Stop selling us short

Colin Welsh, CEO of Simmons & Co. International Ltd.

April 1, 2016

Recent increases in crude prices and oil stocks belie the reality that exploration and production activity continues to weaken and there is no prospect of it improving in the near future. Spending on oilfield drilling and services has fallen further, hundreds of jobs are disappearing every month, and for most companies cash is running down or out. Only the fittest companies are going to survive this downturn.

Data from Quandl.

The outlook for 2017 is, however, better than many analysts had predicted. The fact that all oilfields decline, and if there is little or no money spent on them they decline faster, is beginning to show in production numbers.

The long anticipated 4 MMb/d from Iran that was expected to swamp the market will take some time to appear because Iranian oilfields have had little investment or technology applied to them in recent times. Concerns about imploding emerging markets oil demand also appear to have calmed.

Schlumberger summed up the situation nicely in a recent presentation:

“E&P activity continues to weaken. We expect this to continue well into the second half of the year (2016). The market will return to growth when the production deficit becomes pronounced. The recovery in service activity will lag higher oil prices by some time. The longer E&P investment is below production replacement needs, the sharper the market recovery will have to be to meet demand.”

If you are looking for an accurate prediction of short-term oil prices, I suggest you consult an oil trader or hedge fund manager, because it’s their derivative contract activities that have driven prices down to levels that don’t make sense from any economic perspective. These bets are predicated on news flow and the direction of the herd rather than fundamentals. This is well illustrated by the recent 40% rise in oil prices driven by a 15% reduction in the number of short positions when Russia started talking about the potential of a production freeze (a suggestion that is of little value when those offering it are already producing at maximum levels).

The market will recover, but it’s impossible to predict when with any accuracy. In the interim, we have to live with continuing trauma.

The unfortunate consequences of making long-term decisions based upon short-term prices are that it is catastrophic for many companies and the people involved, it damages the industry, and makes it really hard to ramp up activity when the market needs it. Much of the damage is irreparable, e.g. when key infrastructure is decommissioned or core expertise leaves the industry permanently.

The late founder of Simmons & Company, Matt Simmons, used to refer to oil and gas as “industrial oxygen” – an apt description of its critical role in so many aspects of our lives.

Perhaps there should be a ban on short selling crude contracts, similar to the ban on short selling banking stocks that was put in place during the banking crisis. This would stabilize crude prices and avoid the partial dismantling of the industry that is currently underway. It would also enable the determination of a sensible, long-term energy policy.

Colin Welsh is head of international energy investment banking at Simmons & Co. International, part of Piper Jaffray. He studied accountancy, economics and law at the University of Aberdeen and qualified as a Scottish Chartered Accountant with Ernst & Whinney (now EY).