For decades, Organization of Petroleum Exporting Countries (“OPEC”) policy has largely set the tone for oil prices and sentiment surrounding the energy sector in general. While still controlling roughly a third of the global oil supply (44% when including Russia as part of the new “OPEC+” group), OPEC’s efficacy, however, has been recently put into question. Such doubts seemed to have peaked in Spring 2017 when oil inventories in the US remained stubbornly high in the face of OPEC+’s 1.8 million barrel/day production cut that became effective on January 1, 2017. A logical explanation was that the impact of the agreement was simply delayed due to strong production from OPEC countries just prior to the cuts, resulting in bloated barrels in storage that were shipped in the first half of 2017. Even so, rapid growth from US shale producers (short-cycle production) increasingly led some analysts to question if OPEC can still effectively control supply and bring global inventories down to its goal of the five-year average. As recently as Summer 2017, the consensus seemed to think this was improbable.
Fast forward a few months, and, in the words of Michael Scott (NBC, “The Office”), “How the turntables have turned.” Instead of a world bloated with oil and doubting an antiquated OPEC, in our view, increasing tightness now best characterizes global oil markets. In fact, according to Energy Aspects, the global inventory overhang now stands at just 150 million barrels (“mmbls”), down from a peak of roughly 600 mmbls in 2016, and as high as 450 mmbls at the end of Q1 2017. Even more significantly, when combined with robust demand conditions (where consumption is growing at a swift year-over-year rate of 1.5 mmbls/day), days of supply is now lower than the 5-year average.
We believe several factors caused this seemingly sudden shift in supply conditions. First is OPEC, which, in late-May 2017, extended its policy of production cuts for another nine months. At that time, Saudi Arabia (its most critical member at nearly a third of OPEC production) also pledged a dramatic reduction in its exports. As shown in the chart below, Saudi has upheld this vow with its exports falling roughly 1 mmbls/day from March 2017. Furthermore, according to Saudi’s energy minister, it has instructed state-run Saudi Aramco to make an “unprecedented” cut of 560 thousand barrels (mbls) per day to customer allocations in November 2017 and to only supply 7.15 mmbls/day versus “very strong demand” of over 7.7 mmbls/day. Undoubtedly, the Kingdom is highly motived to achieve lower global inventories and in turn higher oil prices, given its potential IPO of Saudi Aramco (expected in the second half of 2018 or early-2019) and the massive reduction in its cash reserves since oil prices fell in 2014.
Another OPEC goal was for oil futures price curves to move to backwardation (i.e., downward sloping), which suppresses the economic rationale for producers or speculators to store inventories. OPEC seems to also have accomplished this goal, as increasing global oil tightness has been reflected in the Brent crude forward curve (red line in chart below) being in backwardation through the end of 2019.
Granted, WTI crude (the US benchmark) remains in contango through mid-2018 since excess inventories can still be found in the US, mainly at the Cushing, OK hub. Hurricane Harvey accelerated the pace of US refined product draws (gasoline and distillate), where US product inventories now approximate or are below the five-year average. For crude, however, Hurricane Harvey led to a temporary retracement to what had been a consistent trend of inventory reductions in the US since April 2017. Nevertheless, we expect those remaining inventories to also be reduced in upcoming months. In our view, additional US draws should be in part driven by the Brent-WTI spread, which has expanded to +$6/barrel. This large spread implies US crude exports are likely to remain near what is today considered to be maximum levels. Also, we believe further inventory draws should stem from robust crack spreads (refined products pricing minus crude prices) at refineries, many of which have deferred Fall 2017 maintenance given their high levels of current profitability.
Also benefiting the oil supply picture are realizations that US shale may not be growing as fast as previously thought and that several factors should serve as real constraints to upcoming shale production growth. To start 2017, the general expectation appeared to be for 400-500 mbls/day of production growth in the US. However, given the dramatic expansion in the US oil rig count for much of this year and dramatically-lowered breakevens quoted by numerous US producers, many analysts boosted their growth expectation closer to 1 mmbls for 2017. Moreover, some pundits even extrapolated this growth to additional years, with the US ultimately producing at a 13-14 mmbls/day rate, up dramatically from this year’s 9.7 mmbls/day forecast by the Energy Information Administration (IEA).
However, we believe such expectations for 2017 and beyond now look aggressive, especially given several increasingly-obvious constraints on supply growth and relatively flat production being reported in recent months within the contiguous United States. In our view, the most significant current constraint is in pressure pumping, where reactivations of crews and ordering of new equipment has lagged the recovery in drilling. The result is a large increase in DUC (drilled but uncompleted) wells, as well as growing lead times and service costs for fracking crews. Additionally, we believe sweet-spot exhaustion (where producers have drilled their prime acreage and best formations first) and diminishing returns of technology-driven efficiencies have also played roles in lowering growth expectations. Finally, we believe other physical limitations like water, trucks, labor, and even takeaway capacity are likely to have significant influence on the extent and pace at which shale production can ramp in the intermediate term.
Finally, we believe oil supply growth seems risked to the downside due to several global geopolitical issues. Most immediate could be the oil supply implications should the Trump administration, on October 15, 2017, choose to not certify Iranian compliance with the 2015 Iranian nuclear deal. The return of sanctions could put at risk much of the 1 mmbls/day of growth in Iranian exports since the nuclear deal was signed. Separately, following the overwhelming passage of the Iraqi Kurdistan independence referendum on September 25, 2017, Iraq has threatened to shut off its pipelines, which represent 600 mbls/day of production from that region. Finally, militant disruptions in Libya and Nigeria have made production from those countries largely an on/off switch in 2017, with production most recently ramped back closer to full practical production at 920 mbls/day and 1.77 mmbls/day, respectively, in September 2017. In sum, while the outcomes in these various global hotspots are difficult to predict, we believe that in all cases the risk for oil production is to the downside.
The combination of the factors above leads us to believe there is healthy support for oil prices in upcoming months. While sentiment in the sector seems to have recently improved, many investors remain unconvinced about the longevity of such favorable conditions and are concerned about risks to both supply and demand issues in 2018. We acknowledge the various macro and energy-specific risks that could reverse the trend of inventory tightening. Still, we believe indications currently show OPEC will stay the course, supply risk from geopolitics will remain ever-present, demand will stay favorable, and constraints to US shale growth will persist. As such, oil markets may continue to feel quite tight for some time longer.
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