Stronger Greenback, Surge In Oil Supply Will Be Among Several Negative Catalysts For Oil In 2017

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Summary

U.S. dollar will offset some of OPEC production cut in 2017.

Federal Reserve should follow through on rate hikes with Trump economic policies.

Better conditions in Libya and Nigeria should generate a lot more production in 2017.

Shale production will climb significantly and start to compete at the global level.

Level of compliance by OPEC and non-OPEC participants in the deal also a big question.

source: Stock Photo

In my view the timing of the decision by OPEC and Russia to cut oil production was about as bad as it could get. The Federal Reserve went all-in on raising interest rates in 2017, shale producers are ramping up production and starting to compete on the global stage, and Libya and Nigeria, while still at risk, are starting to settle down and focus on increasing production.

Combine that with uncertainty surrounding how much compliance to the production cut agreement there will be this time around, and the time it'll take for some to do it, and you have a lot of challenges that must be worked through for the cut in supply to have the desired effect of supporting the price of oil.

With all these things working against it, I don't see oil rising to the level the market is hoping for, in light of the slowing down in demand from parts of Europe and Asia.

U.S. dollar and Trump policies

There is no doubt the Federal Reserve held back on raising interest rates until after the election, so it wouldn't give the impression it was favoring one candidate over another. Some have suggested it pulled the trigger because of a Trump win in order to undermine his performance in office, but I don't think that's the case.

That said, I do think the clearly stated economic policies of Trump at least had a slight impact on the decision to go ahead and raise rates; specifically his message of committing to a major fix on the infrastructure of the U.S.

What this means is the Fed will almost certainly raise rates throughout 2017, and that will support the U.S. dollar, which in turn will put downward pressure on the price of oil. Alone this isn't extremely significant, but when adding other negative catalysts in, it reveals a formidable picture of offsetting factors that will without a doubt frustrate the purpose of cutting oil production.

Libya and Nigeria

Conditions in Libya and Nigeria have been improving, and that has brought about a quick increase in oil supply to the market, led by Libya, which stated it has a goal of boosting production to about 900,000 barrels per day by March 2017. Before the internal strife initiated in 2011, Libya had been producing approximately 1.6 million barrels per day.

While Nigeria will add to global supply, Libya will be the main catalyst of the two in regard to offsetting a significant amount of the oil cuts from the November 2016 agreement. For that reason what Libya does in the short term will have the most impact on support or non-support for oil prices; even beyond what shale producers will do.

That's because for the most part, its infrastructure remains in place, and it only needs to boost production in secured areas to raise output levels. Further out U.S. shale producers will become more important, but in the short term, Libya, as it relates to the impact of more oil being added to the market, will be the key player to watch.

U.S. shale production

The thing that the U.S. shale industry has repeatedly done when OPEC kept the spigots open in an attempt to slow down its pace of growth, is it always was able to surprise to the upside. The reason for that was from improvements in efficiencies, technology and productivity. The sector was able to increase production while cutting costs.

Eventually it had to cave in some because of the debt levels and higher costs some of the companies incurred, but overall, the U.S. shale industry was far more resilient than the market believed it could be, and it, not OPEC, has is the swing producer of the world.

After all, OPEC is now making decisions based upon what shale producers in the U.S. do. The cartel didn't make a decision to cut oil production on the same basis as it did in the past, but because U.S. shale producers not only survived the supply attack from OPEC, but vastly improved itself during the process. It's now a lot leaner and productive. It's OPEC that's on the ropes in this competitive battle, not U.S. shale producers.

The only question now is how quickly shale producers will complete their premium wells and bring more oil to the market. Recently it quickly added 100,000 barrels per day to the market, and in my view what's holding them back from going all in is uncertainty as to how committed those agreeing to cut production levels are.

In other words, OPEC and Russia could be trying to lure U.S. producers into thinking they're going to remain faithful to the agreement, which would to some degree provide a floor on oil prices. If shale producers ramped up production in response to that, they would be faced with whatever price environment they were selling supply into. If OPEC and Russia were to pull out of the agreement, it would cause the price of oil to plummet, which would catch many of them in a net of disappointing earnings.

Shale producers have reached a level where they can compete against anybody, but they don't want to just throw their best wells into the market and get much weaker results than they could have.

My thought is they will continue to complete a decent amount of the thousands of drilled but uncompleted (NYSE:DUC) wells they have, but they'll do it at a measured pace. For that reason I see their impact on the price of oil significant, but spread out over the next year.

I think once it's clear OPEC is once again weak on compliance and unwilling to give up market share, it'll provide a more market-driven oil price, which will be lower than some are looking for it to be in 2017.

That's the push and pull of what OPEC and Russia are doing at this time. Shale producers could boost production at a quick pace and compete at the global level be increasing exports, which would force the hand of OPEC and Russia, or they can take a more measured approach and gradually complete wells over the next couple of years.

It's not a matter of if shale producers are going to raise production, it's only at what pace they're going to. That's why in the first quarter I see Libya being the most important producer, as it'll be able to increase supply levels and exports much quicker than anybody else. If shale production in that time surprises to the upside, I think the production cut deal will quickly collapse. That would probably happen before the end of February.

The reason I see it happening that quickly is some producers aren't even going to start cutting output until after that - including Russia.

Compliance to the oil cut deal

Both OPEC and Russia have been notorious for ignoring the quotas associated with production cut deals, and there is no reason to expect that to change this time around. Some analysts have said this time there's likely to be 80 percent compliance. My answer to that is this: why?

Nothing has changed from the point of view of competing for market share. What has changed is there is a powerful competitor in the U.S. shale industry that didn't exist until the recent past. That industry has no interest in playing nice or making agreements with other companies to cut oil production in order to support oil prices; as a matter of fact in the U.S. it would be illegal to do so.

My view is compliance is under pressure than in the past because of shale oil companies. If they increase production quicker than I'm thinking they will, investors might as well price in non-compliance at huge levels and assume the deal is only a piece of paper with little adherence to the quotas and terms associated with it. This could happen with Libya alone. If shale production climbs swiftly, it's game over in my opinion.

Why that is highly probable can be represented by Russia and Oman, both countries not part of OPEC. In December Russian oil output was the same as it was in November, coming in at 11.21 million barrels per day. Supposedly it's going to cut that by 300,000 barrels per day by the end of the first half of 2017.

Oman, which obviously isn't a big player in all of this, has agreed to cut production by 5 percent in March.

Take these two countries, which aren't going to do much in the way of cuts in the first couple of months of 2017, and add that to added production from Libya and U.S. shale producers, and it already points to an underwhelming outlook for the deal, and this doesn't include some of the increases in supply from Norway and others.

Conclusion

The financial media has missed a big part of the picture with this production cut agreement, and that is the impact the strengthening dollar will have on the price of oil, increased supply from Libya, shale producers and Nigeria, and the level of non-compliance on quotas that are always inherent in these types of agreements with OPEC and Russia at the center of them.

Trump will quickly increase spending on infrastructure projects; the Fed will consider that a strong catalyst for the U.S. economy and will continue to raise interest rates, strengthening the U.S. dollar; and supply will surprise to the upside in 2017, putting pressure on OPEC, Russia and others to comply at very low levels to the deal, if they comply at all.

That means Saudi Arabia would have to carry the brunt of the deal in order to make it work. That's not going to happen.

What that suggests to me is there isn't much of a chance of this deal surviving. At best it could technically remain in place, but the market will quickly find out if there is any legitimate or meaningful compliance to the terms of the deal.

A strong U.S. dollar and supply exceeding what was expected in October when the baseline of output was more subdued, points to the price of oil not finding the support it was looking for. It's definitely going to disappoint the first half, if the deal even remains in place at the end of that time.

As I've mentioned several times in the past, if investors want to take a position in oil, look to the low-cost shale producers as the companies to take positions in. In no particular order of importance, companies like Apache (NYSE:APA), Continental Resources (NYSE:CLR), EOG Resources (NYSE:EOG) and Devon Energy Corp. are good companies to take a deep dive into. There are others as well.

The recent increase in hedging by many shale companies in response to the quick upward move in the price of oil from the announcement of the deal, has strengthened their potential for 2017.

With debt for some of the other shale producers maturing this year, that would be the chief area I would use to separate the shale producers. Why invest in a heavily indebted company when you can go with those that have more discipline and less risk?

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.