Andy Hall: Global Oil Demand To Be Higher Than Many Expect

Oil prices fell 8% on Monday, proving to anyone who still needed the lesson that macro is hard and pricing commodities isn’t for the faint of heart. But in a July 1st letter to investors reviewed by ValueWalk (ie, before Monday) Astenbeck Capital Management chairman Andy Hall explained why we should be too concerned about short-term bumps.

“Despite the lackluster price action, underlying fundamentals for oil continue to improve,” he wrote. “Low prices really do cure low prices and it’s not just on the demand side of the equation either. Supply will inevitably be affected by the 40 to 50 percent drop in oil prices over the past year – it just takes longer for the impact to manifest itself.”

Andy Hall

Andy Hall – Global oil demand might be double initial expectations

In the US year-on-year oil demand is up 4.6% (reaching 7.2% in June), miles driven is up 3.9%, and gasoline consumption is up 5.1%, so it’s fair to say that demand has responded to lower prices. Hall also points to strong oil demand in China and India, the second from a very low per-capita level, as well as the finally recovering Europe as reasons that the annual growth in global oil consumption could end up being twice as high as initial estimates.

Andy Hall – Why shale oil is so sensitive to price movements

Hall also explains the role that US shale oil now plays as marginal supply that can modulate their production in response to price movements. Shale oil wells have a much shorter lifespan than their traditional counterparts, producing 60% or more of their total output in the first year while a traditional well might pump oil for decades. So even though US shale only accounts for about 5% of global oil, that percentage can shut down and then come back online a lot faster than the rest of the industry.

It’s also economically feasible to hold back on shale oil. Delaying a short project for a year to benefit from higher prices is profitable (as long as prices do in fact recover). But if you’re operating a traditional oil well the one year you don’t drill right now would show up as an additional year of production years or decades into the future. Once you discount that extra year back to the present day it would require an enormous change in prices to justify the wait.

Andy Hall – Two reasons long-term oil production may decline

But that just tells us that traditional oil wells won’t shut down as long as price of oil covers the cost of keeping the pumps running, a very low bar. Many of those same wells aren’t economical on a full cycle basis at $65 per barrel, let alone the mid-50s we’ve seen recently. Since Saudi Arabia has decided to favor production and market share over high prices, expensive sources of oil like deepwater drilling and Arctic wells won’t be launched. If prices get high enough that investors start looking at these difficult projects again there will also be a substantial delay before they can actually get oil to market.

Even if production in the continental US ramps up completely, with a jump around $65 and another around $80, Hall argues that it won’t be enough to offset the decline in oil production from currently uneconomical sources. When you throw in the geopolitical instability in the Middle East and North Africa, the possibility of major disruptions that have nothing to do with prices could push prices up even more.

Andy Hall

“Iraq is fighting a civil war which it appears to be losing putting its ability to continue growing production at risk,” writes Hall. “Meanwhile, Saudi Arabia is fighting a proxy war with Iran in neighboring Yemen. It is also facing an existential threat from ISIS which is endeavoring to stir up sectarian unrest in the oil producing east of the country – home to most of Saudi Arabia’s large Shiite minority.”