Oil has rallied 27% from recent lows. Several prominent investors, analysts, and industry insiders have called this the bottom in crude oil prices. There are predictions that crude oil can recover to as high as $65 by year-end. These predictions are driven by three forces:
On July 30, 2015, I wrote a note presenting a 12-24 month bearish view on crude oil and a bullish view 2+ years out. At the time, I pointed to 1) strong US Dollar, 2) continuing supply growth, and 3) slowing demand growth. Today, the US Dollar remains strong, Iran is prepared to bring oil to global markets, and demand has increased slightly year-over-year.
Use my interactive crude oil chart to see how a) US refinery demand for crude oil and b) US oil production have changed over time.
| Week ending: | February 20, 2015 | January 1, 2016 | February 19, 2016 |
|---|---|---|---|
| US Refinery Demand | 15,243k bpd | 16,617k bpd | 15,685k bpd |
| US Production | 9,285k bpd | 9,219k bpd | 9,102k bpd |
| US Net Imports | 6,801k bpd | 7,010k bpd | 7,403k bpd |
| US Surplus | 843k bpd | -388k bpd | 820k bpd |
Since the beginning of the year, US refinery demand is down 932k bpd and US production is down 117k bpd. However, refinery demand has seasonality. Year-over-year, demand is up 442k bpd and production is down 183k bpd. However, US oil is not a closed system. Imports are up 602k bpd yoy and up 393 bpd since the beginning of the year.
Demand exhibits a lot of variability. Crude oil must be refined before it can be used. Refining capacity in the US has not grown at the pace of US oil production and refinery utilization oscillates between 85% and 95% largely due to seasonality, facility maintenance, and equipment failure. Pumping more oil doesn’t mean more gasoline and diesel production if the bottleneck of refining has not been widened. As a result, oil stockpiles build when refineries cannot accept more feedstock.
The very slight decreases in US production have been replaced by increased imports. Supply responses in the US can been fulfilled by production around the world, such as Iran’s planned ramp up. Oil is a global supply problem, not merely a US supply problem.
It is important to note the data is extrapolated from surveys and there is some margin of error to the measurements (for example, findings of EIA and API surveys can differ by millions of barrels in stockpile changes each week); therefore, we should not rush to conclude trends from smaller fluctuations that may be measurement variability.
In past oil cycles, low-cost producers had strong balance sheets while high-cost producers had weak balance sheets. As oil prices fell, high-cost producers filed bankruptcy. This time it is the reverse. Strong balance sheet producers like Exxon Mobil, Chevron, and BP have high-cost offshore oil platforms. They can sustain losses with mountains of cash and are not in danger of missing debt repayments. Weak balance sheet producers have low-cost onshore wells. With cash operating costs of $30 per barrel, they can keep pumping until their debt payments are due.
In the US, businesses do not cease operations upon bankruptcy. The bankruptcy process is intended to maximize the recovery value for creditors. In the case of oil E&P firms, creditors are much better off taking control of producing wells rather than barren fields.
The likely result of a bankruptcy will simply be senior creditors taking over the equity of the firm and the firm’s debt burden getting lifted. The firm would then emerge from bankruptcy with an even lower cost of production. Investors must remember that fracking firms are losing money at these oil prices because of their debt service. Many are not losing money on a cash operating basis. Once these companies are free of debt service, they may be able to operate at $30 per barrel.
In other cases, oil assets will be sold to surviving firms, which will reduce overhead costs and decrease the cost of production. Either way, there will be more barrels at lower cost.
If there is no new investment, global oil production is estimated to fall 4% each year as wells age. Capex around the world is definitely down—billions of dollars of new projects have been cancelled or delayed. For conventional drilling projects, this takes supply away from the years in the future when these projects should have come online. For unconventional drilling projects, this takes supply from the near-term. According to Baker Hughes data, oil rigs in North America have fallen from 1,609 rigs on October 10, 2014 to 413 rigs on February 19, 2016.
But . . .
It is well known that shale wells do not last as long as traditional wells. Tight oil wells often produce 1,000 bpd at start and decline 6 - 10% per month to 100 - 400 bpd by end of year one. After the steep decline of the first year, these wells continue to produce oil at a more stable level for an average of 6 - 7 years (traditional wells can produce for decades). We are also learning that newer technology is extending the life of these fracking wells over previous estimates.
A 60 - 90% production decline in the first year may sounds troubling, but only a small portion of the 9.2 million bpd US production will still suffer this steep decline. Some estimate US production may decline by 1 million bpd in 12 months if no new wells are brought online, but after that the declines would be much less drastic.
The upward force capex cuts have on prices is not the same today. Fracking has a much shorter lead time than traditional oil drilling. US companies can drill horizontal wells in one to three weeks. If oil prices recover at all, US companies can ramp up new oil production within a month. Investors may be anchoring expectations to previous oil cycles in which offshore drilling could take a year to recover production drops. The cost of drilling has decreased from billions of dollars to single-digit millions with unconventional drilling. Furthermore, the plunge in oil prices has forced US firms to become even more efficient. The capex required has declined through increased pad drilling, longer-lateral wells, lower oilfield service costs, and high-grading. Overall, this means new supply can respond to rising prices much faster than in previous oil cycles. Update: After writing this report, Reuters reported a number of shale firms say they will return to drilling if oil reaches $40. EOG Resources has become more efficient that its better wells can yield 30% returns with oil only at $40.
DUCs are a new phenomenon that pose a major obstacle to any price rise. This began as a consequence of the times. E&P firms had signed contracts to hire drilling rigs for a set time period. As oil prices fell and oil companies needed to conserve cash, they kept drilling with the rigs they already hired but did not hire crews to complete the wells. In other cases, firms needed to keep drilling as part of the conditions of their land lease. The well completion process involves pumping water, sand, and chemicals to hydraulic fracture shale rock to release oil and gas. Firms also became more efficient, drilling more wells per rig.
Drilling is 3/4 the cost of setting up a well, so much of the capex is already done. The cost of completing wells has dropped 40%. NY Times reported there are over 4,000 DUCs in the US ready to produce over 500,000 bpd once firms decide prices are high enough to release the oil. To frame this significance, Iran is expected to add just 300,000 bpd of production this year. These figures place production at 125 bpd per well, which already accounts for the steep productivity decline curve (wells often produce 1,000 bpd at start). In the Eagleford, 40% of the 1,400 DUCs would be profitable at sub-$30 oil but firms are holding back in hopes for higher ROI if prices recover. Completing these wells will quickly make up for the capex cuts so far.
Anadarko, EOG Resources, and other major producers are now intentionally using this strategy to warehouse oil underground, ready to release to the market the moment oil prices rise. Executives at Anadarko report they are drilling more wells in 2016 than in 2014 with fewer rigs and more efficient well designs. This backlog of DUCs around the country is growing.
The main driver of the recent 27% rally in oil prices has been speculation that OPEC and Russia will freeze production at January 2016 levels. Mohammed bin Saleh al-Sada, current OPEC President and Qatar’s Minister of Energy, believes the freeze could increase oil prices to $50 in a year. It is important to clarify that discussions are to freeze production, not cut production.
So far, five of OPEC’s thirteen members (Saudi Arabia, Kuwait, United Arab Emirates, Qatar, and Venezuela) and Russia are reportedly interested in the freeze plan. However, Iran has called the proposal a “joke.” There is some talk that Saudi Arabia, Russia, and a few other OPEC members may meet to discuss this freeze in March.
However, the next OPEC meeting is not until June 2, 2016 and any decision to change the quota requires unanimous approval by all thirteen members. It is possible that OPEC allows an exception for Iran, but that still means Iran will add 300k bpd in 2016 and another 500k bpd in 2017 according to EIA forecasts. This is more than adequate to make up for US production decreases.
Furthermore, Iraq has not agreed to the freeze. Iraq increased production to 3.297 million bpd in December despite ISIS clashes. Investors should expect this to continue as the country recovers, especially if any progress is made against ISIS.
Throughout history, past efforts to raise prices through collusion were mitigated by rampant cheating. Saudi Arabia bears the brunt of the production cuts while smaller countries that require the revenue continue to ramp production. Today, Saudi Arabia cannot bear this alone as the kingdom desperately tries to meet budget expenditures by planning an IPO of crown jewel Saudi Aramco. Russia and other OPEC members are in similarly dire situations in which the incentive to cheat is too high.
On the bear side, there are those who believe oil will never reach $45… ever again.