What's Next For Oil?

| About: iPath S&P (OIL)

Summary

Oil has rebounded from February 2016 lows for a number of reasons.

Production disruptions have supported prices in the near term.

Capital expenditures in the oil and gas industry continue to fall, setting the stage for higher prices at some point in the future.

In July 2014 the price of West Texas intermediate crude peaked at roughly $105 per barrel. Since that time the price has fallen in almost uninterrupted fashion, hitting a low of about $26 per barrel in February this year. This was actually a lower low for oil than was reached at its nadir in the 2008-2009 recession. Since February the price structure has improved with West Texas intermediate crude moving up to around $45 per barrel. Analysts seem to be split between those believing the bottom is in and prices are destined to move higher versus a camp that believes this up-tick is just a temporary reprieve before the price structure deteriorates again.

In our view the recent recovery is rooted in a confluence of political, technical and fundamental factors which will reverberate into the future. Politically and technically several phenomena converged in February. At the time virtually everyone concluded oil prices were doomed to remain depressed as the world was running out of storage capacity and producers were in disarray. Generally when "everyone" leans to the same conclusion the market becomes vulnerable to a change in sentiment.

This was provided on the political front by murmurs of a possible agreement by producing countries to freeze production. Even though Iran never agreed to a freeze, insisting it should be permitted to boost output to pre sanctions levels, the fact that Saudi Arabia and Russia were in discussions gave the market hope. A formal agreement to freeze production never materialized but by the time producing countries formally met and failed at the so-called Doha round in April, other factors had taken hold to influence pricing.

There were two such developments affecting demand which began in February. First, oil and most commodities are priced in dollars, and the dollar's strength had been a negative for commodities generally. But beginning in February as the Federal Reserve began backing away from its commitment to institute multiple interest rate increases this year, the dollar exchange rate began to weaken, supporting oil and other commodity prices as well.

Second, at the G-20 meeting in Shanghai rumblings of a global need for fiscal stimulus emerged. And China formally announced that it would raise its deficit/GDP ratio by introducing new fiscal stimulus measures. This development began to ease concern over the fate of the Chinese economy, at least for the near term. As China economic data began to show stability, concerns over emerging market economies generally began to ease and commodity prices began firming.

Fundamental supply and demand prospects also came into play and these were largely supportive. The International Energy Agency reaffirmed its view of rising global demand as shown on Table I below, even as it continually warns that a global recession could wreak havoc on the energy market by choking demand. The International Monetary Fund coincidentally reduced its global growth forecast to a mere 3.2% (3% being the rate of demarcation separating growth from recession), but markets largely ignored this, at least for the time being. Meanwhile, in this country gasoline demand has consistently been strong running 4% to 5% above last year's level and its five-year average.

On the supply side oil markets have benefited from a series of production outages. These occurred in North Africa, Kuwait, northern Iraq from political discord and more fundamental problems in the North Sea. More recently Canada has lost about 1 mmbd of production from wildfires that are raging near the Canadian tar sands. Despite these and talk of a production freeze which never formally occurred, OPEC production reached a new all-time high of 32.6 million barrels per day in April. This may have begun to give the market pause in the move toward higher prices, but this remains to be seen. The Saudi decision to replace long time oil minister Ali al-Naimi with Khalid al-Falil may also inject uncertainty into Saudi's policy of retaining market share at the expense of price stability heading into June's OPEC meeting.

In the midst of all this and a much more fundamental consideration are expectations about future supply and the responsiveness of marginal production to price trends. The U.S. shale industry is the central focus. As is well documented the shale revolution in the U.S. was key to enabling U.S production to rise from roughly 5.5 mbd in 2009-2010 to about 9.6 mmbd at its peak in 2015. This was instrumental in moving the global market toward surplus. And it was certainly a factor causing Saudi Arabia to shift from its role of being the world's swing producer to a position of market leader with the intent of eliminating marginal production via lower prices. Of course political tensions with Russia and Iran also were undoubtedly factors in the Saudi decision to pull the rug from under the price structure.

Regardless, high cost production quickly began to be affected by lower prices. Chart I below shows a recent history of the world active drill rig count. Chart II below shows a breakdown of active land-based oil and gas well drill rigs in the US. From a peak of over 1,600 oil rigs in November 2014, the U.S. active oil rig count has fallen steadily and is currently below 350. This represents about 80% of the decline in the world rig count.

U.S. production was not immediately responsive to this collapse because there's typically a lag between drilling and production and because massive productivity improvements have lowered the cost structure of lifting oil from existing wells. But beginning this year the Energy Information Agency finally began reporting a consistent decline in production. From the peak of about 9.6 mbd, the Energy Information Agency is currently estimating production at about 8.8 mmbd with many industry watchers projecting a further decline to close to 8 mmbd by year end.

Even with production beginning to show sustained restraint, above ground inventory is extremely high. At the end of April the Energy Information Agency put total commercial crude and product inventory in the U.S. at about 1.37 billion barrels or more than 100 million above the same period last year and more than 20% above the April 2013 level which was considered normal. So despite lower production domestically, inventories have yet to show a trend toward reduction as imports have been surging.

The existing high level of above ground inventory should act as a restraint on the price structure. Indeed, the Energy Information Agency highlights the inventory condition as being a constraint on prices until 2018 when it expects inventories to have begun a sustainable decline. The fact that Iran is determined to boost production should also remain as a restraint. And as long as Saudi Arabia remains determined to retain market share, the overall price structure could be expected to remain depressed - at least in the short run.

The price structure is instrumental in affecting future supply. In our January 2016 report on the Oil Outlook we described two macroeconomic models to trace out prospective future supply prospects. We showed oil production to be closely and significantly related to a two-year moving average of industry capital spending. And industry capital spending was shown to be significantly related to a three-year moving average of the oil price. Based on a sustained $40 per barrel price for West Texas intermediate the model forecast a decline in global output from 93.6 mbd in 2014 to an expected 86.1 mbd in 2017 and 80.4 mbd in 2020. Using the International Energy Agency demand forecast shown on Table I, this would create a huge deficit in the global supply-demand balance. In a dynamic context this would obviously have significantly positive implications for prices which in turn would bring production back on stream depending on the actual price response.

But this would not be likely to occur in a smooth fashion although as can be seen from the Table I International Energy Agency forecast, the forecast path is presumed to be smooth. But the fact is that major oil companies have been routinely announcing cancellations of long-term projects. Indeed, the Norway based Rystad Energy Group estimates that to date approximately $270 billion of projects globally have been either deferred or cancelled. These projects are not easily or quickly turned on and off, so this estimate would be consistent with our model forecast.

We noted earlier that record levels of above ground inventory would act as a restraint on prices. Also to be considered is that the breakeven price for producers is lower than only a few years ago as a result of lower service costs and improved productivity. If we think back just a year, conventional wisdom was that U.S. shale production would break even at between $60 and $70 per barrel for West Texas intermediate. Recently Pioneer Natural Resources (NYSE:PXD) and EOG Resources (NYSE:EOG) implied that rigs might be reactivated at a $50 price. Hess (NYSE:HES) recently suggested its reactivation threshold would be about $60 per barrel.

Because the oil market is currently in contango meaning distant futures are above the prevailing spot price, the spot price can be a misleading barometer. Looking one year ahead, the spread between cash and futures is currently about $3 per barrel. This would suggest that producers like PXD and EOG are not yet in a position to hedge production at a profitable price and thus reactivate rigs. Naturally market observers will be carefully monitoring the structure and level of futures prices and weekly changes in the drill rig count to get a sense of how itchy producers are to boost production. Any evidence of increased output would help contain potential price increases given prevailing high storage levels.

Political issues are probably not having any imminent impact on the current energy market. But looking ahead they could become a significant impediment to the supply response to price signals. Generally speaking one can infer an inverse relationship between the political climate toward energy and the energy price. The higher is the price, the more likely the public would be disturbed by the price at the pump, implying less resistance to environmental concerns etc., which might constrain production.

As an extreme example one can think back to the energy crisis of the late 1970s when President Carter appealed to the public to conserve usage while sitting by a fireplace wearing a sweater and expressing support for the coal industry as a solution to the country's energy needs. In the current environment of surplus the coal industry is in desperate shape and some presidential candidates express support for its ultimate demise. The entire fossil fuel industry is once again out of favor as policies tilt toward support for restraints on drilling and increased incentives for the expansion of renewable fuels.

Even though the 2010 Deepwater Horizon oil spill in the Gulf of Mexico resulted in severe environmental damage, the thought of curtailing output was very unpopular in its immediate aftermath as oil prices were high and rising. But the story is now different. On April 14, 2016, the Obama administration released a final draft of regulations affecting domestic offshore oil and gas drilling. Exxon Mobil (NYSE:XOM) is warning that compliance will cost $25 billion over 10 years and render many offshore projects unfeasible. XOM cited an industry review of 175 wells drilled in the Gulf since 2010 concluding that 63% would not be drilled as designed under these rules. Wood MacKenzie Ltd. estimates that if these new regulations become fully effective, exploration outlays in the Gulf would tumble by 70% over the next two decades, wiping out as many as 190K jobs.

The Oklahoma state government, normally friendly to the fossil fuel industry, has issued orders curtailing well operations in response to fears that waste water injection from oil and gas wells is causing small earthquakes. Finally, a University of Michigan study has traced a big increase in ethane emissions into the atmosphere beginning in 2010, providing more fodder for environmental advocates. The study traced the emissions to shale drilling in the Eagleford and Bakken shale formations.

The problem with this regulatory fever, of course, is that there's a lengthy time lag between investment and production in the energy industry. This creates a climate for boom-bust cycles whose timing is extremely difficult if not impossible to foresee. Regulatory fervor now could have an adverse effect on production in 2018-2020, precipitating a new supply-demand imbalance and consequent price surge. No econometric model could accurately account for this.

There's finally the issue of industry wide bankruptcies as a result of the price collapse. Bankruptcies are now mushrooming among both producers and service providers. But unlike past periods when bankrupt drillers were quickly liquidated, excess liquidity in the general economy is working in favor of bankrupt companies. For example, Swift Energy (NYSE:SFY) was well regarded in the industry but it could not continue operating under its prevailing capital structure thanks to the oil price collapse. SFY is working to maintain operations by getting shareholders to receive equity in a successor company. Unlevered, it would be in position to quickly increase production with improving market conditions. Recently bankrupt Energy XXI (NASDAQ:EXXI), Samson Resources, etc., are pursuing similar strategies.

The point is that the short-term supply response to a price recovery may be quick and at a lower price point than many thought likely just one year ago. The implication is that prices could stay lower for longer than is currently being assumed by industry participants and investors. This would be a positive for consumers of energy, but it would be a negative for longer term investment in potential new supply, raising the odds of another price spike later this decade. The lower for longer hypothesis also would force major oil producing countries to perhaps rethink current policy or to accept a lower level of prices for a longer period than may have been assumed. And this would raise a whole other set of thorny problems as the International Energy Agency estimates that among Mideast oil producing countries export earnings have fallen from $1.2 trillion in 2012 to $500 billion in 2015 and perhaps as low as $200 billion this year.

Table I mmbd

2015

2016

2017

2018

2019

2020

2021

World Demand

94.5

95.6

96.9

98.2

99.3

100.5

101.6

Non-OPEC Supply

57.7

57.1

57

57.6

58.3

58.9

59.7

OPEC Crude*

32

32.8

33

33

33.2

33.5

33.6

OPEC NGLS

6.7

6.9

7

7.1

7.1

7.1

7.2

Total World Supply*

96.4

96.7

97

97.8

98.7

99.5

100.5

Implied Stock Change

2

1.1

0.1

-0.4

-0.7

-1

-1.1

*OPEC actual output in 2015. Assumes a post-sanctions increase for Iran in 2016 and adjusts for OPEC capacity changes thereafter.

Click to enlarge

Chart I World Active Rig Count

Click to enlarge

Chart II U.S. Oil and Gas Rigs in Operation Click to enlarge

Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.

Disclosure: I am/we are long SWTF.

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.

Additional disclosure: Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.

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