Shorting Oil, Hedging Tesla

[jhm]

Marginal revenue is

dR_0/dQ_0 = P + Q_0×dP/d's
= P + K Q dP/dQ
= P (1 + K/ PED)

Yikes, autocorrect screwed up my formula. Should be

dR_0/dQ_0 = P + Q_0×dP/dQ

In any case, I hope people can appreciate the conclusions. It's always been a puzzle to me why a player like the Saudis wouldn't just keep increasing market share until they were physically unable to do so. Now I see more clearly why big players value market share and do not want to dilute revenue.

I think this sort of analysis comes close to explaining why big auto does not want to develop competitive EVs. It actual impacts in two ways, it increases supply at an insufficient markup, but it also makes demand for gasmobiles more elastic. This latter effect is more subtle, but it is most problematic. Eventually, Tesla will gain enough scale and product depth that demand elasticity for gasmobiles is compromised, especially for higher performance cars.

 

[neroden]

This condition on marginal income can be expressed is margin profit rate, thusly,

(P - C)/P > - K / PED

Thanks for this. Thanks very much.

Keep in mind that PED is a negative number. So what this condition for increasing production means is that the marginal profit rate for a major producer needs to be proportional to its market share. Thus, bigger producers are looking for a bigger markup opportunity before they take on a project to increase supply.

So think about Saudi Arabia sitting on about 10% market share. If PED is about -0.13, then the Saudis are looking for a markup of about 77% = 0.1/0.13. I think this is about right based on behavior.

Now consider what happens if new technology inceases absolute elasticity. Suppose PED shifts to say -0.4. Then the Saudis would be looking to increase market share if they could get a markup of just 25% =0.1/0.4, whereas they used to pass on anything with less than a 75% markup in the past.

Hmmm. Let's suppose PED magnitude only goes up a little, to -0.25 (so doubled from -0.13; so a change from $40 oil to $50 oil causes a demand drop of 6.25%). This makes the Saudis' desired markup 40%.

The Saudis are widely believed to have a production cost of $10/bbl on new drilling. This gets them their 77% markup at $45/bbl. However, a 40% markup would be... $18/bbl.

Oooh. Ouch. Now, the thing is, nobody else has a production cost that low...

The astounding implication here. Is that as oil demand becomes more elastic, oil producers will fight more fiercely for market share even as their profitability declines. We should see consolidation across the industry. So watch merges and acquisitions rise. Meanwhile petrostates will falter from declining margins. The enormous profitability of crude has been derived from lack of any clear alternative, but all this is changing.

This is gonna happen very, very fast, isn't it? Now, right now, Saudis are deliberately propping up the price of oil in order to float the Aramco sale. As soon as they've cashed part of Aramco, they should go back to short-term profit maximization, and max out pumping at any price over $18/bbl.

I wonder if we can analyze any of the other major players with large market share individually to work out their markups, marginal production costs on new wells, and therefore their target prices above which they drill more.

 

[jhm]

Meriden, I'm glad you like this. We're on the same page regarding Aramco. Post IPO I think it will all go back to drill at will. M&A activity will scoop up the carnage.

There are various reports that estimate break even levels for different countries. I think we can cross this to market share data. One caveat is that some countries like the US have lots of competitors. They do not set production under one centralized authority, so you cannot use the national market share to explain much. A better analysis would be by company. Also corporate fillings would indicate production and gross margin. So let's keep our eyes open for this sort of data.

We might think a bit about how US oil majors are diving into shale right now.

 

[neroden]

Meriden, I'm glad you like this. We're on the same page regarding Aramco. Post IPO I think it will all go back to drill at will. M&A activity will scoop up the carnage.

There are various reports that estimate break even levels for different countries. I think we can cross this to market share data.

Yeah. I would love to read it if you collect it. ;-)

One caveat is that some countries like the US have lots of competitors. They do not set production under one centralized authority, so you cannot use the national market share to explain much. A better analysis would be by company.

Oh yeah -- it's easy enough to find the well production cost for the Integrated Oil Companies, and it's easy enough to find their market shares. Though I've been too lazy to do it! The National Oil Companies are the hard ones. Basically every country is either "national" or "open market", and the IOCs drill all the oil in the open-market countries. There are a few "mixed" countries with both NOCs and IOCs but they don't produce enough to be important.

 

[jhm]

Neroden -> Meriden, autocorrect strikes again! Ducking posses me off.

 

[jhm]

Oil Companies’ Modest Prize: Breaking Even
Well here are some daring breakeven prices. As long as the dividends keep comimg...

So debt throws a wrinkle into the above theory. Producers can be pressed into continued overproduction in service to debt and apparently to dividend imvestors. So while they cannot find sufficient markup to expand production, they shrink a bit which is in agreement with the theory. But they do not seem to be reducing production fast enough to optimize total return, and this reflect attending to liquidity problems.

 

[replicant]

Meriden, I'm glad you like this. We're on the same page regarding Aramco. Post IPO I think it will all go back to drill at will. M&A activity will scoop up the carnage.

Somewhat related: I recently spoke with a risk manager at a large agro-industrial group, who's the leading European producer of biodiesel. I asked him how the Dieselgate would impact his activities and I was surprised to hear that he considers this an opportunity. Because they're owned by oildseeds producers, they'll have to fight for this market until death, while their competitors – who are just traders, like Cargill – are expect to leave the market quite soon (they can take some losses and switch to other activities). This scenario reminded me of Saudi Arabia vs US frackers.

 

[neroden]

And the reason why the fossil fuel companies will continue overproducing right into bankruptcy and beyond:

Most Lucrative Energy Job? Some Say It’s CEO of a Bankrupt Company

 

[renim]

....
I think this sort of analysis comes close to explaining why big auto does not want to develop competitive EVs......

no, no, no, but the result is the same

• big auto, their executives all rose through the ranks by mitigating risk. EVs are an unknown, with a major risk issue. So only the CEO / founding owners could sanction major expenditure on EVs.
• ToyoHondaHyundai were all in the H2 camp anyway, so anti EV. (Seriously, Toyota IP expense on H2 was enough to buy Tesla circa 2012)
• GM went with both EV and PHEV, but prioritized bringing PHEV to market so not to encourage CARB.
• Ford didn't believe in EV, EVs was what the Model T competed against a century ago.
• RenaultNissan spent 5 billion on EVs, so all in so to speak, but Carlos Ghosn is not a typical automotive CEO (like Elon Musk, Carlo Ghosn is from the developing world, not the developed world)
• VW - diesel was the future

different reasons, but fundamentally only RenaultNissan went all in on EVs and that was because their marketing department believed in the 100 mile EV as being a real option (due to significant number of Renaults in EU never drive more than 100mile in a day from dealer door to crusher.

now things are different, China is the real driver, what their plans are is not plain yet, but 50km Chinese range (probably same as EU) PHEVs apparently may become the minimum spec required. Obviously EVs can happily co-exist with 50km+ range PHEVs

(batteries are like airbags, lots of risk taken by the automaker, even worse, lots of revenue to battery maker, lots of risk to automaker)

 

[jhm]

US ommercial crude inventory is up 1.6 mmb this week. I hear there is endless demand just around the corner.

 

[TheTalkingMule]

US ommercial crude inventory is up 1.6 mmb this week. I hear there is endless demand just around the corner.

So I have a question. It's been clearly illustrated that IEA, analyst, and producer "projections" are so nonsensical that they should almost be completely ignored. If these "analysts" are now present at OPEC meetings, and we can assume have an insiders grasp of domestic production, at what point does this see-saw game become fraudulent?

From Bloomberg today.....

Crude pared gains after government data showed U.S. stockpiles climbed to a record last week as production increased.

Supplies rose 1.57 million barrels to 535.5 million, the most in weekly data going back to 1982, the U.S. Energy Information Administration said Wednesday. A 150,000-barrel decline was forecast by analysts surveyed by Bloomberg. Output grew 52,000 barrels a day to 9.2 million, the highest since January 2016. Refineries processed more crude as they boosted operating rates.

I guess it's just our fault for listening to analyst surveys, but this seems to be getting more and more shady as the end nears. Not to difficult to connect the dots here and see how a few extra billion could be made if the right folks are sharing the real info on a weekly basis and the right folks choose to "project" a rosy scenario.

How is there not a way to prove that? Can you not track if someone is right most of the time?

 

[SebastianR]

If we are trying to understand the production glut, then this post is informative:

Don’t Be Fooled By Daily Oil Prices | OilPrice.com

Here is an interesting point of view regarding drilling costs vs oil and gas prices. When oil and gas prices rise, so do the costs of drilling and completion. However, if you look closely at the higher price timeframes you’ll notice something very interesting - actual margins from higher oil and gas prices compared with the higher drilling and completion costs are relatively the same margins as when commodity prices and drilling costs are down.

So, with that being said, why not drill all you can when drilling and completion costs are significantly down, rather than waiting for oil prices to increase before drilling. Thus, when prices do go up, you have a realistic chance of cashing in on a true windfall. In like manner, if you wait to drill until prices are higher, you diminish your true upside potential.

A wise old production engineer once told me that in order to maintain a company’s operational capabilities, at a minimum you need to replace every barrel of oil you produce with two barrels due to production declines and company growth needs. So, keeping that in mind, it is also a good idea for companies to be able to continue to develop their leases even during daily pricing downturns

(bolding mine)

He also says that you need to be profitable at around $12/barrel and that you are doing it if you are not... The key argument is: oil prices have been going up and down for some 150 years. No need to worry about oil prices if your costs are low enough. He advises not to do hedging etc. Quite a "basic" or "simplistic" world view - my industry could not survive with this level of sophistication.

So my take is twofold: First, wow - this reads like a blast from the past. Secondly, I'm quite happy with the fact that we will have a perma-glut at mini prizes soon and that we don't need to rely on the oil business to go bankrupt because of lack of profit margins. The way the industry seems to be run you could squeeze out quite a bit more profitability with modern financing instruments.

 

[neroden]

Interesting article to read from an outsider perspective as an insight into the minds of the oilmen: and very much seems to be written by someone who doesn't have a clue about the (nonexistent) future of his industry.

A wise old production engineer once told me that in order to maintain a company’s operational capabilities, at a minimum you need to replace every barrel of oil you produce with two barrels due to production declines and company growth needs.

Can't. Can't even replace it with one barrel. Stopped being possible circa 2008. Try to do that, you find your breakeven costs are way up there in the $40s... This is because peak cheap oil is in the rearview mirror already.

The oil industry has always had booms and busts driven by supply, because of the lag time between high prices and high production. The rule of thumb among the old oilmen was "never borrow to drill". However, the shale "revolution" changed all that and they all got highly leveraged. Now Exxon, Chevron, et all are loading up on debt too. So the "more profitability with financing"... they've been doing that since 2005 or so.

He actually warns oilmen not to expect prices to go back up. What he doesn't get is -- they need prices to go back up, or they are permanently unprofitable. There is no $1/bbl oil left to find.

The thing is, as they continue to drill into a glut, they are going to be *completely* blindsided by drops in demand. They simply don't understand the *concept*. And now that they're leveraged, the stockholders are in a much worse position. Someone sitting debt-free on an oil well will still do OK for quite a while, but someone who's borrowing to the hilt -- that's when the bankruptcy happens.

I've spent a while calculating the substitution point. Should probably recalculate it every six months. Anyway, I calculated it again.

This time using
-- Model S efficiency (.38 kwh/mile -- most electric cars should be more efficient),
-- national average electricity prices (12.22 cents/kwh -- solar and wind should bring this down),
-- average national new-car fuel efficiency (24.8 mpg!!),
-- along with JHM's regression of national gas prices versus WTI (here : Shorting Oil, Hedging Tesla ),

I find that the national-average price at which oil becomes competitive with electricity as a motor vehicle fuel is... wait for it...
$8.80/bbl

Nobody can drill a well with a breakeven that low. Nobody.

If we assume 56 mpg Prius Eco, of course, we get $64.31/bbl. But even the Prius c (46 mpg) calculates out to $46.51/bbl. The most efficient non-hybrids get 35 mpg, which gives us $26.94/bbl, and they're econoboxes.

The light truck situation is even more extreme. Best non-plug-in gasmobiles get 22 mpg. Compare the highly inefficient BYD e6 (0.47 kwh/mi), and you find the substitution price of oil is $13.08/bbl.

It's going to be hard to sell people on paying a premium for gasmobiles, which shake, rattle, are noisy, have poor responsiveness, and require oil changes and trips to the gas station. Purchase price parity for electric cars == death of gasoline car sales. And that's it for oil prices; aircraft kerosene sales cannot make up the difference.

For those who wish to calculate such scenarios themselves, the formula is

WTI price where electric is same price on average in US == ( electricity price $/kwh * EV fuel efficiency kwh/mi * ICE fuel efficiency mi/gal - $0.922) / .0261

Note that in almost every foreign country, gas taxes are higher, so the price of oil at which substitution makes economic sense is even lower. So I'm actually rigging this in favor of the oil companies.

If a company happily drills secure in the knowledge that they break even at $12/bbl, they'll be losing money when the oil price drops below that. Which it will.

 

[SebastianR]

@neroden - thanks for the above. Great reading and great thinking. Of course what you compare are the running costs of energy and not the one-time investment costs for buying an ICE vs. buying an electric vehicle. Which of course is all fair enough and doesn't take away from your points.
So what I'm wondering about is the cost of financing for a carbon economy vs. a non-carbon economy. You mentioned the risks of leveraged oil producers, but that's not what I'm after right now. I find that one of the key stumbling blocks for the adoption of renewable energy in developing countries is the upfront capital needs of renewables - which are typically higher than those for carbon power plants, ICE vehicles etc.

So very true to idiom "it's very expensive being poor", financing costs may keep significant portions of the global population stuck in a carbon economy (and that's the standard BEV bear argument "toy for rich people"). Of course I have high hopes that renewables are falling quickly enough in terms of costs, to make this a temporary problem but for now it persists. Thus I think it is great news if e.g. the World Bank gives out cheap loans for renewable energy projects (ref. the Electrek briefing a few weeks ago).

So what I'm pondering is: Are low interest rates helping rewables more than the carbon industry? Or is it the other way round? I feel that financing is, what broke Solar City's neck - on the other hand I also believe that much of the cheap financing is responsible for a lot of the utility driven push to change to renewables.

 

[jhm]

Hey Neroden, there are a couple of points that simplify things.

One, while there is a wide diversity of fuel efficiency in vehicles, the relative efficiency of ICE to electric is fairly stable. Consider one EV at 0.32 kWh/mile comparable to an ICE vehicle with 25 mpg. Or another EV with 0.25 kWh/mile comparable to 32 mpg. In terms of fuel displacement both EVs are identical. The both have a displacement ratio of

8 kWh/gal = 0.32kWh/mile × 25mpg
= 0.25kWh/mile × 32mpg

So this sort of displacement ratio should be fairly stable over a range of vehicles, driving conditions, and driving styles.

It also helps us estimate the lifetime displacement of a battery. Suppose a battery has a cycle life of 1000 cycle, that is, you can expect a life discharge of 1000kWh per kWh of battery. Then the life displacement is 1000 ÷ 8 kWh/gal = 125 gal per kWh of battery. So here we don't need to be too worried about how many mile per day are driven, how big the battery pack is, how efficient the vehicle is, and so on. All that sort of complexity washes out once you assume that there is sufficient motivation to use a battery until it ceases to be useful. For example if the first owner puts low miles on a car, then the second owner may well rack up miles faster than the first, putting a premium on a car with a lightly used battery. So it all washes out. And this also makes it easy to quantify the impact of Gigafactory capacity. For example, 100GWh of batteries can displace about 12.5B gallons.

The other point is that some analysts like to assume increasing mpg on conventional vehicles as a way to down play the displacement of EVs. It believe this is a deceptive red herring. Consider this, about 66 mb/d is used for motor vehicles. Now suppose this fleet now has an average 25mpg, but is expected to increase to 35mpg in a certain number of years. Does this have any impact on EVs? No, it is irrelevant information meant to distract from a bigger problem. That is, assuming the same size conventional fleet, consumption falls from 66 mb/d to 55 mb/d. An 11 mb/d decline in consumption is a much bigger hit in ten or so years than EV displacement. It would be a devastating loss of oil demand. So the problem is that the ICE fleet has to grow very fast to out pace the impact of increasing fuel economy. That is, as the fleet average increases from 25 to 30 mpg, the size of the fleet must grow by 20% just to maintain the same level of consumption.

Furthermore, anything that weakens demand for ICE vehicles compromises the growth needed to sustain oil demand. So the threat of EVs to oil is not simply displacement of demand for gasoline, but it is a potential Oswald effect for ICEVs. Just slowing their growth will undermine demand for oil. This is why the sex appeal of Tesla is so threatening. I undermines the enthusiasm consumers have for conventional vehicles. This is true both for those seeking an impressive ride and those who are looking for economy. If you have to get 50mpg or more just to be at parity with an EV on fuel economy, then why not just get an EV which will be more fun to drive? So across the spectrum EVs will erode demand for gasmobiles, nostalgic motorheads notwithstanding.

So the idea that an EV only displaces a super efficient ICEV in the future already concedes that oil demand is in decline. Certainly, oil demand per vehicle Is falling either way. So as unit growth in convention cars slows, we slide past peak demand for oil, even before the fleet begins to decline in size.

 

[neroden]

So very true to idiom "it's very expensive being poor", financing costs may keep significant portions of the global population stuck in a carbon economy

You're absolutely right, of course. Once purchase price parity is reached, however, I figure financing will be just as easy for an electric as for a gasmobile, and I expect this will be visible in the used car market.

So what I'm pondering is: Are low interest rates helping rewables more than the carbon industry? Or is it the other way round?

Renewables are more upfront-capital-intensive and less operating-costs-intensive than fossil fuels, meaning low interest rates help renewables more. I believe this effect dominates over all others.

 

[adiggs]

Brent over $60 within 3 months.

I read it here, today:
The Insignificant Truth: Why Gasoline And Distillate Draws Don’t Matter | OilPrice.com

The title does a remarkably good job of seeming irrelevant to me relative to the content of the article (they say the finished product draw doesn't matter, but I think the writer missed 2 or 3 steps in the logic process, and just assumes that the reader can fill them in - I do that myself sometimes ).

The conclusion is clear and unambiguous though. US inventory draw is inevitable - global inventory draw has begun and inevitably, the US must follow. And thus, Brent to $60 in the next 3 months.

 

[adiggs]

Or maybe, "we have too much oil" (quote from this article):
OPEC Deal Extension Looks Shaky As Shale Hedges Production | OilPrice.com

With what looks to me like an early harbinger of a double whammy coming to the oil market. Shale producers are busy hedging their future production, with this article being the first instance I've seen with some numbers to it. Namely - 1/3rd of big producers have 26% of their future production hedged. The precision of the numbers .. I have some doubts about how precise they are. But as an order of magnitude, that isolates producers from downside risk to a noticeable degree.

And with all that hedging leading to all that new shale oil coming to market, that will further pressure the individual actors within OPEC to either not sign on to another round of supply suppression, or to stop / reduce compliance. OPEC is good for another 1.8M bbl/day of withheld supply today (90%+ of that anyway based on compliance), and I see little reason to believe there will be much delay in bringing that supply to market in a matter of days or weeks (certainly not years, and probably not months).


Future US shale oil supply locking in nice future prices around the $50/bbl level, and 1.8M bbl /day of OPEC oil being withheld from the market - that's a lot of extra supply to soak up, in a market that looks like stagnant or declining demand.

 

[neroden]

Well, remember, demand decline doesn't really kick in *big time* for a few years... I'm still waffling between my two scenarios for oil price over the next decade (which we could call "up then down" and "just down").

 

[jhm]

Ok, I'm looking at Brent futures again. Here's Dec 2019.

Notice how strong the down trend was. I noted that before the recent tumble and saw trouble forming. Then the price fell. It has since found a floor and clawed back up. But now it looks like it is hitting resistance right where the down trend would put it.

So it appears that this downward channel may consider. I am not a technical trader, so that is not the basis of my concern. My interpretation is that producers are selling futures. I see this as driving the down trend. When the price broke down, this out the price too low to be useful for hedging. So selling pressure stopped as the price hit the floor. The recovery of price brought it back to a level useful for hedging. So the hedging can and must continue, and so the down channel resumes. I'm really not sure where this will end, but I don't see how the front end can maintain current prices.