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The oil and gas markets are engineered markets and are highly manipulated, and might be best described as "opaque free-markets" (CME: CL and BZ). Additionally, pundits and big banks often make wild predictions on oil prices that are sometime contradictory and sensational i.e. Goldman Sachs' June 2017 prediction of $45, but in January, 2018 (or 6 months later) Goldman is predicting $80 oil price. There are many factors that affect oil price movements such as geopolitics, global economy (supply & demand), OPEC and the new kid on the block called "Shale producers". However, in this article, we would discuss "risks and strategies for unwinding the OPEC & non-OPEC members' agreement".
One of the biggest challenges facing the oil markets in 2018 is how to skillfully unwind the OPEC and non-OPEC agreement without causing "shocks" to the oil market. In this article, we would succinctly elucidate the risks involved and the strategies needed to smoothly exist the OPEC & non-OPEC agreement. First, here are some background information.
- The OPEC and non-OPEC agreement cut 1.8 million barrels (1.2 million from OPEC countries and 600,000 barrels from non-OPEC members like Russia, Mexico, Oman, etc. The world oil consumption was about 96.5 million barrels per day, and IEA & OPEC's forecast for 2018 is about 97.8 million barrels per day.
- Both OPEC and non-OPEC members are producing at their maximum capacity, may be with the exception of Saudi Arabia, and even if prices rise to above $70, few members can increase oil production easily or quickly if the agreement is allowed to end.
- Venezuela is struggling to meet its OPEC quotas of 1.972 million, and in October 2017, it under-produced 109,000 barrels. Production has declined about 20,000 barrels per month in 2017, and the country's output is at 28-year low. Similarly, Libya and Nigeria are a going concern and their production may face interruptions.
- Most OPEC producers use oil shipment and pricing mechanism that lags "the spot price" by around 3 months (i.e. Saudi, UAE), which makes it difficult for oil buyers /refineries to compare relative cost of different types of crude. Additionally, oil shipments are not "destination-free" and require declaration of "bill of lading" ahead of time, denying sellers "arbitrage opportunities" that might exist in the oil markets. In the US, forward oil pricing is available, which is more transparent and makes it easier to plan. This gives advantage to shale producers who can use "forward oil pricing" to gain more access to the growing Asian buyers.
The biggest challenge to the "OPEC and non-OPEC agreement" is Shale oil producers
Shale oil producers are the biggest challenge to the oil market dominance of conventional producers in OPEC and non-OPEC countries, and with the recent rise in oil prices, the decision-making process of the OPEC/non-OPEC members would be tested. Here some key facts about shale oil and gas production.
- Shale oil and shale gas production decline rates are very high. First year decline rates, from initial well production (IP), is about 50%-to-60% and second years is around 70%-to-80%. What this means is that if the initial production was 100 barrels, then after 365 days (I year) of production, the well is only making 50-to-40 barrels.
- Shale oil production accounts for more than 50% of total US production (over 5.0 million barrels), and shale gas contributes even greater percentage to the US natural gas production. The average US oil production for December 2017 was about 9.7 million (EIA data)
- The US lifted 40-year old ban on oil exports, and shipments have been going to Europe and Asia. For the month of December 2017, the US crude oil export averaged about 1.4 million barrels per day, and is likely to grow. The reason is that the spread between Brent and WTI is about $5.24, and the Dubai and WTI is about $2.0. Hence, these makes WTI-priced oil more competitive globally.
- Sweet spots in most of the shale plays are gone (or taken), and companies would have to drill in less productive parts of the oilfield. As the MIT study pointed out (on the weakness of the EIA's US oil forecasting methodology), companies would have to move to tier-two sweet spots, which are not as productive as previous oilfield acreages, and probably, are more complex geologically.
- More than half of all US Shale oil production now comes from wells drilled less than 3 years ago, suggesting that companies would have to continue drilling higher number of wells to maintain current trends or increase productions from shale plays. Shale oil wells' recovery factor is about 10% of original-oil-in-place (OIIP), and there are no viable technologies for enhanced oil recovery (EOR) for shale oil.
- EIA drilling productivity index shows newly drilled wells are producing less oil/gas than previous wells on per drilling rig basis or (on per foot of lateral basis even though newer wells have longer lateral lengths, and deployed bigger hydraulic fracture treatments)
- Most of the shale producers are highly leveraged, less diversified in terms of production from non-shale oilfields, and investors are asking prudence in cash-flow use, which might make it difficult for them to ramp up production in a $70 oil environment.
- Even though producing cost per barrel of shale oil have gone down substantially across most of the shale plays, few oilfield basins are truly economical at or below $45 oil price. Hence, most shale oil producers, skillfully used hedging strategies (3-way collar options, Swaps) to limit exposure to oil price risk, but that might also deprive them profit gains if oil prices increase rapidly.
- The concept of DUCs (drilled but uncompleted) in shale basins means that when oil prices rise to an acceptable level, producers can quickly complete the wells (using hydraulic fracturing) and put it on production in 3-to-6 weeks. Currently, there are 5,000 wells on DUCs' list in various shale plays.
4 Charts that tel the story of (OPEC & non-OPEC vs Shale Producers) Part 1:
Figure 1 shows plot of US Oil Storage, 5 years moving average of US Oil Storage, and average yearly WTI Oil price. The chart shows two important points; first, there was a big increase of US Oil Storage from 2014-to-2017, and it was close to 100 million barrels above the 5 years moving average. Secondly, from 1982, the 5 years moving average and yearly US oil storage were very close, with few million barrels apart. Lastly, the US oil storage is gradually declining, and we might get "storage normalization" at the end of 2018
Figure 1: Chart showing US Oil Storage, 5 year moving average US Oil Storage, and WTI Average Yearly Oil Price (Data obtained from EIA report)
Figure 2 shows the relationship between US oil storage and WTI oil price. Plot of historical data shows that WTI oil price has an inverse relationship with US oil storage, which makes sense since it suggests imbalance between oil demand and supply. Additionally, since March 2017, the amount of US oil storage has been declining from high of 535 million barrels to 419 million in January, 2018. More importantly, figure 2 shows that the SPR (Strategic Petroleum Reserve), which is an emergency crude oil stored underground in LA & TX, and maintained by the department of energy (DOE) was mostly flat, at about 700 million barrels. However, since March 2017 it has declined about 50 million barrels, and the reason is that the US government plans to sell half of the oil in SPR storage gradually. It was part of the White House budget sent to US congress in 2017.
What impact would the 350 million barrels SPR stored oil that is planned for sale is going to have on the global oil markets or what can we infer from it? First, it might cause an imbalance in the global oil supply and demand if released too quickly into the oil market. for instance, if oil prices reach $85-to-$100 per barrel there would be more enticement to release large amounts of SPR oil. Secondly, by selling half of SPR oil, the US is sending a clear message about the diminishing "reliance on oil imports" or the need to maintain large inventory of oil storage. However, the SPR oil release/sell process would probable be gradual and take long time because it's often part of the yearly budget submitted to the US Congress. Hence, the impact of SPR oil release on the global oil markets might be very small, if at all.
Figure 3 shows average yearly US oil storage changes versus time overlaid with periods of official US recessions. The data shows that though most people think that high oil prices caused most of US recessions, there is little correlation to back up that type of conclusion. However, the big recession of 2008, which occurred after oil prices rapidly increased to $140, is open for debate. One important finding from Figure 3 is that the fluctuations in US oil storage year-over-year have had wild swings recently from about +80 million to -70 million barrels, especially since 2014. Are we going to see cyclical and wild swings in US oil storage in the future? Though no one knows what would happen, recent changes such as US lifting of oil/gas export ban and the high spread between Brent vs WTI would probably lead to "mean reversion" and stabilize the US oil storage around 350-to-400 million barrels.
Figure 4 shows the correlation between WTI oil price and US Dollar Index. In this analysis Down Jones FXCM Dollar Index was used, which is a basket of 4 global currencies (The Euro, the British Pound, the Japanese Yen, and the Australian Dollar) versus US dollar. For more details, please see the FXCM website. Clearly, there is an inverse correlation between the US dollar and WTI oil price, but the question is what to expect in the short-term (1-to-3 years) given that the US Fed Bank's draw-down on QE (quantitative easing) and expected interest rate hikes? Rising oil prices might cause inflation and prompt the Fed Bank to raise interest rates, which would put pressure on commodities denominated in dollars (petrodollars). Usually weaker dollar means higher commodity prices, and vice versa.
Additionally, Figure 4 shows technical analysis, Fibonacci Retracements and Rising Wedge, of WTI oil price (CME: CL). The blue bars overlaid in the chart are daily volume trades of WTI oil price. From technical analysis point of view, the Rising Wedge (dashed red lines) is a bearish pattern, but WTI oil price broke it upward at the end of December, 2017. Similarly, Fibonacci Retracements (yellow lines), which is ratios used for identifying potential reversal levels, was acting as resistance at level (38.2%) or WTI oil price (of $58.68), but oil price momentum broke it upward at the end of December, 2017. Hence, the next big test for WTI oil price is at $68, which is the 50% of Fibonacci Retracements. In short, if WTI oil price declines, its first support is $58.68.
Figure 4: Correlation between WTI Oil price and US Dollar Index (Dow Jones FXCM Dollar Index). The chart also shows technical analysis (Fibonacci Retracements and Rising Wedge) of WTI oil price (ThinkorSwim data)
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Disclosure: I am/we are long BHGE. 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.