With markets on the move on the heels of today's Jobs Report, below legendary Jeremy Grantham warns "Nothing like this has ever been experienced before." Another legend in the business repeatedly cautions people to keep an eye on bank runs in Greece.
By Art Cashin Director of Floor Operations at UBS
February 6 (King World News) – The markets weren't quite blazing Thursday. Things were warm and glowing but not quite blazing.
February Bull Run Continues – Stocks in New York opened smartly higher at Thursday's opening. The acrimony in Europe seemed to temper a bit. Merger mania was in the air and the morning's economic data was generally supportive.
The rally continued and even expanded into late morning. About that time, I sent this note:
Primary motivator was flurry in M&A activity with a bit of help from the crude bounce. The S&P stopped short of the key band at 2064/2067 (right shoulder of H&S).
Traders will watch for any signs of bank runs in Athens. They are possible and could throw Europe into a jumble.
After noon, stocks churned horizontally and trading slowed slightly. I noted that in this follow-up:
Compared to recent days the market is almost comatose. Traders continue to watch crude and the streets of Athens.
Run rate at 12:30 projects to any NYSE final volume of 770/850 million shares.
(The final NYSE volume was 793 million shares.)
The lateral trading took on a life of its own and traders began to monitor the range. I pointed that out in another follow-up:
Markets continue to trade just below late morning highs – – S&P (2060), Dow (17850) and WTI ($52.10). Bulls may need to punch through to avoid image of a ceiling developing.
The equity markets kept testing those levels through much of the afternoon. Oil, however, eased back, under $51.
Around 3:25, the Dow pushed above that 17850 level and spurted over 60 points higher. The S&P got though the 2060 ceiling but could not attain liftoff. Its high was under the 2064/2067 level I had cited in my first note. That leaves the technical picture unclear.
Oil's Well At The Oil Well – In the latest GMO market letter, Jeremy Grantham walks us through some fascinating aspects of the fracking influence in today's oil market and the economy. Here's a bit (editor's note: the $32 per barrel price he notes is where North Dakota Williston Crude traded in late January):
The unique features of U.S. fracking
So what happens now? We originally heard a brave story of how increased fracking production would cheerfully continue full steam ahead, even at prices below $40 a barrel. This is of course nonsense: it was not clear that the U.S. frackers were making very good money collectively at $100 a barrel. Now, at $32,1their cash flow drops by $68 a barrel (less taxes, etc.) and we are meant to believe that they are merely winded. Rigs are being rapidly withdrawn as I write. What is not realized yet, although very shortly will be, is how rapidly fracking wells deplete. Even some of the recent impressive improvements in “productivity” have been moving more of the total output into the first year. Up to 65% of all of the available oil is now often delivered in the first year!
Even in the heyday last July, 75% to 80% of all new production in the Bakken was needed to offset the decline from existing “legacy” wells. It could be worked out that daily production would start to decline with only a 25% reduction in oil rigs at work, a level we are rapidly approaching. Thus, at current or lower prices, Bakken production should turn down by June and possibly by the end of the first quarter.
Meanwhile, back at the head office, several of the “majors” are also savaging their capex budgets for regular oil development. Unlike fracking, which takes days to adjust, old-fashioned oil, which is increasingly deep offshore or in countries that we can all agree are more difficult to operate in than, say, North Dakota, can take 5 to 10 years (and occasionally 15) before a planning dollar becomes gas in the tank.
Spending cuts, therefore, will echo into the quite distant future as reduced oil production for which there will be no quick fix, for by then any increases from fracking will be distant memories. And this is a key point: U.S. fracking is the only important component of global supply that can turn up almost immediately by bringing in new rigs and drilling wells in under two weeks, adding 20-30% to production in a year as it did for each of the last two years. It is also the only important component that can turn off quickly by depleting almost completely in three years.
As with Alice’s Red Queen, if you pause for breath in fracking you go backwards: more wells must be drilled all the time to even stay still as the wall of rapidly depleting wells builds up behind you. Nothing remotely like this has ever been experienced before so drawing wrong conclusions, as if the traditional data applied, is particularly easy.
The New Oil Balance
Lower oil prices and much reduced capex will guarantee that oil from fracking will start decreasing this year and that the supply of traditional oil will be less than it would have been. Indeed, at recent prices very few, if any, new drilling programs will be started, and a mere three years later at current prices, 80% or so of Bakken production would be history. But right now we have a substantial excess of production, and oil demand is notoriously inelastic to price in the short term – people will not be leaping into their cars to celebrate lower gas prices.
But with time they may drive an extra 1-2% percent here and elsewhere and the excess will slowly clear: possibly by mid-year and almost certainly by the end of next year. After supply and demand come into balance, the price initially is likely to rise slowly, held in check by the increasing amounts of U.S. fracking oil that can be profitably produced at each new higher price level. It is this rapid response rate that will make the frackers the key marginal suppliers. This is a sensitive and, I believe, unknowable equation as to precise timing, but this phase will likely end only when fracking production, even at much higher prices, tops out, as it most likely will in the next five years.
After that, I believe the equation will revert to the relatively more stable and more knowable one of the 2011 to 2013 era, in which the price of oil will be the full cost of finding and developing incremental traditional oil, which by then is likely to be over $100 a barrel. (In the interest of full disclosure I personally have been and will continue to be a moderate buyer of oil futures six to eight years out, for reasons that should be clear from the above. It should also be clear that such a bet can lose easily enough.)
King World News note: Below is an incredibly important summary of Grantham's extraordinary piece:
- The simplest argument for the oil price decline is for once correct. A wave of new U.S. fracking oil could be seen to be overtaking the modestly growing global oil demand.
- It became clear that OPEC, mainly Saudi Arabia, must cut back production if the price were to stay around $100 a barrel, which many, including me, believe is necessary to justify continued heavy spending to find traditional oil.
- The Saudis declined to pull back their production and the oil market entered into glut mode, in which storage is full and production continues above demand.
- Under glut conditions, oil (and natural gas) is uniquely sensitive to declines toward marginal cost (ignoring sunk costs), which can approach a few dollars a barrel – the cost of just pumping the oil.
- Oil demand is notoriously insensitive to price in the short term but cumulatively and substantially sensitive as a few years pass.
- The Saudis are obviously expecting that these low prices will turn off U.S. fracking, and I’m sure they are right. Almost no new drilling programs will be initiated at current prices except by the financially desperate and the irrationally impatient, and in three years over 80% of all production from current wells will be gone!
- Thus, in a few months (six to nine?) I believe oil supply is likely to drop to a new equilibrium, probably in the $30 to $50 per barrel range.
- For the following few years, U.S. fracking costs will determine the global oil balance. At each level, as prices rise more, fracking production will gear up. U.S. fracking is unique in oil industry history in the speed with which it can turn on and off.
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In five to eight years, depending on global GDP growth and how quickly prices recover,
U.S. fracking production will start to peak out and the full cost of an incremental barrel of traditional oil will become, once again, the main input into price. This is believed to be about $80 today and rising. In five to eight years it is likely to be $100 to $150 in my opinion. - U.S. fracking reserves that are available up to $120 a barrel are probably only equal to about one year of current global demand. This is absolutely not another Saudi Arabia.
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Saudi Arabia has probably made the wrong decision for two reasons:
First, unintended consequences: a price decline of this magnitude has generated a real increase in global risk. For example, an oil producing country under extreme financial pressure may make some rash move. Oil company bankruptcy might also destabilize the financial world. Perversely, the Saudis particularly value stability.
Second, the Saudis could probably have absorbed all U.S. fracking increases in output (from today’s four million barrels a day to seven or eight) and never have been worse off than producing half of their current production for twice the current price … not a bad deal. - Only if U.S. fracking reserves are cheaper to produce and much larger than generally thought would the Saudis be right. It is a possibility, but I believe it is not probable.
- The arguments that this is a demand-driven bust do not seem to tally with the data, although longer term the lack of cheap oil will be a real threat if we have not pushed ahead with renewables.
- Most likely though, beyond 10 years electric cars and alternative energy will begin to eat into potential oil demand, threatening longer-term oil prices.
***ALSO JUST RELEASED: Billionaire Eric Sprott Just Made One Of The Most Dire Predictions Of 2015 CLICK HERE.
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