Can Production Capacity Lower The Oil Glut In 2016?

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Includes: USO
by: Gary Bourgeault

Summary

The oil glut may shrink in 2016 from production reaching top levels.

Production capacity may be the only answer for a true rebalancing of the oil market.

Why it still may not support the price of oil, even if it does happen.

One factor that hasn't been talked about much in the oil sector has been production capacity, which, by the end of 2016, may be topped off; at least with non-shale producers.

The importance of that is once full production capacity is reached, we reach the top level of supply. That means if demand does rise to estimated levels, it could offer some support to the price of oil in the latter part of 2016.

There are a couple of elements to consider there. First, it's not a guarantee that projected demand will reach estimates. Questions are already arising as to whether or not the demand estimates are too optimistic. I tend to think they are.

Even if most other production capacity tops off, there is still the ability of shale companies to start production at their DUC wells, which would quickly add supply to the market.

What this could do is help reduce the excess oil inventory, which may have some small effect on prices.

The problem is not only the shale producers, though, it's also the fact that production capacity will be added to with Iran boosting production in a big way, and Indonesia and Libya expected to add to the daily total. Together, it will add far more than 1 million barrels per day to production, so we have yet to see what capacity will be. That will determine whether inventories will rise or shrink.

Rebalancing

One interesting idea to consider in regard to the market rebalancing is that reaching the top of production capacity may be the only event that would trigger it under these market conditions, where no producer is willing to cede market share.

The reason for the aggressiveness concerning market share is related to the changing oil market, which, with the introduction of shale production, has changed the landscape forever. Now countries specifically must take steps to adjust to the eventual and inevitable loss of market share to shale oil producers, which means they have to shrink budgets and reduce the number of programs offered to their people.

Market share is being battled over by the state-owned companies because they're trying to extend the period of time they have to make these adjustments, in order to reduce the amount of potential unrest that could occur if drastic measures have to be taken.

Once no more capacity can be added, these companies and countries have no more weapons in their arsenal. Concerning capacity, I'm not talking about future capacity, which could increase from exploration and development. This is solely about current capacity.

There are only three things that could rebalance the oil sector: increased demand, voluntary production cuts or the collapse of shale oil. Of these three, only an increase in demand has any basis in reality at this time. That won't be enough to have an impact in 2016.

Demand, production and shale

Production is going to increase in 2016, and even if demand rises in response to the low price of oil, even at current production levels it probably wouldn't have an impact. Add more than 1 million barrels a day to production in 2016, and it quickly removes that as a rebalancing catalyst.

Shale oil has been the big disruptor in global oil markets, and it will remain so for many years even though it has been forced to temporarily pull back.

The reason for that is it doesn't have to have production at full capacity, because it can develop drilled and uncompleted (DUC) wells and wait for market conditions to improve before bringing them into production.

This is a huge, new factor that most of the market isn't getting. The market understands the concept, but it doesn't take into account the impact it will have on the oil market rebalancing in the future.

Every time OPEC attempts to support the price of oil by lowering production, shale oil companies could bring more supply to the market and put a cap on the mid and upper price levels. That competitive factor has never been a part of the market in the past.

What I'm saying is rebalancing will eventually happen, but it won't be companies with exposure to U.S. shale that will have to adapt - it'll primarily be OPEC that will lose market share over time. Either that, or it'll have to roll the dice with the citizens in those countries and hope they don't rebel against a much smaller budget, which is the consequence of the battle to maintain market share because of much lower revenue coming in.

Conclusion

Production capacity does need to be considered when analyzing oil, but I don't see it as a factor in the next year, and possibly two years, because no one is going to back down on the production side outside of shale companies.

OPEC is now battling OPEC concerning market share, for the reasons of buying time mentioned earlier. In the case of Iran and Saudi Arabia, they're also fighting proxy wars in Yemen and Syria, which makes the stakes even higher and the possibility of coming to a production cut agreement about zero.

It will probably take until the last quarter of 2016 before OPEC is operating at full capacity, and I'm thinking in terms of Iran and Indonesia there. Libya will add to supply, but it's still in shambles, and it may take longer for it to ramp up production to past levels.

For these reasons, even if production capacity approaches the top, there will be no way demand will rise in conjunction with it. That means the price of oil, barring a geopolitical event or an agreement to cut production by OPEC (which isn't going to happen), will continue to fall. Production capacity not only won't change that scenario, it'll make it worse, because more oil will be supplied to the market.

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.

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