Arthur E. Berman is a geological consultant with thirty-seven years of experience in petroleum exploration and production. He currently is consulting for several E&P companies and capital groups in the energy sector.
Erik Townsend welcomes back Art Berman to MacroVoices. Erik and Art put perspective on OPEC, the 9-month extension on production cuts and OPEC's goal to keep a floor under oil prices. They look at the positioning of oil traders since February and the reasons for lower oil prices. They further discuss the inventory data, forecasts and the impact of capital markets.
Here are some excerpts from the interview:
Erik: Well, I think it's very very important, this point that you're making, because the popular narrative that you read in the financial press is that there have been profound improvements in efficiency and they paint a picture that suggest that going forward, you know, the breakevens for U.S. shale production are going to be in the, you know, $35-$40 range, and as long as we have oil at those prices, we can just keep on going. What you're really saying is that the breakevens came down to that only because people were forced to fire sale their services at prices that would eventually drive them out of business. They managed to get through that, and they can't stand to do it much longer and that those prices have to go back up. So, that suggests that the breakeven price that everybody in the industry, in the investment industry anyway, seems to think is in a secular downtrend, really it's been a down spike that was artificial that has to mean revert. Am I right about that?
Art: You're absolutely right, and of course, the other component is that for many of these producing companies have laid off tremendous numbers of staff, and so their costs are down. I spent a fair amount of time and I've got a post out there from a month or so ago on this for those that are interested. I went through the annual reports of a number of companies, both shale producers and major oil companies, and what I found was that an awful lot of the reduction in breakeven prices is because companies have written off huge amounts of reserves that are no longer commercial, and at present oil prices, OK, so when you right down reserves, two things happens -- the first is, reserves you keep are, they're more productive wells, so the breakeven price on the reserves you keep is lower because your high-grading, OK, but the other thing is, is you're writing down all the equipment costs, you know, the depreciation, and the amortization, and all that stuff on all those wells that are off the books. And so, the headline looks good, but the reality is, is that the reserve base has fallen by 50% or 60% over the last two years, and that's not good for investors. So, as always, there's two sides to every story, and I think that story is clear, and by the way, what I found was, that the breakeven cost for the majors was just about exactly the same as for the supposedly super nimble, innovative, efficient, small independents, and that's not the narrative. The narrative says that, oh those guys are, you know, they're quick and smart and fast, and they can adjust, and the big majors, they're dinosaurs, no! They're all breaking even at $40 a barrel, so you know, this a function of accounting, is what I'm trying to tell you, Erik.
Erik: The next slide moves on to comparative inventory. I just want to cover for the benefit of any listeners who have not heard your prior MacroVoices interviews, comparative inventory simply means, as we look at the weekly inventory data, we don't care so much about the absolute number, whether it's a build or a draw on inventory, we care about how that compares to the moving average historically, seasonally adjusted effectively to how that same week of the year over the last four or five years, what we should be expecting and we compare it. So, what are the comparative inventory charts telling you now?
Art: Right, and as you know, I mean, comparative, if I had only one tool to use in trying to figure out price trends and where they're going, this is the one I would use. Obviously I'd like to use more tools and do, but I can't understate the value of this particular technique, which is, if other people use it beyond a couple of us outliers, they never publish it.
So, what I'm showing here, the graph on the left is OECDs, that's the rich countries of the world, including the US, inventories, and the graph on the right is U.S., basically WTI, and so by cross plotting these, you know, basically the current inventory minus the five-year average, and cross plotting that with price on a weekly basis for WTI, and a monthly basis for OECD, you get this yield curve, and it's certainly clarifies and demystifies where these price trends are going, and it also gives you an indicator by where that yield curve crosses the Y axis, that's what we call the mid-cycle price, OK, so that's where the price is going, and so all you need to do is say, well, if everybody thinks we're going to get to $70 oil or $65 oil or whatever the analysts say by the end of the year, then it becomes a fairly simple issue to say, OK, great, so how much does comparative inventory have to drop before I get the $65 on that yield curve? And what I find for both of those, OECD and U.S., is it has to go down a lot, it has to go down like 130 million barrels, and that's comparative inventory, I mean, just to drop 130 million barrels in absolute inventory is quite a stretch. So, at current withdrawal levels, how long is that going to take? Well, assuming that they just keep on rolling on at the rate they do, they are now, and they won't, that's a year. And to me that's not bad news, I mean, given the absolutely oversized kind of inventories we've gotten around the world, the fact that it might take a year after Saudi or OPEC cuts, that's kind of standard, but somehow the market doesn't see it that way. The market thinks that, OK, now they cut, it's smooth sailing, we're going to be there real soon. Frankly, I mean, I hope we do get there, because it benefits me as someone who drills wells and makes money from producing oil, but I don't see it, Erik, I mean, I think it's going to take at least, and again, you know, then you start looking at what smart people, with sophisticated modeling software, what they forecast the inventories to be over the next 6 months, 12 months, 18 months, and what they're telling us is no, we don't expect to see inventories reducing at the rate that they have been. So the good news, the best new is it's probably going to take at least 9 or 12 or 15 months to get to where we might be able to support $65 oil. That assumes the global economy can stand it. The bad news is that we might not get there that quickly either.
Erik: Now, the popular, mainstream media narrative is that boy, this glut of oil, it's been a tough roll here for quite a while, but it's finally over, it's clearly ending, it's got to be the end. But if I look at slide nine, Art, it looks like you're actually projecting glut chapter two comes in 2018. What's going on here?
Art: Yeah, that, well, again now we're dealing in the realm of forecasts, and forecasts are always wrong, but you know, again, I think that the forecasts are undoubtedly notionally correct, and so what the slide on the left shows, the graph on the left, this is IEA's forecast of the production minus consumption balance in the world, and what it's showing is that, I mean, as early as next month, you know, you look at where that first downward arrow points and you see a big spike, well, that's May, and so IEO is saying, you know, that the negative market balance that we've been seeing for the last couple of month is going to reverse next month, and we're going to have maybe a million barrels to the positive, and moving forward into 2018, we're going back to like you say, not as much of a glut as we saw in '15, peaking in '15 and declining in '16, but another mini oversupply, that's what IEA forecast based on all the factors that I discussed, you know, Iraq, Iran, Libya, Nigeria, Venezuela, Brazil, etc.
And then the graph on the right is simply again taking IEA's inventory levels for OECD, which is in red, and U.S., which is in blue, and I can't explain exactly why they think U.S. stocks are going to continue falling, but they have been, so maybe that's reasonable. OECD stocks, which include U.S., are going to be flat for the rest of the year, and then both are going to increase dramatically in the coming years. So, if we place any credence in these kinds of forecasts, and as I say, I don't believe them, but I think that they're notionally correct at least, 2018 doesn't look too good, and as far as, we're done, we're finally in the clear, and I don't depend solely on this source of data, you know, we'll get to the next slide with quarry research, but those guys do a really good job. I've known the principal down there for quite some time, years, and they're completely independent of IEA, EIA, and they're coming up with pretty much the same view. Again, it doesn't make it right, but that's the way that I have to imagine the future, of course supported by a lot of other trends that I see in the present.
Erik: Well I have some theories of my own as to how the shape of the term structure is being engineered by the people that are setting these expectations. I'll save that for slide 14. Why don't we come back to Macquarie on slide ten. Tell us why you see this financial data basically suggesting, at least in the short term for the next year or two, that we're going to have continued, you know, production strong and prices low.
Art: Well, I mean I think it has all got to do with two issues- it has got to do with everybody has got to survive in an indebted world, and that means cash flow, and that's companies, national oil companies, little oil companies, and countries. OK, so there's only so long that we can, I mean, even if we're losing money on each barrel we sell, we've got to have cash flow to service debt and to keep shareholders happy, and to keep our countrymen if we're dealing with developing countries from dying of starvation. So, and then there's capital markets, and you know, the capital markets of the world, the credit markets, and the central bank policies that we've been living with now since the financial crash, they're all geared toward maintaining more production, that's just the trend that we've seen. When interest rates are low, people are willing to put their investments into riskier places, like oil and gas, because they got to have the yield, and again, we see the forward curves that I think are kind of reflecting that.
So, you know, we've looked at all of this, query looks at potential problem countries, I've already mentioned Russia, but Brazil is another country that is in, that's got a ton of new offshore reserves and discoveries that the country is in a terrible problem with corruption, you know, there's riots and demonstrations every day. They've got to put some money out there. The query sees Russia, Brazil, and the U.S. with all our capital markets and our "rah-rah make American great again," etc. These three countries, they see as being the real engines of production growth, no matter what OPEC does, and then OPEC, they say, man, you know, it's good enough that you guys have apparently adhered to the guidelines of the production cuts for six months, but do we believe you can hold this thing together for another nine months? No, we don't.
And then you got, you know, our U.S. president talking about selling off of half of the United States strategic petroleum reserves, which I think is an absolutely awful idea, but regardless of what I think, that puts another 300 million physical barrels out there on the market on top of all this kind of stuff, and I repeat the term structure here only to emphasize that, pick any one of these curves you want, the most optimistic to the most pessimistic, and none of them see prices over $50 a barrel until sometime out two and a half to three years from now, which doesn't mean it's going to happen that way, obviously, but what we're seeing I think is a coming together of an awful lot of lines of evidence and opinion that all bias you very much toward the low side of price and the high side of production.
Conclusion: Art Berman does a great job adding clarity to the obstacles facing the crude oil markets over the next few years. Looking at the real breakevens for shale producers and the obstacles facing global producers, we are likely to see range bound oil prices until there is a material drawdown in the inventories.
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. I have no business relationship with any company whose stock is mentioned in this article.