The Intelligent Quant INTL FCStone’ November 2018 “Lalways tried to turn every disaster into an opportunity” John D. Rockefeller This Rockerfeller quote reminds us of two important lessons. Firs, billionaires and management consultants both utter philosophical truisms, but only the former act on them. Second, real money is rarely made in tame markets: wealth is built by overcoming one’s feelings of fear and keeping the eye on the prize (which is coincidentally the title of the greatest book Lhave read on the oil marker) This report will argue that the painful, sevenaveek long (and counting) oil market disaster may offer investors such an. opportunity in 2019. The first part will argue that the secular case for oil remains intact, as evidenced by the fact that oil prices are still 100% above their 2016 lows. © The valuation of oil versus financial assets still suggests that oil prices are t00 low. The behavior of energy stocks, which fall in tandem with oil prices but fal to participate meaningfully in any oil rally, indicates that investors have capitulated on the sector. © The mountains of cash burnt by U.S. shale exploration and production companies sugyests that the industry needs higher prices. Or it will run of other people's money to spend, which will likely happen anyway based on my forecast for a global savings squeeze. The collapse in investment and new discoveries will eventually have its predictably negative effect on global oil supplies The second part will try to explain why oil prices are collapsing despite this bullish secular outlook, My case will be that supply and, to a lesser extent, speculative excesses, were the primary reasons for the selloff. A century and a half of repeated oil crashes taught us that the oil market tends to fall towards entropy unless prices are managed by a coalition of large producers. The Saudi diplomatic fiasco, Russia’s indifference to OPEC, and an unexpected easing of USS. sanctions on Iran broke the necessary discipline to keep prices in check, Of course, it is always possible that the oil crash is an early sign of a much more dangerous beast, like a global recession or an implosion of the Chinese credit bubble. But I do not believe that we have seen enough evidence to make such a momentons call. Also, from that perspective, the collapse af ail prices it brings relief to its weakest links: China, Europe, and non-oil producing emerging markets. the hest passihle news for the glahal ecanomy as My friend and former colleague Warren Pies contributed the third pare. Warren cut his exposure to oil in August, so I asked him what it would take to turn bullish again, 1 ~ Better inventory data: Warren's model, which normalizes inventories over all petroleum products, motivated his September downgrade, While the latest data is not as bearish as it was during the big oil glue of 2015-2016, inventories still need to improve. 2- An increase in Brent differentials: itis hard to for oil prices to rally sustainably when the most important contract is showing signs of relative weakness, as it has this past month. 3 - A return to backwardation would indicate that the current supply glut has been absorbed by the market. _——— TT ik — XX Vincent Deluard, CFA Vincent.deluard@intlfestone.com (+1) 510-851-3350 Page |1The Intelligent Quant INTL FCStone’ November 2018 ‘The Secular Case for Oil Remains intact Seven weeks of uninterrupted price declines have brought WTI prices in clear bear market territory. Adjusted for inflation, oil prices have fallen back to their 2004 levels. My favorite measure of oil prices is the amount of real S&P 500 index dividends that can be bought with a barrel of oil because it adjusts oil prices for the inflation in financial assets prices: the measure currently stands at $1.0, the same level as March 1986, when a barrel traded for $12. Oil has lost more than 70% of its real buying power versus financial assets since the 2008 peak. This chart powerfully summarizes the drain of the petrodollar savings glut: as I explained in “Higher for Longer, Much Higher for Much Longer”, the great commodity bull market of 1998 to 2014 was effectively a tax on the global economy. Because this tax was collected by oligarchs and dictators in sparsely popnlared countries, the proceeds were nor spent in the real economy, hiir reinvested inte financial assers Lower commoxlity prices, the shift of oil revenues back to the U.S., and soaring valuations for financial assets have brought an end to this era. Price of Oil in S&P 500 Real Dividends Dividend per barrel in 2018$ (LS) Real price of olin 2018 $ (RS) ——Nominal price of ol 160 140 $350 ts the new $20 120 109 80 oo 4” 1986 1988 1990 1992 1994 1996 1998 2000 2602 2004 2006 2008 2010 2012 2014 2016 2018 As ugly as the oil chart looks, itis immensely better than that of dejected energy stocks. Energy stocks account 5.4% of the MSCI U.S. Index market capitalization, versus 6.4% in February 2016 and 7.2% in October 2001 when a barrel was worth $33 and $21 respectively. Energy Weight in the MSCI U.S. /World Index Hs SWI Price per Barrel (RS) MSCI World Index (LS) ==== MSCIUSS. Index (LS) eo 16% 140 14% oat 12% 100 toe 80 8% 0 6% % 40 2% 20 Source: Bloomberg 0% ° 2000 2001 2002 2003 2004 2005 2006 2007 2008 2609 2010 2011 2012 2013 2014 2015 2016 2017 2018, a Vincent Deluard, CFA Vincent.deluard@intifestone.com (+1) 510-851-3350 Page |2The Intelligent Quant INTL-FCStone’ November 2018 Oil & Gas Equipment & Services stocks have been the whipping boy of the already-battered down energy sector. Schlumberger trades in the mid-40s, versus a 2016 low of $61 and a 2008 low of $35, when the price of a barrel of WTI oil traded at $29 and $36, respectively. The post2016 investor capitulation can be best summarized by comparing the two scatter plots below, which show the 12-month percent change in the relative strength of the S&P 500 Oil and Gas Equipment and Services Index versus the IZ-month percent change in oil prices. Changes in oil prices explained about half of the relative gains of Oil and Gas Equipment and Services stocks between 1989 and 2016. The y-intercept of the regression line was zero, indicating that Oil and Gas Equipment and Services stocks performed in line with the market when oil prices were flat. This normal relarion has collapsed since 2016: change in oil prices explain less than 15% of the relative performance of the SS&P 500 Oil and Gas Equipment and Services Index. Incredibly, the yintercept of the regression line is mines 17%, indicating that the SSP 500 Oil and Gas Equipment and Services stocks can be expected to lose about a fifth of their relative value when oil prices are flat. In layman’s terms, that means that oil stocks fall with oil prices in oil corrections but fil to part pate to the upside. Relative Strenght of the Oil & Gas Equipment Index versus Oil Prices: 1989 to 2016 00% 12 Month % Change in the RS of the S&P 500 Oil Equipment & Services Index 100% 12-Month % Ci 2016 to Today 30% 20% Tie OTT 14 40% oe 0% 12 Month Se Change in WTI Prices Vincent Deluard, CFA Vincent.deluard@intlfestone.com (+1) 510-851-3350 Page | 3