Inventories will continue to rise, but the momentum is slowing.
The following are some observations as to how we got here and how we’re gonna get out.
9 reasons why oil has taken so long to bottom:
1. OPEC increased production in 2015 to multiyear highs, principally in Saudi Arabia and Iraq where production between the two added 1.5 million barrels per day (mb/d) to inventories after the no cut stance was adopted.
2. Russian production increased in 2015 to post Soviet highs.
3. Long planned Gulf of Mexico production began coming on in late 2015.
4. An overhang of 3,000 or 4,000 shale wells that were drilled but uncompleted (“ducks”) entered a completion cycle in 2015.
5. Service companies and suppliers went to zero margin survival pricing (not to be confused with efficiency). The result has been an artificial boost to completions that cannot be sustained.
6. Resilience among a few operators in the Permian who felt the need to thump their chests, creating the rally that killed the rally last spring (disclosure: I own stock in Pioneer Resources but am going to dump it if they don’t cut it out!).
7. The dollar strengthened.
8. Iranian exports are coming.
9. And, finally, China.
5 Demand-Side Reasons Why We Need to Hang-On:
1. Chinese oil demand is up year-over-year by 8 percent. It is expected to slow in 2016 to as low as 2 percent (maybe) but it is still growth in a tightening market.
2. Watch Chinese car sales. They were sluggish in early 2015 but finished very strong in what could be a 2016 V-shaped recovery.
3. The Indian economy is on a tear. The IMF has it as the world’s fastest growing large economy. GDP growth was 7.3 percent in 2015 and is projected to be 7.5 percent in 2016. That trumps Chinese growth. Although India’s oil demand is only one-third that of China, it is the growth picture that should be better covered by analysts and headlines. India is about to be the world’s most populous nation with a middle class that is likely to double over the next 15 years. 40 cars now service 1,000 people but that is rapidly changing. And this is not something that will occur sometime, someday in the future. 2015 Indian consumption grew by 300,000 barrels per day (bpd).
4. U.S. consumption has been increasing with higher employment and lower fuel costs. Truck and full size SUV sales have been extraordinary.
5. Europe, the world’s largest oil market, is in a decade long decline but not as steeply as it was. Asia demand is strong with Vietnam’s GDP growing 7.5 percent in 2015. Middle East countries are seeing increases in consumption. And as a final observation, go back one year when most oil analysts were looking at supply as the means to a correction. Demand was thought to be too inelastic and would thus take too long to play out. But it was demand that responded first. When the story is written, it will be demand that outplayed supply 2 to 1 on our way to parity. Thereafter, if we go into imbalance, it will be the damage done to supply that really moves prices.
16 Supply-Side Reasons Why We Need to Hang On
1. Earlier in 2015 global supply exceeded demand by about 2.2 mb/d according to the EIA. Others had it at 2.5 mb/d. The EIA now has it down to 1.3 mb/d and change. We are still nowhere near an inflection point but we are converging.
2. The rig count in OPEC’s GCC countries has not corrected down with prices. It is mostly maintenance drilling and somewhat additive in Saudi Arabia. The level of production that we have seen lately likely means the GCC is close to or at capacity.
3. There is near universal acknowledgement that there will be another 300,000 to 500,000 bpd decline in U.S. production this year. It could be more given the struggles of the onshore conventional market which alone should give up 150,000 bpd. Shale’s steep decline rates will easily make up the rest even against increasing Gulf of Mexico production.
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4. Global non OPEC, non U.S. production will decline by 300,000 to 400,000 bpd in 2016 according to the IEA. This number could increase as marginal production at current low prices comes off line due to lifting costs.
5. After an upside surprise in 2015 Russian production, there is a building consensus that 2016 results will be off with further declines thereafter. Russian oil giant Lukoil is stacking contractor rigs which will show up fairly soon in the numbers. State backed Rosneft is showing financial strain.
6. Pemex production is down 10 percent.
7. North Sea production, which has increased over the last few years, will slip in 2016.
8. Long-term Canadian oil sands projects will come on in 2016 as will some production in Brazil, but even collectively the amounts are small. It’s probable too that some of the oil miners will put a hold on production due to lower product costs (about $15/bbl less than WTI) and extraordinarily high lifting and processing costs (some of the sands are subjected to subsurface CO2 drives, others are surface mined).
9. Anticipated Iranian exports are here, but the projections are all over the place from the Iranian government’s claim of 1 million b/day in 6 to 12 months to Rystad Energy’s claim of 150,000 b/day. Even the middle ground argument of500,000 b/day assumes Iran can get back to their long term trend line, which had been declining during the 5 years prior to 2011 sanctions. Fields are in poor repair and the gas drives essential to production have been mostly abandoned. All in, it’s most likely that production will stutter step up to the trend line due to delays caused by political process and infrastructure funding. This, like all things, will take longer than expected but watch out for early sales. You will be seeing more inventory than production as Iran unloads the 30 to 45 million barrels of oil in storage. Allow some time to work off stocks to get an idea of the actual production numbers which will likely disappoint.
10. Depending on the source, $140 to $200 billion of expenditures has come off of long term projects in 2015 with calls for another $40 to $150 billion in cancellations and postponements in 2016. This won’t be made up by renewables. The current and projected crude and natural gas prices have dis-incentivized consumers from wind and solar. Governments after the Paris accord may throw money around but consumers will likely not follow until commodity prices make them.
11. All said, these capex cuts will result in a loss of at least 5 mb/d in long-horizon production. These are the goliath type projects that we absolutely need to match to current plus anticipated consumption increases.
12. Existing wells have natural decline curves. Some hold up better than others but all said the global yearly decline rate without additional drilling is right around 4 mb/d.
13. Hedged bets started coming off in late 2015 and will continue in early 2016. Accompanying this could be the capitulation in activity and production that the market has been looking for.
14. Global capex declines have occurred here and there over the past 20 years but always rebound the following year. For the first time in recent history, the global oil complex has charted two consecutive years of declining budgets. 2014 showed a small constriction but 2015’s 20 percent capex decline is unprecedented in terms of size and is the highest by percentage in 20 years. And right now, 2016 doesn’t look like it’s going to have much bounce to it.
15. The world seems to be moving closer to a supply side disruption. Middle Eastwars, skirmishes and terrorist attacks are increasing in size and frequency. Libyan oilfields are a constant target. Nigerian installations are vulnerable. ISIS controls most of Syria’s small oilfields. Yeminis missiles are targeting Saudi oil installations and would have hit their targets in December launches had the Saudi’s not shot most of them down. Iraqi production is somewhat safe, but only somewhat. Venezuela’s PDVSA is teetering in its ability to pay for the imported diluents needed to export its crude. Tankers are stacking up in the Jose Petroterminal demanding payment up front before unloading up to 3 million b/month of naphtha. And then there’s the torched embassies, mass beheadings, a resurgent Shiite state and a hardening Sunni stance amid a claw back of freebies to Saudi Arabia’s citizens. It’s not good. Not at all. Our best hope is that price rebalancing will occur quickly through supply and demand metrics rather than bloody supply-side shocks.
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16. At $25 oil, the Bakken is at $13 to $15 after transportation which puts operators up there underwater after lifting costs, taxes and carrying royalty owner costs. Sub $30 oil will not only kill development drilling, but it will be where production stops. In cases where operators are committed to selling natural gas produced alongside oil there may be a reason to continue due to supply obligations, but otherwise what’s the point? If you want to lose money buy a boat. It’s more fun.
6 Things to Ignore
1. This is not the 1980’s with 14+ mb/d spare capacity. In 2016, we are oversupplied by about 1.5 percent and it will be at zero by early to mid-2017. The last time we were at zero was late 2013/early 2014 when WTI was at $100 and Brent up around $105+.
2. Lower for longer is true but $29 oil is not. This is a classic over-sold scenario and likely somewhere in the realm of capitulation. Operators and service companies can find a footing at $50 oil. We won’t prosper but we’ll survive. $100 may be a long way off and that’s because ridiculously high, sustained oil prices only leads to ridiculously low sustained oil prices. But who wants $100? It will only get us back to $30. The industry makes no sense at the top or the bottom. The high middle is best.
3. Demand is dropping. Not true. Demand growth may be slowing but not by much. Consumption is up and it is increasing.
4. Chinese demand is down. The rate of growth may slow in 2016 but it will still be up year-over-year. A 6.8 percent Chinese economy is consuming more oil now than a 10 percent economy was 5 years ago. A lot more.
5. We’re going to float the lids right off our oil tanks. Don’t worry. You can sleep tight. We’re not.
6. Efficiency gains are offsetting the declining rig count. This one is always amusing. Give me the rig count and higher density fracking and you take all the recent efficiency gains and let’s see who gets invited to the bank’s Christmas party.
6 Things You Shouldn’t Ignore
1. Q1 oil prices are going to be ugly. Try and ignore them if you can. The market will remain uncertain over Iran as it determines and adjusts to how much oil is coming on.
2. Hedges coming off will not bode well for producers and the service companies looking to them for a lifeline.
3. Spring debt redeterminations may knock the wind out of the E&Ps. If capitulation hasn’t already occurred, it will then.
4. China. The sinking Shanghai Composite Index is oil’s anchor.
5. Pioneer and other chest thumpers getting too aggressive. Any recovery will be short lived if they jump the rig count as they did in the short-lived Spring 2015 rally. Traders are fixated on even meaningless moves in the rig count. Best to play it cool. We all want to work but operators need to practice some restraint.
6. Lack of capitulation. There will be no recovery until there is general agreement that the shorts cannot drag the market any lower. The Saudi’s, with Russia following, can always point to a large U.S. failure as proof that they did not blink first.
14 Things We Owe Ourselves:
1. The water wars of 3 or so years ago are mostly solved. Recycling frac water is now a ‘’gimme’’. Marcellus operators like Shell and Cabot are able to boast of 99 percent recycle rates. We still have hurdles with deep well brine injection but the issues are getting defined and will be addressed.
2. Progress is being made on recognizing and reducing methane emissions from well sites. Ultimately, this could slow drilling in places like the Bakken until infrastructure is in place, but it will also move operators to effectively use lease gas to power operations.
3. No government agency provided directives for Halliburton and Pattison to build dual fuel frac fleets that run on clean burning lease gas. They just did it in cooperation with their customers.
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4. We’ve proven than natural gas is beyond abundant.
5. There have been fewer bankruptcies than anticipated.
6. No one has been arrested yet for fracking.
7. Harold Hamm was still able to write a billion dollar personal check.
8. Aubrey McClendon was still able to raise fresh money.
9. T. Boone Pickens overshot the mark with an $80 call but his optimism helped us – a lot.
10. Even President Obama jumped in and did us a favor with the elimination of the 40 year old export ban. It might have been done grudgingly but we got it.
11. LNG exports will set sail by March 2016.
12. Coal miners displaced by the current administration’s EPA in Kentucky and West Virginia have been finding work in oil and gas fields. Hopefully they’ll find more soon enough.
13. We can celebrate the abrupt end of the glossy multicolored booklets from fawning jewelers and art auctioneers arriving in the mail.
14. David Einhorn’s crass and predictable “mother fracker” short on Pioneer Resources was a yawn. The stock even climbed after the news. If this was a political statement, which was my read of the subtext, then short the stock now big guy.
The inevitable will occur. Supply and demand will cross. The question is will Wall Street notice? Some of the analysts caught the cross in early 2014 but most didn’t. For full disclosure, I missed it too.
The question this time around is will we see it coming and if so will it be an orderly reaction? Or will the market miss the coming wake-up call and instead deliver a severe supply disruption with skyrocketing prices and a political response along the lines of windfall profits taxes? My worry is that everything takes longer than you think, from recognizing coming imbalances in the global crude complex to painting the house. In the meantime, just hang on and keep your equipment running. You’re going to need it. Until then, all the best of luck.