Home Capital Group and MCAN: A tale of two subprime lenders

While the current woes at Home Capital Group, Canada's largest alternative lender, are being prominently featured in the media, the official line is that the situation is 'idiosyncratic' (1) and contained - famous last words.  In 2007, the US subprime crises was also described as contained by then Fed Chairmen Ben Bernanke.  Just how contained Canada's version of the subprime crisis is depends on how widely spread the fraudulent origination practices that caused Home Capital's troubles were.  If other lenders had similar problems in their origination channels, Canada's subprime lending crisis cannot be considered contained.

Meet XCEED, Another Canadian Alternative Lender

Another Canadian alternative lender of note is Xceed, a subsidiary of MCAN.  Xceed offers insured and uninsured mortgages, with characteristics such as minimum credit scores as low as 500, and LTVs of up to 90% with secondary financing as described in the advert for brokers below:

Offering LTVs of 90% with secondary financing on uninsured mortgages is a circumvention of Canada's mortgage rules which require mortgages with LTVs greater than 80% to be insured.  These types of loans are risky according to Scott Hannah, the head of Canada's credit counciling society who said "at least 10 percent of homeowners who are taking out this type of product may find themselves in hot water within the first couple of years of home ownership," (2)

These X-Series loans were introduced by Xceed after it was purchased by MCAN in 2013, with the ultimate goal of generating deals for the insured side, according to Micheal Misener, then VP and CIO of MCAN. (3)  Note that Mr. Misener left MCAN in Q2 of 2016, take note of that timing.

MCAN Single Family Origination Explode, then Collapse

MCAN's single family mortgage origination numbers between 2013 and 2017 is shown in the chart below:

MCAN acquired Xceed in Q1 2013, and you can see the expected bump single family originations in the following quarter.  Originations were then roughly flat until Q3 2014 when they exploded, then peaked in Q3 2015 before falling back to 2013 levels in 2016.  Management attributed the growth in origination starting in 2014 as Xceed outperforming expectations, but the following collapse in 2016 was attributed to a new underwriting system and software upgrade.  Management indicated that origination growth would resume after the new system was implemented, but instead origination collapsed further in Q1 2017, to levels not seen since BEFORE Xceed was acquired.  MCAN's Q1 2016 report provides the following insight:

It appears that after implementing the new mortgage underwriting system, Xceed was finding and declining a significant amount of business that did not meet their underwriting standards.  Just how much business was declined?  Management doesn't say, but for context, at the peak in Q3 2015 over $200 million in mortgages were originated, while in Q1 2017 that number fell to under $17 million.  That's pretty significant considering in 2015 MCAN expressed a desire to GROW the Xceed business.

While the patterns observed in MCAN's Xceed business are interesting on their own, when one steps back and looks those patterns in the context of what was happening in the broader Canadian alternative lending space, and specifically at Home Capital, during this time another picture is painted.

MCAN and Home Capital Group, a timeline

A timeline of events for Home Capital Groups was sourced from the Globe and Mail (4) and compared to events at MCAN.  In late 2015, HCG publicly disclosed mortgage fraud in it's broker channels, coincidentally MCAN single family origination peaked around this time.  The drop in originations at MCAN began in earnest in Q1 2016 and was blamed on a new underwriting system and software upgrades. A bunch of red flags then appear at MCAN in 2016 Q3 including the disclosure of a new risk related to accuracy and completeness of borrower information and the departure of a key executive who oversaw Xceed.

2013 Q1

• MCAN aquires Xceed, an alternative lender in Canada

2014 Q3

• Home Capital Group “became aware of irregularities” associated with certain mortgage applications and launches an investigation.
• Sudden growth noted at MCAN, credited to Xceed

2015 Q1

• HCG files annual financial statements for 2014 and blames a decline in mortgage originations on “external vagaries such as macroeconomics, seasonality and competitive markets,” according to the OSC

2015 Q3

• HCG publically discloses fraud in broker channels
• Mortgage originations at MCAN peak

2016 Q1

• MCAN originations start to decline, new underwriting systems blamed

2016 Q3

• Micheal Misener, VP and CIO who oversaw the Xceed business, leaves MCAN
• MCAN adds a new risk to it's disclosure concerning the accuracy of borrower information

2017 Q1

• HCG terminates CEO Martin Reid.
• Originations at MCAN collapse further, declines blamed on new rules in underwriting software
• HCG discloses that the OSC served several current and former executives with enforcement notices concerning disclosure

Based on the timing of these events, it seems possible that some of the business terminated by Home Capital found it's way over to Xceed and provided for some of the explosive growth noted in that business.  When the fraud at HCG was discovered, MCAN may have started to investigate it's own channels, and it's likely they found problems based how much business was declined after.

Trouble Brewing in Insured Mortgages?

Recall that MCAN purchased Xceed with the stated purpose of generating deals on the insured side.  Those insured mortgages are securitized, sold, and moved off the balance sheet.  It's difficult to track where these types of products end up, but they are frequently purchased by other financial institutions such as banks, insurance companies, and MICs.  Banks and insurance companies are complex businesses and it's difficult to see how specific products in their portfolio are performing, but we can look at publicly traded MIC's.  That data from Eclipse MIC, a public MIC is revealing:

A significant number of recently issued insured mortgages appear to be going into arrears.  Note that these are likely not Xceed originated mortgages, and this information is shown only to demonstrate the possibility of a wider problem in the insured mortgage market.

Who's On the Hook?

It's tough to say where these losses will end up.  One would think the mortgage insurance companies, are going to end up with elevated losses, but in the case that systemic origination fraud is discovered coverage might be declined.  If losses are large enough the private mortgage insurance companies may find themselves in a difficult situation, leaving the MICs on the hook.

Disclosure:  While this post should not be taken as investment advice, the author has modest short positions in both HCG and MKS.  HCG is a high conviction short, while MKS is a much lower conviction call as the company does not appear to have the same funding vulnerabilities as HCG and the Xceed portion of their business represents only a portion of the companies value.  Shorting MKS would be a bet on contagion from HCG spreading to other lenders.

(1) Home Capital's problems contained: Bank of Canada's Poloz
(2) Canadians skirting new mortgage rules with risky bundled loans
(3) MCAN & Xceed’s New X-Series Mortgage
(4) Home Capital Group: A Timeline

Linn Energy - Is there any value in the equity?

A few years ago, a number of bloggers pointed out Linn's Ponzi-like financial structure, with a strong bear case spelled out by Bronte Capital, Hedgeye, and James Kostohryz on Seeking Alpha (links to these blogs are in the footnotes).  While Linn has since declined significantly since then, but the worst may be yet to come.

Linn’s Ponzi Like Returns

Looking at Linn’s characterization of distributions for the past two years would indicate that the payouts were predominantly a return of capital and therefore not taxable.  While this might sound appealing, the reason these distributions are not taxable is because Linn is not making money, they are simply returning shareholder money back to shareholders.  However, paying your investors returns from their own capital, rather than from profits sounds quite a bit like the definition of a Ponzi scheme as provided below:

 “A Ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by the operator.”

Let’s say a business takes money from investors, and returns that money to investors in the amount of 10% a year.  Well after 10 years that business would be out of money to return to investors and fold, unless of course that business is a Ponzi scheme which successfully attracts capital from new investors to return to old investors.  As Bernie Madoff proved, given a level of obfuscation, Ponzi schemes can go undetected for a while and even grow quite large before inevitably imploding.  Madoff successfully obfuscated his Ponzi scheme behind a large trading operation.  In the case of Linn energy, the Ponzi like financial structure is obfuscated in the form of an oil and gas company. 

To illustrate, let’s think about how a Ponzi scheme works:

Step 1: Raise money from investors

Step 2: Return money back to investors in the form of a regular, predictable distribution.  Since profits are small to non-existent, most of the distributions are a return of capital, rather than a return on capital.

Step 3: Raise more money from new investors to continue paying old investors from fresh capital.

Step 4: Repeats steps 2 and 3 until investors stop giving you money

Linn energy effectively works the same way, but with a few additional steps.

Step 1: Raise money from investors

Step 1a: Convert that money into oil and gas reserves by buying energy assets

Step 1b: Produce from those reserves, converting the oil and gas back to cash

Step 2: Return money back to investors in the form of a regular, predictable distribution.  Since actual profits are small, and in recent years non-existent, most of the distributions have been a return of capital, rather than a return on capital.

Step 3: Raise more money from new investors to continue buying more oil reserves, allowing you to continue paying distributions to investors.

Step 4: Repeats steps 1a through 3 until investors stop giving you money

Now I call Linn Ponzi like rather than a straight out Ponzi scheme, because there are actually a couple of ways this business model can work.

1.  Oil prices rise faster than the rate the company is paying out distributions.
2. The company is unbelievably good at generating value from acquisitions.

If you believe either of the above to be true, then it might be possible for Linn to offer a sustainable return to investors. Case 1 is easy enough to address - if you believe that the price of oil will rise faster than Linn’s distribution yield, you would better off putting your money in the commodity as opposed to Linn equity.  Case 2 requires a little thought.

When it comes to making acquisitions, every transaction has both a buyer and a seller and information is asymmetric.  Typically, the seller knows much more about the asset he’s selling then the buyer and is unlikely to take less than market value except in distressed situations. Furthermore, the transaction costs involved in buying and selling energy assets are significant as, much like in real estate, there are all sorts of middlemen, such as investment bankers and lawyers, who need to be paid off.  These transaction fees can easily add another 5% to the price of an acquisition. Finally, acquisitions must often be made at a premium to gain support from shareholders of the selling company. For these reasons, it is very hard to create value in acquisitions except in the following situations:

1. Situations where there are significant synergies created due to the combination of entities.
2. Strategic situations where the buyer is acquiring a company for access to technology or new markets.
3. When the buyer has a lower cost of capital than the seller and can finance growth in the acquired company.
4.  Distressed asset acquisitions..

None of Linn's acquisitions really appear to have created major synergies for the company.  Linn may argue that the assets bought from Devon had significant operational overlap, but this in itself does not mean much in the way of synergies.  Certainly not enough to justify the price Linn paid for Devon’s assets.

It also does not appear that any of Linn’s acquisitions provided Linn with new technologies it could use elsewhere in its portfolio, nor did any of Linn’s acquisitions provide the company with new markets.

Early in Linn’s history, Linn may indeed have had a lower cost of capital than the companies it was buying, due to the marked up valuations of MLPs.  But this is not a sustainable advantage because as company issues more shares and more debt its liabilities rise until the cost of capital difference deteriorates.  As Linn's cost of capital has risen, it's ability to generate value in this way has evaporated.

Far from picking up assets at distressed valuations, it actually appears the Linn has been selling or otherwise shedding assets at distressed levels.  Linn needed to sell its Granite Wash assets to shore up liquidity and did so at a price that may have been lower than similar transactions in the area, and the DrillCo JV appears to be distressed financing deal in disguise.

DrillCo a bad deal for both shareholders and bondholders

Far from being a vote of confidence in Linn's, Blackstone's DrillCo joint venture appears to be more of an opportunistic distressed financing deal, which effectively results in Blackstone getting a 15% rate of return with Linn's reserves serving as collateral.  Furthermore, the DrillCo deal subordinates existing bondholders and Linn shareholders, as much of the economic value of those reserves will be transferred from Linn to DrillCo as part of the deal.  It's important to note that Linn itself does not even generate 15% returns on a corporate level, so it's hard to see how this deal creates value for the company.

Where things went wrong

I previously noted that there were a couple of situations where Linn’s business model could work.  The first is in an environment of continually rising oil prices and the second is if Linn can consistently make acquisitions that generate value.  The current falling oil price environment is a disaster for Linn, as the company has levered up its balance sheet buying assets that are now worth far less than what Linn paid.  Complicating matters is the fact that Linn’s cost of capital has risen to the point where the company is unable to make the acquisitions required to keep it’s Ponzi like business model going.  Since Linn’s business model has imploded, future growth seems almost out of the question, and the only question left to ask is how much residual value is left in the units?

So how much value is left in the equity?

Answering this question requires a close look at Linn’s valuation and posing the question “If Linn was valued like any other company, what would it be worth?”.

A peer group for Linn might be composed of Anadarko, Apache, Continental Resources, Devon Energy, EOG, among a few others.  The EV/EBITDA ratios of these companies are as follows:

Anadarko – 5.20

Apache – 3.18

Continental – 6.59

Devon – 4.8

EOG – 5.83

Average – 5.12

By comparison, Linn’s EV/EBITDA ratio is 8.26, much higher than the 5.12 average of the companies I listed above.  For Linn to be valued similarly to other E&Ps by this metric, the companies EV would need to drop by roughly 38%.  The unfortunate problem for Linn’s equity holders is that roughly 80% of Linn’s EV is debt.  This means that if Linn was valued as an E&P rather than an MLP, the shares would be worth close to zero.

Bulls may argue that MLPs are valued on their tax advantaged distributions and not their earnings, but this ignores the fact that for distributions to be sustainable they need to come from earnings and not from returning capital to shareholders.  Secondly, bondholders do not receive the same tax advantages as MLP unitholders and don't view the assets any differently.  If all the value of the company is in the debt, as opposed to the equity, the (unwarranted) MLP premium enjoyed by Linn should no longer apply.

Linn’s asset quality is low

I assumed in the above comparison that Linn’s asset quality was on par with its peers, but in reality, Linn’s assets are very marginal.  Given its business model, Linn has been incentivized to make a lot of acquisitions, and it the process the company has accumulated a disjointed portfolio of assets that other oil companies did not want.

• Linn’s assets in the Rockies, while not bad, do not compete against other North American shale plays.
• The assets in the Hugoton basin, Mid-Continent, and Permian are primarily mature wells nearing end of life.  The company did have some prospective wells in these area’s but they were sold (Granite Wash), or traded for more mature wells (Exxon trade).
• The California assets primarily produce thermal heavy oil, not unlike what is being produced in Alberta’s oilsands.  It’s expensive to produce and fetches a discount on the market because it is difficult to refine.
• Linn’s remaining assets in Michigan and East Texas are failed exploration plays that other companies did not see economic potential in.

When you compare Linn’s assets to those of the North American onshore peers I noted above, one would have to think Linn should trade at a discount, rather than a premium, to those companies.  Linn’s assets also make for a poor takeover target.  After all, why would anyone buy a company composed entirely of assets similar to those being jettisoned in favor of core positions in the Bakken or Eagle Ford shales?

(1) http://brontecapital.blogspot.ca/2013/02/linn-energys-queen-gertrude-moment.html
(2) http://brontecapital.blogspot.ca/2013/02/linn-energy-bizarre-definition-of.html
(3) https://app.hedgeye.com/insights/27487-looking-at-linn-energy
(4) http://seekingalpha.com/article/1535352-linn-energy-many-ponzi-like-mlp-blow-ups-to-follow
(5) http://seekingalpha.com/article/1545382-ponzi-or-mlp-linn-energys-unsustainable-distributions

Disclosure: The author is short Linn Energy

Moving back to the short side on oil stocks

In my last post, I noted that the major opportunity to be short oil and gas company stocks had passed, and the comment was fortunately timed.  Yet I did not expect oil stocks to rally as much as they have - Rather, I had been expecting an opportunity to become long oil stocks to materialize.  However, since mid December, the XOI index of oil and gas equities has risen nearly 10%, while benchmark WTI crude prices have dropped by approximately the same amount.  Far from being a buying opportunity, this may be a chance to make more money on the short side.

Before waving away the recent rally in oil stocks, we need to be able to understand it's drivers.  Here I see three possibilities.

1.  Investors believe there is significant value in oil stocks at current oil prices.
2.  Investors are expecting oil prices to recover sharply.
3.  Investors are adding to risk positions in general.

I hypothesize about these possibilities below.

Do investors see value in oil and current oil prices?

The first potential explanation for the rally is that oil stocks had become undervalued given current oil prices, but this hypothesis can be quickly dismissed.  While oil prices have fallen by over 50% in the past 6 months, the XOI has only fallen about 25% in the same period.  Even clearer evidence that oil stocks are overvalued given current oil prices is seen in an RBC research note showing that large cap Canadian oil stocks are still discounting an $80 oil price, as shown in the figure below.

Implied WTI price in oil stocks (RBC Research)

Are investors expecting a rally in oil prices?

A second explanation is that investors are expecting a significant rally in oil prices and are discounting that ahead of time.  My experience is that oil stocks do indeed tend to lead oil prices, but a closer look at the data is necessary to make conclusions here.

First, looking at the NYMEX WTI Futures curve, we are starting to see a fairly steep contango developing in the oil markets.  That is to say, oil is more expensive to buy for future delivery than it is to buy in the spot market.  Steep futures curves greatly incentivize building inventories and buying oil in the spot market, because the oil can be sold for a higher price in the futures market at a virtually risk free profit.  Such arbitrages never last long, and it's likely that we will see a lot of inventory building demand supporting the oil price going forward.

WTI Futures Curve (Alhambra Partners)

Second, oil nearing bottom of my expected trading range of $40-60 based on production costs.  At current prices in the low $40s, only the most profitable core areas of shale plays can be economically produced.  Furthermore, cash flows at oil companies are becoming a major constraint to drilling.  It's therefore not surprising that we are seeing a rapid decline in the US rig count and that decline will continue until we see oil in the $50-60 range, which is a price that I believe will incentivize more drilling and stabilize the rig count.

The combination of a steep contango which incentivizes oil buying the the spot market, along with a drilling slowdown which will eventually constrain supply growth in the spot market, could support a short term rally.  However this is not a high confidence prediction - while the overall picture is supportive of an oil price rally, poor economic data or more bearish inventory/production data could continue to be a drag.

Are investors merely adding to risk positions?

A third explanation for the rally in oil equities is a general move into risk assets that has spilled over into oil equities.  While I don't have data to support this hypothesis, it does seem very likely. Surprise rate cuts and larger than expected stimulus measures in countries around the world have lifted equities across the board.  It should not be surprising that some of the money flowing into equities has found it's way into oil stocks.  However, risk based inflows can quickly reverse into outflows and this is not a sustainable driver for a rally.  At some point, oil will need to rally to justify the valuations of oil equities.

Oil may rally, but even so, oil equities are still overvalued.

For the reasons stated above, we should not be surprised to see a rally in oil prices in the coming weeks or perhaps even months ahead.  But would such a rally continue to support oil stocks?  Intuition would say yes, but data suggests otherwise.

Most alarmingly for investors in oil equities, the gap between oil and oil stocks has reached unprecedented levels.  The chart below shows the ratio of the WTI oil prices and the XOI oil stock index.  Until the recent sell-off in oil, this ratio was dropping gradually indicating moderately better returns for oil stocks than the commodity itself.  This gradual decline in the WTI:XOI ratio is expected behavior, as oil producers are able to find more oil and increase production (and profits) over time.  However, the sudden drop in the WTI:XOI ratio is not sustainable.  The XOI:WTI ratio is normally remarkably stable around it's trend line, and the concept of mean reversion almost certainly applies here.

Looking at the trendline on the WTI:XOI ratio, the bottom of the trend line would indicate a ratio of approximate 0.050.  This implies that even if oil rebounds to $60, assuming the XOI/WTIC returns to it's long term trend we would see a 10% decline in oil stocks.  This in itself is not a great result for oil stock investors, but the downside case is much, much worse. If oil prices continue to fall to $40, which is a very real possibility given deteriorating economic data, the XOI could drop 40% from current levels.

Based on this analysis, it appears that going short oil stocks is once again a very good bet on a risk/reward basis.

Short Positions

As a note of warning, never short companies with great assets or great management teams.  Companies with great assets often become acquisition targets, and companies with great management often find ways to persevere through tough times.   Instead, look for companies with the combination of marginal assets and poor management teams, because these companies are likely to go to zero.  It's not hard to think of names, Canadian Oil Sands and Linn Energy are two that come to mind immediately (and I am short both of these names).

Disclosure: The author is short Canadian Oil Sands (COS.TO) and Linn Energy (LINE)

Cheap Oil, the Dollar, and Deflation

I want to shift gears a little today and open a discussion on some of the wider economic implications of a lower oil price.  The motivation behind this post is a discussion I had with a close friend, a former investment banker who currently works as a corporate strategist for an international oil company.  I mentioned to him how I believed that a lower oil price would almost certainly have deflationary, or at least have disinflationary consequences.  My friend, who is an inflationist, countered with the counterintuitive argument that if lower energy prices stimulate spending in other areas, that spending could result in demand pull inflation.  At the time I wasn't in a position to argue, but his point was not lost on me, so I went home to examine whatever data I could find on the subject.

Correlation between oil price and deflation in past oil price spikes and crashes:

Last week's oil price crash was not unprecedented, and examining past oil price crashes is likely to provide some historical insight.  Recent oil price drops occurred in 1981, 1985, 1997, 2000, and of course 2008.  The price drops of 1997, 2000, and 2008 can be attributed to demand shocks associated with the Asian financial crisis, bursting of the technology bubble, and global financial crisis respectively, whereas the 1985 oil price crash was due to a supply glut after Saudi Arabia flooded the global oil market.  Finally, the 1981 price crash was a combination of oversupply and the early 1980's recession triggered by major interest rate hikes specifically targeting inflation.

In all of these cases lower oil prices led to lower inflation, and even deflation, in the following years as seen in the figures below:

Long term real oil price (www.macrotrends.net)

Long term United States CPI (www.inflation.eu)

When looking at these figures, it's extremely important to acknowledge that in cases where the oil price drops were brought about by recessions it is impossible to attribute disinflationary or deflationary effects to the fall in the oil price.  This leaves the oil price crash of 1985 as the only comparable precedent.  Interestingly, it can be observed in this case that disinflationary effects were short lived.

Disinflationary mechanisms associated with a lower oil price

There are a number of fundamental reasons that we should expect a lower oil price to lead to deflation, at least in the short term.  Chief among those is the impact of the price of oil on the US dollar, as a strong US dollar reduces the price of imported goods and services.  In spite of the recent resurgence in US oil production, the US is still a significant petroleum importer.  As such, the US runs a large petroleum trade deficit, which is US dollar negative.  However, as shown in the following figures, this deficit is shrinking and will continue to shrink, and perhaps even turn to a surplus, due to both lower oil prices and increased US oil production.  This is immensely bullish for the US dollar.

Furthermore, energy, and particularly oil, is an important input to cost of many goods and services.  If the price of oil remains low, we should expect to see some cost savings work it's way back to the US consumer.  In fact, we are already seeing the impact on prices as illustrated by the CPI, and my preferred method of measuring inflation, the BPP index (Billion prices project).  The BPP is perhaps the broadest and most unbiased measure of inflation available, as it measures prices by scraping the internet for prices from hundreds of online retailers.

BPP Daily Index (bpp.mit.edu)

BPP Monthly Inflation (bpp.mit.edu)

Demand Pull Inflation

The crux of my friends argument was that lower oil prices would stimulate spending in other areas, leading to demand pull inflation.  Based on the 1985 precedent, where inflation rebounded quickly after initially falling, the data may actually be on his side.  The arguments against demand pull inflation revolve around consumer deleveraging and economic slack.  If consumers choose to pay back debt instead of spend their petroleum savings, we would not expect demand pull inflation.  Furthermore, if there is enough economic slack to absorb additional demand, the demand pull inflation argument also becomes less compelling.

Measures of household debt appear to be returning to early 2000 levels seen in the chart below.  Although household leverage appears to be stabilizing, there is still some room for leverage levels to decrease further.

Household Debt as a % of Disposable Income (Seeking Alpha via Economics Fanatic)

On the other hand, indicators of economic slack appear to be in line with long term historical levels.  Most of the slack created during the 2008 recession appears to have already been absorbed as shown below:

Indicators of Economic Slack (Wall Street Journal)

With data on household deleveraging mostly inconclusive and data on economic slack showing historically normal levels of slack, it appears that demand pull inflation may in fact be a possibility if consumers spend their petroleum savings.

Conclusions and Investment Implications

It appears my friend has a compelling case for demand pull inflation in the medium-long term. However, in the short term, the US dollar is likely to continue to strengthen and long dated US treasuries may outperform as they will benefit from the current deflationary environment.  That deflationary environment may be short lived due the possibility of "demand pull" inflation, where US consumers spend their petroleum savings on other goods and services.  If this is the case, US treasuries may not be such a good investment in the longer term. It is important therefore to keep a close eye on indicators such as the US trade deficit, household debt, and measures of economic slack.  Personally, I find it difficult to take a position here either way, as timing bond and currency markets is not my strong suit.

OPEC’s miscalculation and the shifting oil supply cost curve

I made my bearish case for oil about a year and a half ago, and so far it appears to be playing out.  This post is a follow up to my prior writing on the subject, given new information since the time of my previous posts.  I now believe the low oil price environment we are now in will persist for some time, and that the price of oil may even slide further.  The reasons behind my current thinking can be summarized as follows:

•   OPEC’s very existence has been threatened by the shale oil revolution because
•  Technology improvements continue to drive down costs in shale oil with the result that
• The oil supply cost curve has shifted downward and flattened allowing for
•  Companies active in oil shale drilling in the US to continue to grow and take share from OPEC even in a depressed oil price environment, the outcome being
• The stabilizing force of OPEC on oil prices will be removed from the market leading to
• Oil prices dropping to the marginal supply cost, which may be as low as $40/barrel for infill wells in established shale plays.

OPEC’s dilemma

The US shale revolution has increased global oil supplies and is cutting deeply into OPECs market share.   In the last 5 years, OPEC’s share has dropped from 41% to below 38%.  While this may not seem like much, the downward trend in share should be alarming to OPEC.  If share dips into the low to mid 30% range, OPEC’s ability to influence global oil prices would be greatly diminished. OPEC’s recent decision not to cut production quotas is a direct response to this threat, and is specifically targeted at US shale production.  It is my belief that OPEC’s actions will ultimately prove futile, and that market share losses will continue.  This belief is based on technological improvements in shale oil production in addition to the fact that oil shale players should be able to continue to increase production at lower prices without further exploration by drilling sweet spots in established plays.

Technology improvements driving both cost and productivity

A number of technological factors have contributed to increasing productivity of shale oil wells and lower unit costs.  These factors include:

Greater fracture consistency:  Fracture techniques have evolved to allow for more targeted, consistent fracks.  An example would be a migration to ball-drop fracks from plug and perf.  An illustration showing the results obtained from improvements in fracture technology provided here. 

Increasing fracture density: With more consistent fracks, oil companies have been able to increase the number of frack stages for a given horizontal well length.  Where a company may have previously employed a 15-stage fracture along a 1-mile horizontal well, they may now have 30 fracture stages.  The additional fracture stages come at a marginal increase in cost and allow significantly more reservoir to be accessed from the same well.  A detailed discussion on frack density is provided here. 

Longer horizontals: Oil producers are also drilling longer wells then they ever had before, made possible by improvements in horizontal drilling technology.  Longer horizontal wells allow for more of a shale reservoir to be accessed from a single well.  A detailed discussion on the horizontal well technology improvements is provided here. 

Pad drilling: Producers are increasingly shifting to pad drilling, which involves drilling multiple wells from a single location.  Pad drilling allows for minimal surface disruption  and fewer rig moves, which significantly reduces costs.  Pad drilling is discussed in depth here.

All of these factors improve productivity and reduce unit costs.  In fact, many companies have increased their type curves by 25-40% in just the past year as discussed below.

US shale companies are raising their type curves

The way to best illustrate the impact that improving technology is having on cost and productivity in oil shale plays is through production type curves.  A type curve is simply a visualization of the production for a typical well in a given hydrocarbon bearing formation over time.  As companies employ more advanced technologies and improve their drilling and completion techniques, production type curves have increased significantly in virtually every single basin.  In the past year, oil companies have been proudly discussing the improvements they have made to their type curves as shown in the screenshots from various company investor presentations below.

EOG - Eagle Ford

EOG - Leonard

Devon - Cana-Woodford

Devon - Bone Spring

Continental - Permian

It’s important to note that it’s not just one company in one basin that is increasing their type curve; it’s virtually all companies in all basins.  Furthermore, both the magnitude and the consistency of the increases have been incredible.  There are companies that have increased their type curve by 20% a year for each of the past 3-4 years with little increase to normalized drilling and completion costs.  This implies unit costs per barrel are falling nearly as fast.

Supply cost curve continuing to shift 

New discoveries and cost improvements in shale oil drilling have led to a major shift in the oil supply cost curve, as illustrated in the chart below (Goldman Sachs via ZeroHedge).

Goldman’s analysis shows full cycle break even costs around $80 for most US shale production, however more recent data from Citi shows even lower break evens in the $60-$70 range (Citi via BusinessInsider). 

Note that these costs are for full field, lifecycle development, which includes land acquisition, exploration, facilities, and infrastructure development.  Break evens for individual wells in established shale plays are lower still, and in a declining oil price environment it’s the break evens for these infill wells as opposed to new field development that matter as companies will shift from exploration to drilling in sweet spots in established areas.  Unfortunately, I don't have data to share here as individual well economic data tends to be closely guarded.

OPEC’s miscalculation

It appears that OPEC’s belief is that US oil producers will be forced to reduce production at oil prices below $70-80, however this is not the case.  While it’s true that most US shale plays have breakeven points above $70, breakeven costs are trending downward.  Furthermore, those breakeven points are based on full cycle development costs, which includes acquiring land, exploration, unlocking the geology by experimenting with different completion methods, and building new roads and facilities in green field areas.  However, a tremendous amount of new oil has already been found in US shale plays in recent years, and much of the infrastructure required to develop it has already been built.

The breakeven point for drilling an infill well in an existing play is MUCH lower than $70, and many oil shale companies have built incredibly deep inventories of infill drilling locations.  What will happen with oil prices below $70 is that oil firms will shift from exploratory drilling to focusing on drilling their best locations in existing fields.  Because of sheer depth of drilling inventory that shale oil companies have accumulated, the production associated with this infill drilling will still be enough to keep US oil production growing in a low oil price environment.

What this means for OPEC is that the decision to pursue maintain production levels in the face of declining oil prices will not have the desired effect of driving out US production and increasing market share.  This will become evident in the months and years ahead as we will likely see US oil production continue to grow in the face of declining prices. 

Long-term implications for the price of oil

For the reasons stated above, I believe the price of oil will continue to fall and remain depressed for many years to come.  Based on falling half cycle development costs in US shale plays, I would expect a long term trading range for oil between $40-$60US.  The prediction assumes that oil demand continues to grow at a moderate place.  Dips below $40 may be possible if we find ourselves in a recession.

Most oil and gas production companies should still be shorts, and oil service companies will be hit even harder.  This is a long-term call.  In the medium-term, especially bearish sentiment at the moment could perhaps set up a short-lived bounce, but I am not a market timer.  My original short “oil services” call was about 6 months early, but has resulted in significant profits to date.

The Bearish Case for Oil – In Charts

In my last post I discussed why oil service companies could make for a great short play.  But there’s a huge caveat to that recommendation – oil prices need to continue their decline to make it work.  In this post, I’m going to try to make a bearish case for oil, supported by current charts and trends.  To give credit where it is due, I lifted most of this data from internet sources which are credited on the charts.

The price of oil, like all commodities, is determined by supply and demand.  For most of the noughties (the decade between 2000-2010), both of these factors were conspiring to drive oil prices higher.  On the supply side, declining oil production in North America along with flattening production at large oil fields in the Middle East were leading to concerns about peak oil.  Furthermore, the war in Iraq, along with the broader war on terrorism and instability in other oil exporting countries added a geopolitical risk premium to the price of oil.  At the same time, the US was enjoying a credit fueled boom as the country rebounded from the recession following the dot-com bubble, and fast growing emerging markets such as China and India seemed to have an insatiable demand for resources.  The rapidly rising price of crude seemed to do little to quench the resulting global appetite for oil.  These conditions have changed for the worse.

US oil supply rising

With the adoption of horizontal drilling and multistage fracturing technology, US oil supply increased dramatically over the past 5 years.  Although we are still well below the peak levels seen in the early 70s in absolute terms, it’s the rate US oil supply growth that has been nothing short of incredible.  What’s more significant is that the supply response to the high oil prices of the noughties has simply dwarfed that seen in the 80s after the 70’s oil crises.  This rising production trend looks set to continue, at least in the near term, as new production is being brought online.

Global oil production rising

In the high oil price years between 2005-2008, global oil supply was in a downward trend, giving some credence to those who espoused peak oil theory.  This trend has now reversed with new supplies coming not only from the US, but also from Canada, Brazil, Russia, and of course OPEC.

US oil demand falling

US oil consumption, on the other hand, has been falling.  The weak recovery in the US has not been enough to stimulate enough new oil demand to offset increasing energy efficiency.  The net result is lower demand in the US.

Global oil demand also falling

The picture for global demand looks just as bad.  While there has been continued growth in emerging markets, that has not been enough to offset demand destruction in the US and Europe.  Furthermore, with growth in China and India is showing signs of cooling, it is unlikely that this trend will reverse itself in the near future.

Price elasticity works both ways

Historically, oil prices have been relatively inelastic.  The global demand growth of the last decade could not be met by new supply, leading to upward price swings.  Well it now appears that supply has finally caught up while demand has cooled off, so we should expect to see price swings to the downside.

http://www.capgemini.com/blog/sustainability-blog/2012/02/oil-supply-economics

Record oil prices in 2008 were a bubble, reflated by loose monetary policy around the world

In retrospect, the massive oil price spike from 2005-2008 was an obvious bubble.  What’s incredible is that in spite of the weak supply/demand fundamentals described in this post, the oil bubble has actually reflated to levels not far from the 2008 peak.  I’m sure my readers (if I have any) will note that this is likely due to the large scale economic stimulus packages and extremely loose monetary policies pursued after the great recession of the last decade, and I won’t argue that point.  But it doesn’t change my view that oil prices are unsustainably high today.  With supply rising and demand falling, we should expect oil prices to fall to the cost of marginal supply.  Oil sands project economics become challenged at prices below $70-80 so if I were to take a guess I’d expect prices to fall to the low end of that range, or 20% below current levels of around $90.  Prices in the low $70s do not seem unreasonable to me, and even if they were realized the long term trend of higher prices that began in the early 2000s would remain intact.