFT) and Google parent Alphabet GOOGL (GOOGL), otherwise known collectively as FAAMG -- have accounted for roughly 40% of the Standard & Poor’s 500’s gains this year.

(The Goldman SachsGS in Your Value Your Change Short position report has been cited as a catalyst for a selloff among the big tech names last Friday.)

At times it seems that the number of articles in recent months devoted to FAAMG and FANG (the latter collection of stocks includes Netflix outnumber articles about the stock market itself.  

But a few pieces of market research published in recent days suggest that too much is being made of the role that these sainted stocks have contributed to the bull market.

Cliff Asness, an influential quant hedge-fund manager, is trying to debunk the notion that the stock market is all that dependent on the performance of a handful of big-tech names.

Writing on the website of his firm, AQR Capital Management, Asness argues that “Any way you slice the data, there isn’t anything truly exceptional about the last two calendar years even if you extend the period to include the strong 2017 FAANG performance through May.”

Asness continues: “In this case the “why” is pretty simple — calendar year 2016 was not a particularly great year for the FAANGs (and you may notice the news stories indeed died down for a while).‘’

He points out that Old Economy stocks like JPMorgan ChaseJPM in Your Value Your Change Short position (JPM), Bank of America BAC in Your Value Your Change Short position                        (BAC) and ChevronCVX in Your Value Your Change Short position (CVX) were among the top contributors to S&P 500 returns last year, while the FAANGs performed more in line with the rest of the market.

The pieces goes on to say that even looking at the last two years ending May 31, which includes the last five months of strong performance by the FAANGS – the contribution of returns of the five best-performing stocks in the S&P 500 is only at the historical average.

“So even including the recent resurgence, gains have not been particularly “narrow” at least as proxied by the impact of the top five contributors to S&P 500 performance,” he concludes.

Lawrence Hamtil, a principal with Fortune Financial, a wealth-management firm based in Overland Park, Kan., makes a related point.

Writing on his firm’s website, Hamtil argues that “even though the feeling is that the U.S. market (as gauged by the S&P 500 index) is currently dominated by several megacaps such as Apple, Alphabet, and others, the reality is that the current market weightings are fairly average, and perhaps even less top-heavy than it has been in the recent past.”

For example, he writes, the current market weighting of the top 10 S&P 500 components is a little more than 20%, with Apple holding the top spot at 3.73%.

“This seems fairly concentrated at the top until it is revealed that from 1980 through 2014 (the latest for which I have data), the average weighting of the top ten S&P 500 components was about 20.5%.”

Thus, he writes, “the current structure is nothing remarkable.”

Regarding the S&P 500’s heavy concentration in Apple, “this, too, is nothing remarkable,” Hamtil adds.

“From 1980 through 2014, the average weighting of the S&P 500’s top position was about 3.8%”

This certainly takes some of the bite out of FANG.