Editor’s note: This article first appeared on Prism Investor.
The anticipation is over and the results of OPEC’s 173rd meeting on November 30, 2017 are in. As we and other observers expected, the cartel extended the production cuts it initiated at the 171st meeting in November 2016 through the full-year of 2018. The 2016 cuts were the cartel’s first in eight years, and demonstrated capitulation to the fact that it can’t control non-OPEC producers, namely U.S. oil shale developers.
The extension of these cuts through next year further demonstrates that OPEC, and Russia, have firmly returned to the “price stability” goal it held prior to the price war gambit it initiated in 2014.
As we mentioned in our November 17 piece, Un-Happy Anniversary – Our Take on Oil Markets Ahead of OPEC’s Meeting, our view is that today’s global oil market is balanced and with crude oil inventories still well above five-year averages, it will take more time for rising demand to burn off relatively high levels of oil stocks. Based on fundamentals, there isn’t much need for the financial markets to send a signal to industry that it needs more supply.
So, what did the market do? Of course, oil prices rose on the news, illustrating the perils of predicting oil prices!
In a previous Industry Insider, we discussed how most oil price predictions are wrong, and we at Prism Investor are not immune from the prediction disease. Consequently, although we do not make specific point estimates, we do make directional calls. That crude prices increased in the wake of the announcement is a little counter-intuitive, but the price surge in the wake of OPEC’s announcement is the seed that may lead to more production.
Let’s turn to the bullish factors. First, oil inventories in both OPEC and OECD countries have been falling since May 2017, but they are still well above their five-year averages. Second, overall oil demand continues to rise as the global economy grows consistent with OPEC’s forecast for oil consumption increases 1.5 million barrels of oil per day in both 2017 and 2018.
Demand has never been the problem in this most recent cycle, instead it’s been the persistent global oversupply resulting from resilient production, primarily in the United States.
As we noted in our prior Anniversary piece, global oil demand and supply have been well balanced since 2Q16. The “problem” in terms of creating an upward price trend has been rising production from U.S. oil shale developers and above average crude oil inventories.
Demand has never been the problem in this most recent cycle, instead it’s been the persistent global oversupply resulting from resilient production, primarily in the United States. The U.S. Energy Information Agency reported that America is currently producing approximately 9.6 MMBopd, with about 1.6 MMBopd coming from the Permian Basin.
In our Industry Insider from October 23, 2017, we noted anecdotes and information that suggested active operators were planning on standing-up at least another 30 rigs in the region, which could drive production up by another 720,000 Bopd. Based on the market’s bullish reaction to OPEC’s decision to extend production cuts, we anticipate U.S. producers are scrambling to add-on oil price hedges to lock-in returns on new drilling and recognize that our estimate of U.S. crude oil production reaching 10 MMBopd in 2018 is most likely conservative.
Grumbling in Russia
Russia signed-on to the pact with OPEC, agreeing to limit domestic production and to work with Saudi Arabia to keep 1.8 MMBopd off the market. The question is for how long?
“Russia is a gas station masquerading as a country” – U.S. Senator John McCain
Multiple media reports confirmed that the Russians agreed to extend the cuts only reluctantly. Combined, Russia and OPEC produce 40% of the world’s crude oil supply making cooperation between the two essential to bring world crude oil inventories down to more normal levels and flip the market from its current supply-driven posture to one that is demand-driven.
As U.S. Senator John McCain once remarked, “Russia is a gas station masquerading as a country” in recognition of that nation’s dependency on oil exports. The U.S. Energy Information Agency estimated as recently as November 2017 that “Exports of crude oil and petroleum products represented nearly 70% of total Russian petroleum liquids production in 2016. Russia’s oil and natural gas industry is a key component of Russia’s economy, with revenues from oil and natural gas activities—including exports—making up 36% of Russia’s federal budget revenues.”
The Russian economy was hard-hit by the oil price war initiated by Saudi Arabia in 2014, which in 2015 pushed the country into a deep recession that shrank GDP by an estimated 4%. The Russians went along with the cuts because they have a strong interest in oil price stability, but the alliance with OPEC is tenuous.
Russian frustration with limiting output stems from the fact that they like their U.S. industry cousins, are market driven. As CNBC reported, “…Russian oil companies, like Rosneft and Gazprom Neft, complained that the deal, which helped lift oil prices, also let U.S. shale increase production and steal market share.”
U.S. drillers standing-up more rigs
It turns out that the Russians are right, U.S. oil producers are preparing for another big push to increase production.
If oil prices make the returns on drilling attractive, then operators will allocate capital to drill more wells. No oil company executive is going to throttle production and shareholder value for the “greater good” of his competitive rivals.
With West Texas Intermediate trading at $55 per barrel or more, fringier areas in the Permian Basin are becoming economic to drill. We anticipate operators are layering on more hedges to opportunistically capitalize on the recent price surge to protect production and drilling economics into 2018, further encouraging industry to stand-up more rigs. In fact, the Baker Hughes North American land rig count increased by six to 929 rigs, 332 more than the same week last year.
In June, Scott Sheffield, executive chairman of Pioneer Natural Resources (NYSE: PXD) one of the largest independent E&Ps in the Permian Basin told Oil and Gas Investor magazine, “In my opinion, the market does not want the U.S. to start growing [production] again…there’s too much inventory.”
Billionaire oilman Harold Hamm told CNBC recently that he felt shareholders are holding public companies to a different standard – focus on returns instead of growth – when he told the network, “…We’re not going to put money in there just for growth’s sake. We want a return, a good return on capital employed.” Hamm also hoped executives would follow the advice being whispered in their ears when he said, “That new dynamic has entered into the market, and it’s affecting everybody out here, and thank God it’s there.” In the wake of the downturn that sent 142 oil and gas companies into bankruptcy between 2015 and October 31, 2017 (per Haynes & Boone), we don’t doubt that some shareholders are worried that E&P shale developers will outspend cash flow and fund it with debt, increasing financial risk. However, we are not convinced that Hamm is echoing the sentiments of every oil company executive being judged every quarter by hedge fund managers looking to beat the index funds.
Sheffield is right, there’s too much inventory, but the U.S. industry doesn’t act in its collective interest like a cartel. If oil prices make the returns on drilling attractive, then operators will allocate capital to drill more wells. No oil company executive is going to throttle production and shareholder value for the “greater good” of his competitive rivals. Given the incentives that prevailing oil prices and hedges give U.S. oil shale developers to drill, we anticipate it is possible that the entire 1.5 MMBopd increase in global demand can be met by the Permian Basin alone, extending the time it will take to burn-off inventory levels down to their five-year averages.
Our take – the bulls are still in the corral
The extension of production cuts from OPEC and Russia will help reduce oil inventories over the next year, however, the pace of that reduction will be mitigated by rising crude production from the U.S., which could put enough incremental barrels on the market to satisfy all of the demand growth expected in 2018. Add the wildcard of quota cheating, especially among the dejected Russian industry, and suddenly it looks like oil markets will remain supply-driven through at least 2018.
In our view, the long-awaited bull market in crude oil isn’t here…yet.