Oil markets

Today’s topics

• Oil (capex)
• Oil (forecasts, demand and supply model)
• Excess bond premia
• Aus credit growth (and banks)
• China PMI

Oil

The capital expenditure discipline of the oil and gas majors over the past decade is really worth paying attention to.

Due to a) overinvestment from 2005-2010 b) the Euro sovereign debt crisis of 2012/2013 c) the China slowdown of 2014/2015, and d) the US shale gas production ramp, industry wide low profitability and poor returns on capital led to a material curtailment of growth capex.

We can now add e) the rise of activist investors and ESG related pressures and f) eventual technological disintermediation, that are causing producers to abandon greenfield development.

And we are left with the intriguing situation that although demand can decline at -x%, each year every year, eventually down to naught, you still get periodic supply side squeezes (due to reserve depletion) that drive the price through the roof, along the way.

And the graph above is total capex, in nominal dollars. So real (inflation adjusted) growth (ex maintenance) capex is much, much less. With the reopening economy meeting negligible new supply (and ongoing reserve depletion) oil’s “last gasp” might be its most profitable.

Oil model

A long while ago Ben Bernanke put out an oil pricing model which splits oil price movements into those attributable to demand proxies (log differences in copper, the US dollar, and simple change in 10 year bond yields) and leaves the residual attributable to movements in supply.

The model is borne out in the below econometric analysis, which has the expected signs, magnitudes and statistical significance of the demand proxies, that replicate the original analysis (and update it for the intervening years).

Such a model demonstrates the massive positive supply shock of US Shale in 2014, where ~50% of the observed fall in the oil price is attributable to adverse supply dynamics, in addition the demand shock of a slowing China.

Similarly we can see the 2020 fall was exacerbated by the OPEC cartel disintegration (Russia, Saudi Arabia disagreement over production volumes), and finally, that the late 2020-present recovery is pretty much purely demand driven. With this level of demand, we’d have already hit c$100/bbl without the supply overhang.

This is a positive backdrop for our oil and gas exposures WPL (Woodside) and ORG (Origin). If the supply discipline shown in the earlier graph of oil majors capex programs continues, it is possible oil spikes even higher over time. Admittedly, those are big if’s, and also applies to the decisions made by OPEC (another big OPEC meeting is set to occur this Thursday).

Still, we think the risk reward is very much in our favour.

Excess bond premia

Corporate bonds are not rewarding you for taking on credit risk. The search for yield, any yield, is causing investors to move, in our minds, to lower quality credits at spreads that don’t provide adequate compensation for default risk.

Aus credit growth (and banks)

The RBA credit aggregate print was released earlier, and suggests credit growth remains strong. There’s little new in this print, in that you can’t have a booming housing market (which is a high leveraged asset) without it.

Whilst we think such high levels of credit growth will prove unsustainable, they are nonetheless a solid driver of bank earnings momentum in the near term. Despite our bearishness towards the banks, they remain around 15% of the direct equity portfolio, reflecting this near term strength (and likelihood of provision write-backs, buybacks, and bumper dividends).

AUDUSD

For those expecting a materially stronger Aussie dollar, and who are feeling surprised at recent weakness.

The below graphs show that the AUDUSD is at about the midpoint of its long run average. Commodities are a quite a bit higher, relative to this long run average, but the interest rate differential is quite a bit lower. The terms of trade and rate differentials are 2 of the main determinants of the level of the exchange rate.

We can also note that sentiment and risk indicators like the VIX are also close on normal.

If we take those factors, and stick them all into some sort of model (in logs/log diffs), we find that the AUD is about right. Firstly, we check that our factors have the right signs and magnitudes that theory expects.

And then we plot the predicted values of the different models against the logged exchange rate (and exponentiate at the end). Note that the dollar spent a long period of time post 2011 in “overvalued” territory, but it is much harder to say it is materially undervalued now.

The model also gives some insight into why we only change our hedging ratio on such an infrequent basis. Really only 2 times in 10 years have we felt you could point to the currency and definitively say “there’s a big risk premia wedge in there that is too high” [low] relative to fundamentals.

We can also suggest that a more hawkish Fed relative to RBA tilts risk to downside, as does the likely slowdown in commodity demand from China.

China PMI

China PMI – modest easing of data continues. This represents a downside risks to commodity prices.