Andrew  Schenkel  The  oil  market   is  very  noisy.    Analysts  disagree  as   to  its  direction   in  the  short  and  medium  term.    As  of  this  writing  (February  26,  2015),  the  price  of  NYMEX  crude  is  $49.50  per  barrel.    What  those  bull  analysts  are  not  seeing  is  the  change  in  the  structure  of  the  market  since  the  large  US  banks   exited   the  market   last   summer.    What   the   bears   are   not   seeing   is   the   time  bomb   a   persistent   low   price   of   crude   means   for   the   high   yield   market.     The   unintended  consequence   of   those   two   conditions   means   trouble   for   the   bondholders   and   the   credit  markets  in  what  appears  to  be  an  implied  U  shaped  recovery.    

I n f e r e n c e   P a r t n e r s ,   L L C   2 8 8   O l d   F o r g e   C r o s s i n g ,   D e v o n ,   P A   1 9 3 3 3  I n f e r e n c e P a r t n e r s @ g m a i l . c o m  

     

The  Oil  Bear  and  Bank  Implosion  

2   Inference  Partners,  LLC  288  Old  Forge  Crossing,  Devon,  PA  19333  

2   THE  OIL  BEAR  AND  BANK  IMPLOSION    

The  Oil  Bear  and  Bank  Implosion  

 

The   oil   market   is   very   noisy.     Analyst   forecast   for   its   price   ranges   from   $49   (JP  

Morgan)  for  WTI  on  the  low  end  to  $69  (Moody’s)  and  $71  for  BoA  ML  on  the  high  

end.    Mr.  El  Badri  the  Saudi  OPEC  Minister  said  that  oil  could  be  $200  per  barrel  if  no  

investment   were   made.     According   to   a   Bloomberg   Intelligence   survey   of   86  

analysts,   the  range  in  average  price  for  oil   is  $35  and  $80  per  barrel   for  2015.    No  

one  has  clarity  on  whether  the  oil  market  will  persist  below  $50  or  shoot  back  up  to  

$100.    (NYMEX  crude  was  priced  at  $49.50  as  of  2/27/2012).    In  the  disagreement  

over  price  lies  opportunity  in  its  unintended  consequence.    

 

Over   the   last   five   years   (2009-­‐2014),   the   total   investment   in   oil   exploration,  

development   and   production   has   been   $5.3   Trillion.     Over   that   time   frame   the  

average  price  of  oil  was  between  $35  (2009)  and  $140  (2008)  per  barrel.    Industry  

analysts   attribute   the   rise   in   the   price   of   oil   to   China   participating   in   the   global  

economy—with  the  purchase  or  cars,  the  paving  of  roads,  and  the  making  of  plastic  

goods  and  fibers  etc.    The  high  price  of  oil  enticed  speculators  to  build  rigs  and  dig.    

Demand   for   oilrigs   from   2009   to   the   present   rose   400%,   according   to   data   from  

Baker  Hughes.  

 

Oil  traders  such  as  Vitol  are  betting  on  a  V  shaped  recovery  to  take  advantage  of  the  

contango  that  exists  in  the  market.    The  V  shaped  recovery’s  perspective  is  based  on  

the  perception  of  a  quick  absorption  of  the  excess  oil,  which  has  been  estimated  at  

between   1.2   and   1.6  million   barrels   per   day.     Vitol,   in   fact,   has   the   largest   crude  

carrier  anchored  off  of  Singapore  ready  to  deliver  its  oil.    Five  small  crude  carriers  

are   moored   in   the   Delaware   river   just   a   short   distance   from   Carlyle   Group’s  

Philadelphia  Energy  Solutions,  which  runs  the  refinery  complex  at  Marcus  Hook.    All  

told,  some  30%  of  the  global  fleet  now  has  oil  ready  for  sale  anchored  off  of  ports.    

(In  2009,  by  contrast,  upwards  of  70%  of  the  global  crude  carrier  fleet  was  used  to  

absorb  the  excess  supply  in  oil  after  the  prices  collapsed.    So  this  condition  is  normal  

when  the  market  and  price  are  under  duress.)    The  contango,  now  valued  at  about  

InferencePartners@gmail.com  The  Oil  Bear  and  Bank  Implosion  

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THE  OIL  BEAR  AND  BANK  IMPLOSION   3    

$6  per  barrel,  makes  good  margin   for   the  physical   trader   like  Vitol,  who  can  place  

the  oil  in  a  short  amount  of  time.    

 

Dodd   Frank   forced   the   big   US   banks   to   exit   the   oil   futures   market   during   the  

summer   of   2014.     JP   Morgan   sold   its   oil   trading   desk   to   Mercuria   while   Morgan  

Stanley  sold  its  to  Rosneft.    Goldman  Sachs  and  other  EU  entities  remain.    Physical  

traders  are  partnerships  and  cannot  match   the  big  banks  deep  pockets  and   talent  

for  taking  risk.    Liquidity  in  the  oil  futures  market  has  dried  up  as  these  players  have  

left…and  so  has  its  upward  bias.    One  role  big  banks  had  in  the  commodities  markets  

was  to  attract  others  to  the  market.  Demand  from  China  created   less  risky  trading  

opportunities  for  the  speculators  in  oil  futures.      

 

The  high  price  of  oil  attracted  speculation   in  shale  oil  exploration  and  production.    

Unlike   conventional   oil   production,   shale   oil   fracking   requires   constant   and  

renewed   participation   in   capital   markets   to   perpetuate   to   drilling   operations.    

Producers  hedge  their  inventory  exposure  through  selling  futures,  and  now  that  the  

banks   have   left,   hedging   is  more   difficult   and   costly.     US   oil   production   has   risen  

from  5.6  million  barrels  in  2010  to  9.3  million  barrels  today.    The  big  banks  financed  

these  operations  through  high  yield  debt  and  derivatives.  

 

The   energy   sector   represents   17%   of   the   high   yield  market   or   approximately   $2  

Trillion,  funding  rigging  operations.    The  six  largest  banks  also  have  $3.9  Trillion  in  

commodity   derivatives   contracts   still   on   their   book   according   to   sources.    

Structured  Credit  expert  Tom  Adams  writes,  “Much  of  the  recent  energy  boom  has  

been   financed   with   junk   debt   and   a   good   portion   of   that   junk   debt   ended   up   in  

collateralized   loan   obligations.…In   addition,   over   the   past   6   months   banks   were  

unable  to  unload  a  portion  of  the  junk  debt  originated  and  so  it  remained  on  bank  

balance  sheets.  That  debt   is  now  substantially  underwater.”    According  to  Fortune  

Magazine,   the   breakeven   cost   for   U.S.   hydraulic   shale   is   $65   per   barrel,  which   its  

article   cites   from   a   study   by   Rystad   Energy   and   Morgan   Stanley   Commodity  

4   Inference  Partners,  LLC  288  Old  Forge  Crossing,  Devon,  PA  19333  

4   THE  OIL  BEAR  AND  BANK  IMPLOSION    

Research.     Overseas   the   situation   for   investment   in   production   is   the   same.  

“[G]oldman   Sachs   found   almost   $1   trillion   in   investments   in   future   oil   projects   at  

risk.  They   looked  at  400  of   the  world’s   largest  new  oil  and  gas   fields  —  excluding  

U.S.  shale  —  and  found  projects  representing  $930  billion  of  future  investment  that  

are  no  longer  profitable  with  Brent  crude  at  $70.”      

 

Because  of  sunk  costs  and  other  factors,  conventional  oil  drillers  continue  to  extract  

oil  even  during  conditions  of  unprofitability.     Some  shale  oil  operators  sold   future  

production  to   finance  their  drilling.    Baker  Hughes  reported  this  week  that   the  rig  

count   has   dropped   to   986,   which   is   the   first   time   the   rig   count   has   fallen   below  

1,000  since   June  2011.    The  Wall  Street   Journal  reports   the  decrease   in  rig  counts  

was   not   enough   to   have   a   “substantial   effect”   on   oil’s   oversupplied   condition.    

China’s  PMI  was  last  reported  below  50  and  is  expected  to  be  below  50  this  month  

too.     (A   reading   of   under   50   suggests   a   contracting   economy.)     Demand   does   not  

appear  likely  for  a  V  shaped  recovery.  

 

When  China  was  busily  producing  goods  after  the  oil  shock  in  2009,  it  took  oil  about  

2  years  to  recover  from  its  lows.    What’s  different  today  from  2009  is  the  amount  of  

high  yield  debt  and  other  instruments  that  financed  the  oil  boom  in  addition  to  the  

exit  of  the  large  US  banks  participating  in  the  oil  market.    A  U  shaped  recovery  of  oil  

or  persistence  below  $65  for  US  drillers  and  $70  for  overseas  producers  means  the  

holders  of   the  high  yield  debt  and  other   instruments   that   financed   the  boom  have  

significant  problems.  

 

 

 

 

 

 

 

 

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THE  OIL  BEAR  AND  BANK  IMPLOSION   5    

About  Inference  Partners:  

Inference   Partners,   LLC   is   a   research   and   consulting   firm   specializing   in   seeing  

unintended   messages   and   alerting   clients   to   change   in   markets   or   competitors  

before  they  disrupt  business  plans  or  diminish  opportunity  share.    Alerting  clients  

can   take   two   forms:   a   workshop   entitled   Turning   Noise   Into   Insight   and   its  

companion   service   Red   Team.   Turning   Noise   Into   Insight   trains   investment  

professionals  on   inference.    Red  Team   is  a   service   that   challenges  or  validates   the  

assumptions   and   inferences   an   investment   professional   makes.     In   addition,  

Inference   Partners   also   generates   industry   landscapes   and   corporate   profiles.    

Inference  Partners  has  worked  with  public  &  private  companies,  foundations,  hedge  

funds  and  governments.      

 

About  the  Author:  

A   former   strategic   intelligence   analyst,   Andrew   Schenkel   founded   Inference  

Partners,  LLC,  a  research  and  consulting  firm  specializing   in  analyzing  competitive  

behavior   and   offering   its   clients   insights   into   the   structure   of   competition   in   an  

industry.     His   private   entity   clients   have   included   ExxonMobil,   Ford   Foundation,  

Symantec   and   VWR   among   others.     Mr.   Schenkel   works   with   the   Academy   of  

Competitive  Intelligence  Onsite  War  Games  programs  as  the  lead  analyst  for  writing  

the   competitor   briefs   and   the   industry   outlooks.  Mr.   Schenkel   is   also   a   partner   at  

TargetProof,   a   start   up   IT   security   firm.     A   graduate   of   Hamilton   College,   Mr.  

Schenkel  was  the  panelist  at  the  Mid-­‐Atlantic  Hedge  Fund  Association’s  10th  Annual  

Conference.  

 

For  more  information,  please  contact:  Andrew  Schenkel  +1  610  247  4977  InferencePartners@gmail.com    This   report   has   been   independently   prepared   by   Inference   Partners,   LLC   as   a   matter   of   general  information  and   is  not   to  be  construed  as  a  specific   recommendation.   Inference  Partners,  LLC  may  invest  in  areas  mentioned  herein.