Energy Outlook - An Update

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Includes: CVX, HAL, RDS.A, STO
by: Lance Brofman

Summary

There seems to be a persistent global excess of oil production capacity.

Rig counts have increased steadily at current oil price levels.

In a longer time period, the higher depletion rates could impact oil supply and price.

This article updates our past year's analyses of short- and long-term developments in the energy industry. In our previous articles "Is Oil Production Still Headed For A Cliff?" and "Will Oil Production Fall Off a Cliff?" we concluded that crude oil prices below $40 per barrel were unsustainable in the short run. We also suggested that a longer-term supply crunch could develop as a consequence of a lengthy period of low prices. At least for now the unsustainability of a price below $40 per barrel has been borne out by the past year's supply response from the world's major producers. Prospects for a longer-term supply are becoming seemingly less likely, however.

Our longer-term conclusion was an outgrowth of two macroeconomic models that we developed. We found a highly statistically significant relationship between exploration and production (E&P) spending and a three year moving average of the oil price. We also found that global oil production was highly statistically correlated with E&P spending in the prior one and two year periods. From these we concluded that E&P spending and future production could be so severely damaged that a sustained price spike could result in coming years.

As we see it there are three interesting dynamics that have begun to take shape in the past year. The first is the emergence of a persistent global excess of oil production capacity. The second is the effect of new industry technologies. The third is the effect these are having on the structure of industry wide capital investment.

In its most recent update the International Energy Agency suggested that a rebalancing of global oil supply and demand was well underway and that balance could be achieved in this year's second half. According to this report rebalancing is mainly a byproduct of production restraint as the International Energy Agency once again revised down its estimate of global demand growth for 2017 to a 1.4% increase vs. a 1.6% rise in 2016.

Crude oil prices bottomed at about $35 per barrel slightly more than one year ago. Since that time prices have recovered to a range between $45 and $55 per barrel with the upper end of this range being most frequent. The initial price collapse from over $100 per barrel in 2014 to the sub-$40 level clearly induced pain throughout the industry. The U.S., for example, saw profits of production and oil service companies collapse as domestic production first rose from a low of 5 million barrels per day (mbd) in 2008 to a peak of 9.56 mbd and then a decline to a low of about 8.4 mbd in 2016. Production among all marginal producers experienced similar pressure while budgets of major producer countries in the Mideast and in Russia came under severe strain.

It was this strain that led to the implementation of a production cutting agreement between OPEC and selected non-OPEC producers. This was the main event that has sustained the initial oil price recovery. The agreement was designed to remove approximately 2.5 mbd from the global market with Saudi Arabia bearing the brunt of the reduction. To date adherence to the agreement has been spotty according to some observers although OPEC officials and the International Energy Agency submit that compliance is stronger than has been the case during similar situations in the past.

The fact is, though, that Saudi has reduced production by more than it initially agreed to cut. There is scant evidence that Russia is reducing output. Iraq is reducing production by not increasing it. There is little information from Iran which has said that it should not be subject to any quota. And countries like Libya and Nigeria, which were not subject to quotas, continually under produce because of ongoing terrorist activities by various militant groups. If instead of under producing, we would submit that normalized production from Libya and Nigeria would very likely made the production agreement completely ineffective, driving downward pressure on prices.

Nonetheless, the prevailing price structure is what it is even though it could be construed as artificially high. But this has left marginal production in place while at the same time there has only been a limited demand response to low prices. Thus, the world is facing millions of barrels of excess production capacity which could be brought back on stream in the event of a supply disruption and a price spike.

An important question is whether or not the U.S. industry constitutes marginal production. The U.S. was never asked to join the OPEC/non-OPEC production cutting accord. Industry producers would not have joined in any event if only because of the fragmented nature of the industry in the United States. At the peak in November 2014, U.S. production was 9.56 mbd with 1602 land-based drill rigs in operation, according to the Baker Hughes index (see Chart 1 below). From that peak there was a steady decline to a low of 316 active rigs at the end of May 2016, yet production fell by only 1.2mbd.

Since last May the active drill rig count has climbed steadily, hitting 683 rigs in mid-April. So the industry's response to the price recovery was swift and it was aided by new technologies. The total of 683 rigs is still less than half the total in operation at the peak, yet production has almost fully recovered, rising to 9.24 mbd according to the latest report from the Energy Information Agency. Were the active fleet to climb to its prior peak, it is estimated that domestic production could be well over 11 mbd.

This industry dynamic is attributable to several phenomena and it has potentially important implications. There has been a sharp decline in the cost of drilling. According to data from IHS Markit, in March 2014 the average day rate for semi submersible rigs was over $500k whereas in March 2017 the day rate was under $200k. A similar decline was observed for worldwide drill ships.

Similarly sized declines for oilfield service projects have been reported by companies such as Halliburton (NYSE:HAL) and Schlumberger (NYSE:SLB). Yet these do not seem to have been captured by published data. In our forecasting models we used the producer price index for oil and gas manufacturing as a deflator for E&P spending. According to this series, prices declined by only 0.7% in 2016 after being flat in 2015.

Newer technologies has also been in play to boost the productivity of drill rigs. One rig can now do the work that required several rigs just a few years ago. Rather than one rig punching a hole in the ground to tap a reservoir, now that same rig can branch out horizontally and tap into neighboring reservoirs as well, boosting overall output per active rig. And whereas an active rig used to employ five to 10 production workers, the introduction of robotics, etc. is cutting the number in half.

To add to this, the Trump administration has vowed an all-in energy policy. And it has already proposed and in some cases put into place a number of policies that would tend to increase potential supply. These include loosening regulations and permitting requirements for drilling, mining, and pipeline projects. The administration is also supportive of expanded drilling on federal lands, and it has a more favorable disposition toward offshore drilling as long as such drilling is not in the view of Mar-A-Lago. All of these have the effect of lowering the break even price for oil, blunting the effect of artificial production cutting agreements.

Some argue that this is all well and good in the short run, but because wells being drilled in the U.S. deplete rapidly, longer-term supply consequences will be negative. Indeed, it is clear from industry reports and long run budgets that the major E&P companies have and are continuing to shift funds toward projects with short-term payoffs as opposed to those with long lead times and substantial investment, but also with large production possibilities. According to Norway-based Rystad Energy, total global discovered volumes of oil and gas last year hit its lowest level since the 1940s. Rystad is predicting a slow recovery beginning in 2018-19. Houston-based Wood Mackenzie is projecting that new projects will double this year from 2016, but it sees deepwater long-term projects remaining very challenged.

Below, Chart 2 offers some regional data that was recently published by SLB, showing offshore depletion rates for major producing areas. The four areas covered by SLB currently produce about 5.25 mbd, or more than 5% of average daily usage of 96.6 mbd in 2016. With depletion rates on the order of 15%, the implication is that production from these areas alone would drop by 190 kbd this year without additional investment. It would be interesting to know if depletion rates are similar for Russia's producing areas.

Chart 2

Based on an average $53 oil price for 2017 and a $70 price for 2018, our macroeconomic energy models forecast continued decline in E&P spending in 2017 and then a modest recovery beginning in 2018. This is similar to Rystad's forecast. But according to Barclay's survey of Global oil and gas companies, the expectation is that E&P spending will rise by about 7% this year, marking the first increase in three years.

To be sure, our models may be undershooting actual spending for two reasons. First, as noted earlier the deflator we used to get at the volume of E&P activity seems to understate the decline in drilling costs by a wide margin. Second, our models are incapable of capturing the apparent shift in spending that is occurring toward short-term projects vs. long-term projects. To us, this suggests that the probability of a significant supply crunch in the foreseeable future is less likely barring geopolitical disturbances.

The phenomena described above support the ability of U.S. producers to turn production on and off is short periods of time. Furthermore, U.S. producers have the ability to hedge their price exposure in the forward markets whereas this facility is not available to government sponsored entities. These would blunt the financial consequences of price swings, increasing their financial health. All else being constant, this would prolong the time that millions of barrels per day of excess capacity would hang over the market.

Looking even longer term, the whole notion of a potential supply crunch is being challenged by the emergence of renewable fuels, electric vehicles, and natural gas to say nothing of the new administration's supportive attitude toward coal. The Trump administration National Economic Council Director Gary Cohn has even gone so far as to say that updating and modernizing the air traffic control system would generate huge savings in jet fuel by reducing waiting tomes and shortening flight times.

The significance of these things is subject to debate, but it is interesting that while 10 years ago the notion of "peak oil supply" dominated industry debates, today the notion of "peak oil demand" is a dominant subject. Officials at Royal Dutch Shell (NYSE:RDS.A) believe a peak could occur as early as the late 2020s, while Statoil (NYSE:STO) has a somewhat longer timetable. On the other side, the American Petroleum Institute, the IEA and officials at Chevron (NYSE:CVX) believe the notion of peak demand is no more likely than the earlier notion of peak supply.

We would not be so bold as to take a position on this issue. But there is one irrefutable fact: Global oil demand is still rising as the global economy expands. However, there is a continuing trend showing that more economic growth is required to generate a given unit of oil demand growth. This is something producing countries with large underground reserves must be cognizant of and which might ultimately force the decision to tap those resource sooner, rather than later. This is yet another reason to be skeptical of the prospect of a lasting price spike that is brought on by market conditions as opposed to geopolitical disturbances.

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.

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