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The Saga Continues; Big Risks and Little Spare Capacity

Posted on 29 February, 2016 at 0:07
Weekly Market Assessment
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The Saga Continues: Big Risks and Little Spare Capacity  
 
In cases of emergencies, people have savings accounts to buffer the blow when something financially goes wrong. When there is a supply disruption in the oil industry, this savings account is called spare capacity. What is spare capacity and why is it important to the oil market? The EIA (Energy Information Administration) defines spare capacity as the volume of oil production that can be brought on within 30 days and sustained for at least 90 days. OPEC (Organization of Petroleum Exporting Countries) spare capacity provides an indicator of the world oil market's ability to respond to potential crises that reduce oil supplies. As a result, oil prices tend to incorporate a rising risk premium when OPEC spare capacity reaches low levels. Today, there is no risk premium in oil's price, while spare capacity is razor thin, and risks to oil supplies is at its highest!
 
  
 
So who should we believe when talking about the numbers regarding oil's spare capacity? Well unlike the demand assessment, where multiple parties disagreed whether there was demand or not, it is a much different story here. According to the EIA (Energy Information Administration) Saudi Arabia has usually kept more than 1.5-2 million barrels per day of spare capacity on hand for market management.
 
Andrew Hall, aka "God", goes onto say, "Today's surplus is only 2 percent higher (1.9 million barrels) than global oil consumption, and it will have dissipated by the end of the year, if not sooner." In his most recent letter to investors, he reiterates his spare capacity concerns, "One of the main drivers for a price jump could be that spare capacity had fallen to as little as 1 percent of global consumption just as there were rising risks of supply disruptions."  
 
Mike Rothman who has been attending OPEC meetings since the 1980's and runs a extremely well respected energy research firm comments on spare capacity. "Importantly global oil demand growth has significantly outrun additions to non-OPEC supply which, in turn, is a key reason OPEC's spare production has been withered down so dramatically."
 
Then there is Gary Ross, who is a leading authority on worldwide energy markets. He has run his firm PIRA Energy from its inception in 1976, building it into the leading international consultancy in energy market intelligence and analysis, currently retained by more than 500 companies across 60 countries.  This is what he had to say about spare capacity. "Last time they (Saudi Arabia) went for market share and pursued this type of philosophy back in 1985, you had ~10 million barrels per day of spare capacity. How much spare capacity do we have in the world today? 500,000 to 1,000,000 barrels per day and yet we have halved the price?! He adds “There’s not spare capacity to speak of instantly available,” Ross said. There are also growing geopolitical threats to supply, including from Islamic State."  
 
Emad Mostaque is a Strategist specialising in geopolitics, frontier markets and oil at Ecstrate. He says, "Spare capacity is at multi-year lows but geopolitical risk is the highest its been in a decade." 
 
Mike Beard of Hodges Capital management states, "I have never seen the oil price so weak when there is the potential for so much unrest."
 
"Oil markets are becoming dangerous with no grown-ups in charge. Spare capacity is wafer-thin, despite the glut, any upset could trigger an oil shock. It is a lot more dangerous than in the 1980s,” said Miswin Mahesh from Barclays. 
 
Finally, everyone can agree on one thing, that there is little spare capacity of just 1 to 2 million barrels or around just 1% of total oil demand.  
 
So why are people referring to the 1980's? During this period, OPEC members were supposed to meet production quotas in order to maintain price stability; however, many countries inflated their reserves to achieve higher quotas, cheated, or outright refused to accord with the quotas.  In 1985, the Saudis tired of this behavior, decided to punish the undisciplined OPEC countries. The Saudis abandoned their role as swing producer and began producing at full capacity, creating a "huge surplus that angered many of their colleagues in OPEC". High-cost oil production facilities became less or even not profitable. Oil prices as a result fell to as low as $7 per barrel. This is what the Saudis are doing today. However with no spare capacity to address potential and ongoing situations in the Middle East, that most likely will get worse, spare capacity has been forgotten for its importance to the oil market.   
 
How important is it to have spare capacity today? I'll start with the CIA Director John Brennan, he told a Senate committee last month that the violence and instability in the Middle East is the worst it's been in 50 years, painting a dire picture of a region he said was facing "unprecedented" bloodshed." Any other time in history with what is transpiring in this region would put oil over $100 a barrel, as violence in these areas poses a major threat to oil supplies.  
 First, we have the Yemen front, where the Houthi's which are backed by Iran (~2.8 Million barrels per day in production) are fighting against the Hadi's, which are backed by Saudi Arabia (~10.2 million barrels per day in production). So you have a proxy war going on in Yemen against two major world oil producers. This is of course occurring near one of the most critical chokepoints for the oil trade, Bab el-Mandab strait, where 3.8 million barrels of oil passes through this strait daily. Then look no further than to Syria and Iraq. Where the United States is leading two different coalitions carry out air strikes in Iraq and Syria, that have targeted ISIL. In Syria, Russia wants to keep Syrian President Bashar al-Assad in power and the United States wants him out. Russia and Iran are working together in this front while Saudi Arabia is aligned with the United States. Deja vu all over again as Iran and Saudi Arabia are at odds in another theater. As of last month, Reuters reported that Iranian backed militants played a key role on the ground as Russian jets intensified what rebels call a scorched earth policy. Recently the Saudis confirmed that they are wiling to send in ground forces into Syria, While just over a few weeks ago, the Head of the Iran''s Elite Revolutionary Guard was quoted as saying,"(The Saudis) have made such a claim but I don't think they are brave enough to do so ... Even if they send troops, they would be definitely defeated ... it would be suicide,” Jafari was quoted as saying. Wow! Ok, so what makes this worse is that recently Saudi Arabia (a majority Sunni country) cut ties completely with Iran (after a Saudi Embassy in Tehran, Iran was attacked after the Saudi's executed a Shiite cleric) and now Iran (a majority Shiite country) is publicly stating that if Saudi troops enter Syria it will be suicidal! Tensions couldn't be any higher and oil's spare capacity couldn't be any lower.Confusing and crazy that all of this is happening near the northern part of Iraq where some of Iraq's major oil fields reside, 4.3 million barrels a day in production. There are numerous oil pipelines, transportation hubs and oil fields all in this battle zone, where Russia, the U.S., France, Iran, Saudi Arabia, ISIL and the Kurds are all going at each other in one way or another. These are major oil producing countries that have an insane amounts of oil supplies that could potential be disrupted. If something "accidentally" happens like the downing of a Russian jet over Turkish territory could spell even more disaster, oh wait that actually happened!   
These are major proxy wars against conflicting political and religious Middle East countries and World powers, that no one is willing to admit is occurring. There has never been so much geopolitical turmoil in this region and still oil trades at depressed levels, as if none of this is happening. It's as if people forgot that around 41% of the global oil supplies comes from this region. All of this could cause a massive disruption in the supply of crude oil to the world, and if this disruption occurs, there is no spare capacity in terms of historic standards that could solve the problem. This would send crude oil prices sky high.  So the need for spare capacity in today's world is even more important because of the turmoil in the Middle East. Just look to recent events in Libya on January 6th 2016. A now failed state that is being taken over by ISIL. The picture below are what happened when ISIL attacked a Libyan Oil Field and blew up four oil storage tanks. Each tank held half a million barrels worth of crude oil. Smoke so large a thick you could see it from space. Click Here is an on the ground video on the tanks on fire.  Think that put a dent in crude oil floating around the world?  
As you can see in the map below what can happen to oil production once a government is overthrown.  A power vacuums opens up allowing conflict to explode without having an organized force to suppress it. Libya is just one recent example as ISIL is now making home in this failed state and over taking its oil fields and ports. Coalitions forces may have no choice soon to start bombing oil facilities in the region to cut off the financing for ISIL. This is why spare capacity is needed for circumstances just like this. Just look what has happened to oil production in Libya over the course of the last few years. I doubt it is going to get any better.  
 

 
 
 
 
Back in December, Russia entered into the Syrian conflict, soon after a Russia plane was downed on the Turkish border. This was one event the oil market was expecting, collateral damage was bound to occur as so many forces fighting in one arena. What came from this was a sudden news flash that Turkey may be blocking Russian ships at the Bosphorus Strait. This Strait of Bosphorus connects the Black Sea and the Mediterranean Sea. Around 2.9 million barrels per day travel through this strait, and The U.S. Energy Information Administration calls the strait “one of the world’s busiest chokepoints." Oil prices jumped 8% on this rumor.
 
These unforeseen events are endless and are now more likely to occur with so many geopolitical and escalating sectarian face offs between nations. Syria, Iraq, Yemen and now some recent reports of the U.S. bombing ISIL targets in Libya, who knows where the next military front may be. What makes this worse is the fact that all of this is occurring in region that the world relies on for oil. The world wont stop demanding oil and right now there is no end in sight to ending geopolitical tensions in the Middle East!  

 
There are endless chaotic situations that could put the global oil supply under extreme stress and the market has lost sight of the importance of spare capacity. The oil spigot in the Middle East are completely opened to flood the oil market to remove the high cost producers and regain market share.  The "so-called" oil risk premium is not factored in at current prices and the oil market is skating on thin ice when looking to the Middle East, where spare capacity is almost non-existent. Any geopolitical disruption and the market will be looking for quick oil, however that request will be met with a barrel of oil with a price tag much higher then current prices and so begins the vicious cycle all over again.     
 
Making the Watchlist: Below are the stocks that I will be looking at over the coming months.  I will provide the the current stock price and why I am watching them. I will comment on them as I continue to keep an eye on them.  You will be able to see and follow their growth and/or decline. Chart links may be attached.
 
 
BlackPacific Capital has created three funds. The first is the Total Return Fund and the other is the Growth Fund. Both of these funds will be compared against the S&P 500. Both will hold a total of no more than five companies each. The Total Return Fund is a low turnover fund where every holding must have a dividend and be undervalued to its peers. The growth fund is made up of momentum high growth stocks where the turnover rate is much higher. Below are their Weekly and Year to Date returns. For more information and to see the holdings in each fund click here.
 
 New holdings and liquidated positions: I have opened a position in Amazon (AMZN) at $533.50. This was entered right near its 200 day simple moving average. It has been added to the Growth Fund after selling out of Under Armour (UA).        

 S&P 500 Return 
Week:1.23% 
Year to Date: -4.42%  

Year to Date: -7.99% 

Week: -2.17
Year to Date: 4.77% 

Week: -12.65%
Year to Date: -12.56%
 

Categories: Weekly Market Assessment

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