This Is When The Oil Market Will Rebalance

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Includes: BHI
by: Daniel Jones

Summary

With investors waiting to jump into the oil market once things sort themselves out, it's only a matter of time before the market rebalances.

In this piece, I decided to dig into the data and I figured out when, most likely, this rebalancing should take place.

Depending on the situations facing the market, investors could see oil output fall by nearly 2 million barrels this year.

If you've been following my articles, you know that I've been writing quite extensively about the oil production regions within the U.S. By breaking down data from each of the seven regions, I've been able to forecast what the output for each location should be by the end of this year if all relevant trends persist. Although this has been a nice exercise, the true emphasis has been to build up to this piece, an article looking at the entire big picture of the oil market in an attempt to figure out what should happen if current trends persist. Before reading this, I recommend that you read my pieces on the Permian, Eagle Ford, Bakken, Niobrara, Utica, Haynesville & Marcellus, and on the oil production regions not covered by the EIA (Energy Information Administration).

A general consensus

In my previous pieces, I focused on forecasting how much oil production will increase or decrease this year given a conservative set of assumptions, a moderate set, and a liberal set. According to my analysis, the conservative assumptions should yield a decrease in production in the U.S. (assuming the "other" category of regions sees output remain unchanged) of 810,759 barrels per day from December of 2015 through December of 2016. This estimate implies increasing production in both the Permian and Utica, while the other five regions report a decrease, led largely by the Bakken and Eagle Ford.

In the moderate scenario, production should drop by nearly 1.48 million barrels per day for the year. This forecast was based on a situation where current decline rates for wells persist, something that I think is a reasonable assumption until we see otherwise. Meanwhile, if decline rates happen to increase (as has been the trend), oil production in the U.S. could fall by nearly 1.97 million barrels per day. In the table below, you can see what my result imply production should be in each of the seven major regions by the end of the year and how they, in aggregate, compare to those same regions using data from December of 2015.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report and STEO

For the purpose of my analysis, it's important to keep in mind that this drop is not what investors should expect from crude oil production every day this year but is merely where we seem to be headed. It's very important to keep in mind, however, that these results can change significantly. If oil rigs rise or fall, if rig productivity improves, and/or if decline rates change, the disparity between my analysis and reality could be material in nature. For instance, in its latest report, Baker Hughes (NYSE:BHI) provided updated rig count data for January. If you take my prior analyses and adjust for these new rig count numbers, five of the seven regions (data is inconsistent between Baker Hughes and the EIA for one and not counted in the same way for another so they've been left out) would see an aggregate drop in output by December of this year of between 134,315 barrels per day and 169,323 barrels per day compared to the numbers I provide in my table.

To get a true sense of the impact of production in the U.S. this year, as well as what impact that has on the oil glut, we need to look at the average production of these regions spread out over the course of the year, which has also bee included in the image. Based on my findings, the conservative scenario should imply that oil production this year in the U.S. should fall by between 419,608 barrels per day and 1.08 million per day.

Looking at the rest of the world

Of course, the U.S. isn't all that matters when it comes to the oil glut. In the table below, I used EIA guidance to look at how much production should change for different regions. This includes the Gulf of Mexico, which is forecasted to increase production by 130,000 barrels per day and the rest of the world, excluding OPEC, which should see production fall by 210,000 barrels per day. I assumed that OPEC output remains unchanged, with the exception of Iran, which I've forecasted at 750,000 barrels per day this year. Although likely too optimistic, it stays true to the country's goal, which is to increase output by 500,000 barrels per day immediately, followed by another 500,000 barrel-per-day increase six months from now, for an average increase for the year of 750,000 barrels per day.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report and STEO

I also had to account for the current oil glut. Estimates vary significantly from source-to-source, with some analysts putting excess production last year at 1 million barrels per day to others assuming that it stands at 2 million per day. To remain moderate, I assumed that the current glut is 1.50 million barrels per day. I also made the assumption that global demand increases this year by 1.42 million barrels per day, in line with the EIA's forecasts. After plugging this in, we arrive at three different scenarios. If we use the conservative U.S. production forecast decline, oil output globally will continue to add to the glut an aggregate of 330,392 barrels per day (or 120.59 million barrels). The moderate scenario should result in the glut shrinking by 34,502 barrels per day (or 12.59 million for the year), and the liberal scenario should see the glut shrink by 334,218 barrels per day (or 121.99 million barrels for the year).

This certainly makes the future for crude this year look like a toss-up. Realistically, any of these numbers could change my analysis significantly. For instance, the glut per day could be much larger or smaller than I indicated, oil production could fall faster or slower in the U.S. (it seems to be leaning toward faster but if oil prices rise then this picture could change), Iran could be faster or slower in its increase in output than they've estimated (I think they will be slower), and demand could come in higher or lower. Any one of these could turn the situation very appealing or very ugly. Similarly, a change in OPEC policy, which I think has a reasonable chance of changing for the better in the next six months, could make the glut shrink much faster.

What should not be discounted, though, is that, if my analysis is correct, the price of oil will likely be much higher toward the end of this year than it is today. According to my analysis, which incorporates my estimated changes, supplies at the end of this year will be lower (using the moderate estimate) by 845,823 barrels per day if you assume that Gulf of Mexico production rises by another 130,000 barrels in 2017 and if Iran can add on another 500,000 barrels per day starting next year (for a total increase of 1.50 million barrels). This does not take into consideration the fact that the EIA is forecasting an increase in global demand for 2017 of 1.42 million barrels per day which, when combined with lower production at the end of this year, could force the glut to die very quickly.

Takeaway

According to my findings, it's something of a coin toss whether or not the oil glut will resolve a large part of itself this year but the results are very encouraging nonetheless. Absent action by OPEC, a faster drop in domestic or global production, or rising demand, it's highly improbable that the market glut will be resolved this year but this doesn't mean that prices won't begin to improve meaningfully. Without action from OPEC, the large deficit in production at the end of this year, combined with growing demand both this year and next year, should let investors see a scenario where the glut begins to die very rapidly in 2017. This is unlikely to result in investors sitting idly by but will likely, instead, result in prices climbing during the last half of this year in anticipation of the glut disappearing. This does not mean that oil production won't increase (it likely will) but the high cost of domestic producers should prevent many players from venturing back into the space on a large scale.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.