The Saudis are Underestimating U.S. Shale — For the Second Time in Less Than a Decade
In early December 2020, TradeSmith Decoder turned aggressively bullish on energy stocks. We bought a sizable basket of fossil-fuel-related energy names at that time — eight in all — anticipating a recovery-fueled share price surge as a result of resurgent oil demand.
That overall basket did quite well, providing multiple instances of either triple-digit gains or close to triple-digit gains, in the space of less than three months.
But we recently took partial profits across the board on that energy basket, and significantly tightened our risk points on the holdings that are left, as such that if prices decline by a modest amount, we’ll be out.
We aren’t turning flat-out bearish on energy stocks at this time, but we’ve definitely shifted to neutral. And if our profit-protective risk points are hit, thus closing out a nice trade, that will be fine.
Our initial energy stocks call was more sentiment-based than supply-and-demand based, meaning, we anticipated investors getting excited about oil stocks as part of the vaccine-powered recovery narrative, with positive emotions getting ahead of the actual demand picture.
We also thought a rebounding crude oil price would give energy stocks a tailwind. In that particular area, the Saudis helped us out twice.
First, the Saudis helped with a unilateral crude oil production cut of a million barrels per day in the first week of January; that news, taken by markets as a total surprise, caused the oil price to surge, and energy stocks along with it.
Then, in the first week of March, the Saudis said they would extend the duration of the production cut when the market had anticipated it was coming to an end. That news (another surprise) caused the oil price to jump yet again, and energy stocks to surge yet again.
That was all well and good in terms of driving the bullish energy stocks. But here is the problem moving forward: The Saudis appear to be underestimating the resilience of U.S. shale producers — for the second time in less than a decade.
In 2014, the West Texas Intermediate crude oil price was above $100 per barrel. At that time, the Saudis decided to wage an “oil war” to try and kill off U.S. shale producers.
During that time, the Saudis telegraphed a willingness to flood the market with excess oil supply, in the hopes that a plummeting oil price would bankrupt the U.S. shale industry and scare off new investment.
As a result of their oil war efforts, the crude oil price did in fact plummet, going from $110 per barrel to less than $30 per barrel in the space of two years.
But the Saudis miscalculated, because the U.S. shale industry didn’t go bankrupt, and shale investment didn’t dry up. Over the next few years, shale production grew so much that the U.S. at one point overtook Saudi Arabia’s spot as the world’s largest oil exporter.
Here in 2021, the Saudis aren’t trying to knock down the oil price with a supply glut. Instead, they are trying to prop the oil price up, and encourage higher oil prices, by keeping supply off the market.
But the mistake the Saudis are making, in our view, is assuming that the U.S. shale industry won’t rebound from the pandemic — the same way it did from the oil war seven years ago.
After the OPEC+ Meeting of March 4, 2021, Saudi prince Abdulaziz bin Salman openly mocked the U.S. shale industry, smugly telling reporters that “Drill, baby, drill is gone forever.”
What the prince meant was that he expected no new ramp-up of U.S. shale output — which is why it was safe to implement production cuts. It would make no sense to try and prop up the oil price with production cuts if U.S. shale producers had the ability to come back strong; the shale producers would just add supply to the market and take market share.
And this is where we run into a problem for oil and energy stocks: If the crude oil price stays above $60 per barrel, it is, in fact, likely to bring back new shale production, which could then glut the market with more supply than it needs.
When we made our bullish energy stocks call in December 2020, West Texas Crude was around $45 per barrel. At the $60 level that is a 33% price increase; at the $65 level it is a 45% price increase.
More importantly, a sustained outlook for $60 and above seems to be the threshold where U.S. shale producers — and oil majors like Exxon — can justify investments in new production.
One way to tell whether a production rebound is happening is to monitor the “horizontal rig count” — a measure of how many rigs the shale patch has in operation.
As the oil price declines to unprofitable levels, the horizontal rig count falls as production shuts down; if the rig count starts to climb again, that is a sign production is bouncing back. With the oil price retaking $60 per barrel in mid-February, that is just what we are seeing, in a kind of repeat trajectory of what happened after the oil price bottomed out in 2016.
This means that, above the $60 threshold, “drill, baby, drill” could prove to be alive and well. That is the level where U.S. oil output is likely to climb if sustained, filling in any gap created by Saudi cuts.
This more or less explains why oil prices saw a large-scale drop last week.
A new five-year forecast report from the International Energy Agency (IEA) showed that any short-run constraint on the oil supply is more artificial than real, meaning, demand is not yet strong enough to justify a rising oil price, which means higher oil prices here and now are born of the Saudis and OPEC+ keeping supply off the market.
This puts the crude oil outlook in a kind of no man’s land.
Below $60 per barrel, the U.S. shale taps are off, which means supply can be artificially restricted if the Saudis and OPEC+ maintain discipline. But if the oil price goes above $60 for a sustained period of time, as the Saudis want, spare production capacity from the shale patch and various oil majors should kick in.
If we combine this implied supply ceiling (above a certain price, new supply challenges the market) with the observation that the reflation-and-recovery narrative was looking a bit overheated, and then add in the challenge of a rising U.S. dollar hurting commodity prices, it looks like the bullish energy stocks narrative may have played itself out for the time being.
Although, with that said, the crude oil outlook (and thus the energy stock outlook) does have one wild-card factor: The potential for supply-shock disruptions in the Middle East, where a sudden cut-off of oil flow could drive an oil price spike.
We saw a preview of the supply-shock factor this week with oil’s sharp rebound on news of the Suez Canal incident — which, if you haven’t heard about it, amounted to a parallel parking job gone badly wrong, but with a container ship longer than the Eiffel Tower rather than a car — and a resulting $400 million-per-hour traffic jam that disrupted global trade.
We’ll have more on the Suez jam-up tomorrow, if we don’t wind up bumping that topic to next week because technology stocks are crashing. (Look out below!)