Is Oil Production Still Headed For A Cliff?

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Our models indicate that energy industry exploration and production spending is a function of oil prices.

Lower oil prices impact energy industry exploration and production spending over a three-year period.

Oil production is a function of energy industry exploration and production spending with lags.

Since May and coincident with the stability of the oil price in a $40-$50 range, the rig count has been slowly and steadily climbing, reaching 428 active rigs.

The rig count is still more than 70% lower than the November 2014 peak of 1607.

In our earlier report on the outlook for the energy industry ("Will Oil Production Fall Off a Cliff?") in January 2016, we examined the then current condition of the oil market and the outlook for industry capital spending and global output. We developed two macroeconomic models: one to forecast energy industry exploration and production spending and a second to relate exploration and production spending to global oil production. We found a highly statistically significant relationship between exploration and production spending and a three year moving average of the oil price. Next we found that global oil production was highly statistically correlated with exploration and production spending in the prior one and two year time periods. The historical fits are shown on Charts I and IA below.

Last January the global energy market was in turmoil. An earlier decision by Saudi Arabia to move away from its traditional role of "swing producer" within OPEC toward one of maximizing production to gain market share resulted in a sharp downdraft in prices. The decision was ostensibly made with the intention of driving marginal higher cost producers from the market while perhaps inflicting financial harm on its neighbors, particularly Iran, being a side benefit.

The price of west Texas intermediate crude subsequently collapsed from a high of about $106 per barrel in July 2014 to a low of about $26 per barrel last February. This was actually a lower low for the oil price than the low that occurred in the depths of the 2008-2009 recession. In percentage terms the peak to trough decline in the Brent crude price was even greater as its approximate $15 per barrel premium to west Texas intermediate collapsed to its current roughly $3 per barrel premium.

Since the February low the oil price has recovered, fluctuating most often in a $40 - $50 per barrel range. The premium which Brent enjoyed has not recovered and is not expected to recover. So in most studies the benchmark global oil price is now interchangeable between the two. In our modeling work we use west Texas intermediate.

The recent price recovery has several possible explanations. For one thing the low of $26 may have simply been too low, pushed to an extreme by technical factors which proved transitory. A second and more substantive explanation is that evidence of a production decline in the United States began to mount. From a peak of about 9.6 million barrels per day, production fell to about 9 million barrels per early this year and is currently running at about 8.5 million barrels per day.

A further explanation relates to developments abroad. At the same time U.S. production was falling production from Iraq, Libya, and Nigeria was being impeded by political/military events. These actually allowed Iranian production to re-emerge in the global market place, post the nuclear accord, with minimal disruption.

Finally, and probably most significant was that Saudi Arabia began signaling a reappraisal of its decision to abandon production discipline and move back to a leadership role in hopes of stabilizing or improving the price structure. This reappraisal was informally codified at OPEC's September meeting in Vienna which climaxed with the announcement of a production cut of 500 - 700 thousand barrels per day to be implemented in November.

Interestingly this OPEC announcement coincided with evidence that the long uptrend in above ground storage was being alleviated. In the United States total commercial inventories climbed from what was a normal 1,100 million barrels to what may be a peak of 1,404 million barrels at the end of this past September. We say a possible peak because in just the past month inventories have fallen by 25 million barrels, contrary to normal seasonal patterns.

This confluence of forces was effective in boosting west Texas intermediate to about $50 per barrel currently. But its sustainability is being met with skepticism by the analytical community. After all, the so-called Vienna agreement in September comes at a time when the International Energy Agency notes that OPEC production was at a record high in September. This is despite outages among members like Libya, Nigeria, and Iraq. Moreover, the deal specifically excludes Iran, Nigeria, and Libya from potential output restraint. It also failed to formally include Russia and other non-OPEC producers. Russia has, however, seemingly endorsed the OPEC agreement and vowed to participate while urging other non-OPEC exporters to participate as well. Of course, Russia is currently producing flat out so it may be that they have little to lose while gaining some diplomatic currency.

Nevertheless, for the agreement to be effective the brunt of any production reduction must fall on Saudi Arabia. After all, Libya and Nigeria could theoretically boost production significantly. Indeed in just the past month Libyan output has reportedly nearly doubled from about 400 kpd to 800 thousand barrels per day. Reports are that hostilities in Nigeria have all but ceased for the time being at least. Meanwhile, Iranian production is still about 600 thousand barrels per day lower than its stated goal of returning production to its pre-sanctions level as soon as is practical. Not only do these make full implementation of an output reduction less plausible, but they also illustrate the severe financial cost that Saudi's initial decision placed on itself.

Beyond these institutional considerations, with the world awash in current production capacity, there are important market determined obstacles to a full price recovery. For example, were the global economy to slip into recession in the next year consensus estimates for about a 1 mbd increase in global demand would prove too optimistic, potentially aggravating an anticipated move toward global supply and demand balance.

On the supply side there is the issue of the response of marginal production to any price recovery. In the U.S. for example the active land based oil rig count peaked in November 2014 at 1607 and fell to a low of 316 this past May according to Baker-Hughes. But since May and coincident with the stability of the oil price in a $40-$50 range, the rig count has been slowly and steadily climbing, reaching 428 active rigs in early October.

Depending on individual company cost structures and drilling locations at least some companies must be profitable with west Texas intermediate in a $40-$50 price range. The producer price index for oilfield machinery has barely budged over the past year. But anecdotal reports suggest a sharp decline in drilling costs along with a measurable improvement in the productivity generated from continually improving drilling techniques. These are lowering break even prices across the industry, consistent with the upturn in drilling activity already in place.

To date total domestic production seems to be stabilizing at about 8.5 mbd. But this raises two possibilities. One is that perhaps after normal lags production may be about to pick up in earnest. Two, if the oil price continues to recover more companies will become profitable, increasing drilling activity and making a rise in domestic production inevitable. Analysts are undoubtedly closely watching the Energy Information Agency weekly reports for such evidence.

For all these reasons any guesstimate of the timing for a rebalancing of global oil supply and demand is tenuous to say the least. What is not tenuous is that the past two year jolt to the oil price structure will have potentially significant long term consequences. The highly respected Wood Mackenzie consulting group recently estimated that the pace of new discoveries world wide in the last three years was about one tenth the historical average.

This partly reflects geological factors but it is also undoubtedly related to the severe financial squeeze put on energy companies and a consequent cancellation of exploration projects world wide. According to Wood Mackenzie estimates, global industry exploration and production spending will fall by 40% in 2016 versus 2015 and would likely stay at this depressed level for at least the next year regardless of any price recovery.

In our macro models we rely on historical data on exploration and production spending from Barclay's Upstream Spending Survey. Barclays estimates that global exploration and production spending fell by 26% in 2015 and is on track to decline by another 22% this year. In our report issued last January our exploration and production model showed that with $40 per barrel oil exploration and production spending would fall by 28% this year and by 25% in 2017. Given the higher prevailing price structure the model seems very valid. Both our model and the Barclays survey are more optimistic than portrayed by Wood Mackenzie.

So what do our models portend if in fact the price structure is in recovery mode. Assuming the oil price recovers to about $55-$60 per barrel next year, the Barclay's survey projects about a 20% increase in North American exploration and production spending which would be more than offset by a continued decline in spending outside North America. This seems reasonable if the domestic industry is very sensitive to price changes.

As near as we can tell the current consensus is that a $45 per barrel price in 2015 will move up to about $55 per barrel in 2017 and then to $70 per barrel in 2018. Based on our model this price structure would forecast a further decline in global exploration and production spending in 2017 and then about a 14% recovery in 2018. Thus, in dollar terms exploration and production spending would be lower in 2018 than it was at the peak in 2014 and even lower than the level that was recorded in 2015. Our forecast is reasonably in line with Barclays one year ahead survey forecast, and it is not as dire as the more extreme decline projected by Wood Mackenzie.

From our estimated path of exploration and production spending our global oil production model would look for a decline in output from about 91.6mbd currently to about 87 million barrels per day in 2017 and to 84 mbd in 2018. Were demand to rise at a steady 1 million barrels per day over the next two years it is clear that global inventories would have to be drawn down significantly to make up for such a supply shortfall. And this in turn would imply that significant upward pressure on the oil price would develop in order to encourage new supply and slow demand.

But, and there is always a but in a dynamic process, the assumption of continued steady demand might be tenuous. For one thing, significant upward price pressure could impose strains on the global economy, choking demand and economic activity. Also upward price pressure would further encourage the development of alternatives. According to the annual British Petroleum almanac the portion of renewable fuels in total world energy usage tripled from 2005 to 2015 and it is forecast to rise by another 50% over the coming five years bringing it to about 4% of total usage. We would guess this estimate is conservative for several reasons. The price of renewables is becoming increasingly competitive with fossil fuel. Public policy will continue to be more favorably inclined toward renewables versus fossil fuel. Technological advancement in the production and distribution of renewables is proceeding very rapidly.

Renewables will not fully or even meaningfully offset the forecast fossil fuel supply - demand imbalance, but it would be a buffer to a serious price spike. Further, intuitively there is reason to believe that the supply response per dollar of exploration and production spending is shifting favorably. Until about ten years ago the lag between discovery and production was in terms of years if not decades. With the development of the shale industry this lag has been reduced significantly; more like months than years, so that higher prices will quickly elicit higher production than any statistical model might capture.

Assuming production discipline can be initiated and maintained by the world's major exporters in the short term, it seems pretty safe to assert that the global energy industry has hit bottom in terms of activity and profitability and that a recovery is developing. A recovery would be a stimulant to the global economy as long as macroeconomic imbalances are avoided along with energy price spikes. From a policy perspective, though, conditions could quickly become very murky if the fossil fuel industry is targeted for destruction by environmental groups and legislative inertia. There is already inertia in several states to curtail fracking activities and if this is advanced it would not only retard industry activity and thus macroeconomic activity, but it would further support the prospect of serious price spike by 2018 when global excess supply is forecast to disappear.

Chart I Exploration and Production Spending as a Function of Oil Prices

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Chart IA World Oil Production as a Function of Oil Exploration and Production Spending

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Note: 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/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.