OPEC and Russia made a massive mistake last November when when they decided to try and establish a $50/bbl floor for world oil prices. And now they have doubled down on their mistake by extending the deal to March 2018. They have ignored 4 absolutely critical facts:
Major US shale oil producers were already reducing production costs below $10/bbl, as the Pioneer chart confirms
The US now has more oil reserves than Saudi Arabia or Russia, with “Texas alone holding more than 60bn barrels”
At $30/bbl, US producers couldn’t raise the capital required to exploit these newly-discovered low-cost reserves
But at $50/bbl, they could
Former Saudi Oil Minister Ali Naimi understood this very well. He also understood that OPEC producers therefore had to focus on market share, not price, as Bloomberg reported:
“Naimi, 79, dominated the debate at OPEC’s November 2014 meeting, according to officials briefed on the closed-door proceedings. He told his OPEC counterparts they should maintain output to protect market share from rising supplies of U.S. shale oil.”
Naimi’s strategy was far-sighted and was working. The key battleground for OPEC was the vast Permian Basin in Texas – its Wolfgang field alone held 20bn barrels of oil, plus gas and NGLs. By January 2016, oil prices had fallen to $30/bbl and the Permian rig count had collapsed, as the second chart confirms:
Naimi had begun his price war in August 2014, and reinforced it at OPEC’s November 2014 meeting
Oil companies immediately began to reduce the number of highly productive horizontal rigs in the Permian basin
The number of rigs peaked at 353 in December 2014 and there were only 116 operating by May 2016
But then Naimi retired a year ago, and with him went his 67 years’ experience of the world’s oil markets. Almost immediately, OPEC and Russian oil producers decided to abandon Naimi’s strategy just as it was delivering its objectives. They thought they could effectively “have their cake and eat it” by ramping up their production to record levels, whilst also taking prices back to $50/bbl via a new alliance with the hedge funds, as Reuters reported:
“OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016…. OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance”.
This gave the shale producers the window of opportunity they needed. Suddenly, they could hedge their production at a highly profitable $50/bbl – and so they could go to the banks and raise the capital investment that they needed.
As a result, the number of rigs in the Permian Basin has nearly trebled. At 309 last week, the rig count is already very close to the previous peak.
The Permian is an enormous field. Pioneer’s CEO said recently he expects it to rival Ghawar in Saudi Arabia, with the ability to pump 5 million barrels/day. It is also very cheap to operate, once the capital has been invested. And it is now too late for OPEC to do anything to stop its development.
On Thursday, I will look at what will likely happen next to oil prices as the US drilling surge continues.
The myth of oil market rebalancing has been a great money-maker for financial markets. Hedge funds were the first to benefit in H2 last year, as Reuters has reported, when:
“OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016…. OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance. In return, the funds delivered an early payoff for OPEC through higher oil prices and a shift from contango to backwardation that should have helped drain excess crude stocks.”
Then the investment banks had their day in the sun, raising $19.8bn in Q1 for private equity players anxious to bet on the idea that prices had stabilised at $50/bbl for US shale oil production. This was 3 times the amount raised in Q1 last year, when the price was recovering from its $27/bbl low.
There was only one flaw in the story – the rebalancing never happened. As the chart shows, OECD inventories are now heading back to their previous record highs, having risen 38.5mb since January’s OPEC deal began. As always, most countries failed to follow through on their commitments – non-OPEC compliance was just 66% in March, and Russia is still producing 50kpd more than its quota this month.
US inventories have also continued to rise, hitting all-time peaks, as the second chart confirms. Stocks would be even higher if US crude oil exports hadn’t surged by 90% versus last year to reach 706bpd this month. This is hardly surprising. Major cost-cutting over the past 3 years means that a company such as ExxonMobil now has an average cash operating cost of less than $10/bbl.
US producers have been laughing all the way to the bank, as the third chart confirms, showing the recovery in the US drilling rig count. Not only have they been able to hedge their output into 2019 at today’s artificially high prices. But they have also been able to ramp up their use of modern, highly efficient horizontal rigs. These now dominate drilling activity, and are a record 84% of the total in use – reversing the ratio seen before shale arrived.
It doesn’t take a rocket scientist to work out what will likely happen next:
US production and exports will keep rising as all the new rigs are put to work – there are already 5500 drilled but uncompleted wells waiting to come onstream. Meanwhile, US demand will likely hit a seasonal peak – Memorial Day on 29 May usually marks the moment when refiners finish building inventory ahead of the US driving season
China’s slowing economy will not provide much support. It became a net exporter of fuel products in Q4 last year and February data showed net gasoline exports at 1.05 million tonnes, as they jumped 77% versus 2016. Diesel exports were also up 67% as refiners followed the US in trying to reduce their domestic supply glut
India’s domestic demand is still suffering from the after-effects of the demonetisation programme. It was down 4.5% in January, and was still down 0.6% in March versus a year ago. Japan’s demand is also down, with the government expecting it to fall 1.5%/year through 2022 due to the combined impact of its ageing population and increasing fuel efficiency. S Korean demand is also expected to continue falling for similar reasons
OPEC may well extend its quotas for another 6 months, but this will just give more support to US shale producers. And within OPEC, Iraq plans to boost output to 5mbd by year-end, versus 4.57mbd in February, whilst Libya aims to double its March output of 622kbd, and Iran has already increased its exports to 3mbd for the first time since 1979
Unless geopolitical events intervene, it is therefore hard to see how the myth that the oil market is now rebalancing can be sustained for much longer.
The past few weeks have been a nightmare for the many hedge funds who gambled on higher oil prices. They obviously hadn’t realised that OPEC’s November quota agreement was most unlikely to lead to a major rebalancing of today’s vastly over-supplied market. But as I suggested in December:
“The simple fact is that the arrival of US shale production means OPEC are no longer the swing producer, able to control the world market. The quotas will have little effect in themselves, as most of the participants will cheat. Instead, they will simply help to boost US oil and gas production, whilst turbo-charging the use of smart meters.”
Now the funds are finally starting to bail out of their positions. As John Kemp of Reuters reported this week under the headline Hedge funds rush for exit after oil trade becomes crowded:
“Hedge funds cut their bullish bets on oil by the largest amount on record in the week to March 14, according to the latest data published by regulators and exchanges. Hedge funds and other money managers cut their combined net long position in the three main futures and options contracts linked to Brent and WTI by a record 153 million barrels in just seven days. The reduction in the net long position coincided with the sharp fall in oil prices, which started on March 8 and continued through March 14.
“Before the recent sell off, hedge fund managers had boosted their net long position in Brent and WTI by 530 million barrels between the middle of November and the middle of February. Funds amassed a record 1.05 billion barrels of long positions, while short positions were cut to just 102 million barrels, the smallest number since oil prices started slumping in 2014. But large concentrations of hedge fund positions, and an imbalance between the long and short sides of the market, often precede a sharp reversal in oil prices.”
Another sign of the hedge funds’ problem is that even after this sell-off, ThomsonReuters data shows their net position on WTI is still higher than in early August 2014 – just before the price collapse from $105/bbl began. Or as Bloomberg noted:
“The value of long positions for Brent and West Texas Intermediate crude, the global and U.S. benchmarks, reached a combined $56 billion on Feb. 23“.
$56bn is an awful lot of oil to have to try and sell in a falling market. And of course, the hedge funds are well behind savvy traders such as Vitol and TOTAL, who have been selling their barrels of stored oil for some time.
Already, WTI prices are back at the $48/bbl level seen at the end of November, before the rally began. Equally important is that the contango in the futures market has collapsed – with prices for May 2018 now just $0.30/bbl higher than for May this year. $0.30c/bbl won’t pay insurance and storage costs for a year, so all that stored oil will now have to be sold, as quickly as possible.
US SHALE OIL OUTPUT IS RAMPING UP VERY QUICKLY
The funds, and many observers, have simply failed to recognise that the structure of the US shale oil market has completely changed in the past 2 years. As I discussed 18 months ago under the heading, Oil price forecasts based on myths, not proper analysis, each well no longer has to be redrilled every few months, .
Today, the Permian Basin in Texas/New Mexico has become the showpiece field for modern shale production. Latest EIA data shows its production next month is forecast to be 2.3mbd, nearly half of total shale production of 5mbd. It also has almost of a third of the 5443 ‘Drilled but Uncompleted” wells, now waiting to produce oil and gas in the major shale fields. And as the chart above shows:
Its oil production per rig has more than doubled over the past 2 years due to horizontal drilling
Each rig now produces 662 bbls/day compared to 288 bbls/day in March 2015
Since May last year, the number of rigs in operation has more than doubled – from only 137 to 300 last month
As each rig normally takes 6 – 9 months to finish its work, the major expansion of production is still to come
Unsurprisingly, major oil producers are heavily invested in the field, with ExxonMobil having just spent $5.6bn to buy 3.4bn bbls of oil equivalent reserves. As the Forbes chart shows, EM’s cash operating cost was already less than $10/bbl last year. And EM now plans to more than double its rigs in the Basin to 25 after the investment closes.
Of course geopolitical events, such as a US bombing of N Korea, could change these dynamics overnight.
But anyone still gambling on higher oil prices and a rapid rebalancing of the market, probably has a very nasty shock ahead of them. The simple fact is that not only are US inventories at near-record levels but, as the top chart shows, the US is now also exporting 5mbd of crude and oil products – and this volume is rising month by month.
It would be no surprise at all, if prices fell back to their median level since 1861 of $23/bbl in the next few months. And they might have to go even lower, temporarily, as many producers happily hedged themselves at $50/bbl for the rest of this year, when the speculative bubble was at its height.
Trading oil markets used to be hard work.
You had to talk to all the major players all the time (not just message them), and learn to judge whether they were telling the truth or inventing a version of it. You had to watch for breaking economic and political news. And you needed your own supply/demand balances. Plus you had to guess how the fabled ”Belgian or New York dentist” – who traded oil futures to break the tedium of drilling teeth – might be feeling each day.
Today’s trading world is completely different:
More than half of all trading is done by machines at ultra-high speed. These are the “legal highwaymen” described in Michael Lewis’ great book Flash Boys. And they don’t care about the real world of oil markets or the economy, as these factors are irrelevant to their business models
Then you have the hedge funds, and even some pension funds, with quarterly targets for profit. They can’t afford to spend time developing a detailed analysis, and waiting for the market to catch up. They have to play the momentum game of finding a story, and jumping on it as quickly as possible
In addition, of course, there are still producers and consumers, who actually need to buy or sell oil. They used to set the market prices in the past, but are just an also-ran today as their volume is so small relative to the others. But in the “real world” outside of financial trading, they are the only people who matter
New data from the CME highlights the change. It shows paper trading in just WTI futures averaging a record 11 million contracts each day in 2016 (each of 1000 barrels). Actual physical production, by comparison, is around only 92 million barrels per day. The speculative tail is indeed wagging the dog.
The chart above shows the current net position of the speculators, which is at a record 371k contracts. It highlights just how much they love the OPEC production cut story – it is easy to understand, and is easy money for everyone, particularly the momentum traders, as the story seems never-ending.
The only problem – for players in the real world – is that the “story” isn’t true. Today’s headlines may say that OPEC has 82% compliance, but this was only because of Saudi Arabia – which cut 564kb versus the promised 486kb, according to the Reuters data above. Outside the GCC countries, not much happened. Venezuela – which led lobbying for an output cut – delivered only 18% of its promise, and Russia only cut 117kb versus its promised 300kb.
“Who cares?”, you might say, if you are one of the highwaymen or a momentum trader. Talk is cheap, and you can tell the media it is early days, and countries take time to adjust. They love an easy story, just as you do, and believe their viewers want a quick trading tip – not a boring discussion about rising US inventories for oil (up another 6mb last week) and gasoline inventories (now actually above the upper limit of the normal seasonal range).
You certainly don’t want to dive into the detail of rising US shale production (already back at April’s level), and rising numbers of drilling rigs (back to November 2015 levels). And you certainly won’t discuss the 5300 drilled but uncompleted oil/gas wells, where producers only have to turn the tap to start earning revenue.
Well, not just yet, anyway. Maybe in a week or two, it might be time to learn a new script. After all, “what goes up, comes down”. The dream scenario for the paper traders would be if today’s major rally was followed by a major collapse. After all, the refinery maintenance season will soon be starting, causing physical demand to drop.
Of course, all this volatility has a price. The market is a zero-sum game where overall, the consumer and the producer pay the cost of the speculator’s outsize profits. And in the geo-political world, there is one major loser – Saudi Arabia.
The Saudis know that President Trump doesn’t support the ‘Oil for Defence‘ agreement made 70 years ago, which protected them in 1990/1991 when Iraq invaded Kuwait. So they have to stay close to the other OPEC members, and make the major share of the cuts. But what will happen in Saudi, if and when prices fall back – say to the $30/bbl level seen a year ago?
Oil prices, and those of natural gas, have been on a wild ride over the past year, as the chart confirms. It shows US WTI prices divided by 6, as this enables a comparison with natural gas prices in terms of energy content:
Oil prices have come down a long way from their 2008 and 2010-2104 peaks
Natural gas prices have similarly never recovered to their 2006 and 2008 peaks
But both saw major increases last year as US production temporarily declined from its peak levels
As the US Energy Information Administration (EIA) reported, US oil production was down 4.5% in December versus 2015, and natgas production was down 3.5% in October versus 2015. Yet as the EIA forecasts:
“U.S. crude oil production averaged an estimated 8.9 million barrels per day (b/d) in 2016 and is forecast to average 9.0 million b/d in 2017 and 9.3 million b/d in 2018. Forecast dry natural gas production increases by an average of 1.4 Bcf/d in 2017 and by 2.8 Bcf/d in 2018″
In natgas, the EIA’s commentary confirmed the market’s underlying weakness:
“US Natgas prices in 2016 were the lowest in nearly 20 years (and) In November 2016, the United States became a net exporter of natural gas on a monthly basis for the first time since 1957″.
Oil markets are also still in surplus, as the International Energy Agency reported last month:
“Global oil supplies in November edged up to a record high 98.2 mb/d, as a drop in non-OPEC output was more than offset by higher OPEC production. OPEC output stood 1.4 mb/d higher than a year ago
OECD inventories have drawn 75 mb since reaching a historical high in July, but remain 300 mb above the five-year average
Refinery crude intake in 1Q17 is forecast to grow by only a modest 310 kb/d y-o-y, after growing by only 350 kb/d growth in 4Q16″
Nothing has really changed in terms of underlying supply/demand balances during the year. In turn, this raises the question as to why prices have risen so strongly, particularly in recent weeks?
The answer is simple, and captured in the second chart showing net speculative positions in the WTI futures market. As Reuters reported last month:
“Hedge funds have amassed a record bullish position in crude oil in anticipation OPEC and non-OPEC oil producers will succeed in rebalancing the market and reducing excess stocks next year. Fund managers accumulated a net long position equivalent to 796 million barrels in the three main futures and options contracts linked to Brent and West Texas Intermediate by Dec. 13. The net position almost doubled from a low of 422 million barrels four weeks earlier.”
Those doing the buying have adopted a high-risk strategy. Of course, the year-end is a great time to move markets, when many players are out of the office. But they are betting against some well-known and well-established facts:
The market is well supplied, and major players such as Shell suggest the world may be close to “peak demand”
OPEC’s record in implementing output cuts is poor, and Russia has never cut production as promised
Saudi Arabia and its GCC partners are the only ones likely to cut production. As I discussed last month, it cannot rely on President Trump to support the critical ‘Oil-for-Defence’ deal agreed in 1945 between King Saud and President Roosevelt. It dare not, therefore, break with its Arab neighbours and keep pumping.
But other OPEC members are unlikely to provide major support.
Iran is highly likely to keep pumping. President Rouhani faces re-election in May, and his position has just become more difficult with the death of former President Rafsanjani.
Libya’s output has already trebled over the past 6 months to 750kbbls/day, and could potentially return to previous levels of 1.6 million bbls/day if the civil war comes to an end.
Nigeria is also capable of increasing output, with its Oil Minister recently claiming it had reached 1.9 mb/d
Others such as Iraq and Venezuela are equally doubtful
The issue is simple. Cash in the bank is the priority for all the major oil producers.
US producers are in best shape, as they have been able to hedge their production at today’s high prices. But cash is the priority for other producers too. The UAE is the only OPEC member in the Middle East/N Africa able to balance its budget at $50/bbl, as the IMF has noted. OPEC also faces another fundamental problem:
Cartels can only operate on the basis of trust – each member has to believe others will take the pain of cutbacks
The OPEC cartel has never seen this level of trust
The only time cuts took place effectively was in 1981-1985, when Saudi cut production from 10.3mb/d to 3.6mb/d
Unless Saudi does this again, which appears unlikely due to its own budget needs, history would suggest the output cuts will fail to achieve their target. And, of course, as prices fall, so countries will have an incentive to sell more in order to boost revenues, creating a vicious circle. Hedge funds will also quickly reverse their speculative positions.
What this may mean for political stability in the Middle East and N Africa is a question for another day. In the meantime, it is clear that OPEC’s output agreement is a highly risky gamble. If it fails, prices could easily fall a long way very quickly, given today’s surpluses.
OPEC is living in the past with its recent announcement of new quotas.
The simple fact is that the arrival of US shale production means OPEC are no longer the swing producer, able to control the world market. The quotas will have little effect in themselves, as most of the participants will cheat. Instead, they will simply help to boost US oil and gas production, whilst turbo-charging the use of smart meters.
OPEC’s core problem was also highlighted by the recent announcement by the US Geological Survey of:
“The largest estimate of continuous oil (shale) that USGS has ever assessed in the United States.The Wolfcamp shale in the Midland Basin portion of Texas’ Permian Basin province contains an estimated mean of 20 billion barrels of oil, 16 trillion cubic feet of associated natural gas, and 1.6 billion barrels of natural gas liquids
“The fact that this is the largest assessment of continuous oil we have ever done just goes to show that, even in areas that have produced billions of barrels of oil, there is still the potential to find billions more.”
The US is already well on the way towards energy independence within the next 5 years, as BP have reported. OPEC’s move will therefore prove totally counter-productive, as it will simply support the growth of natural gas, renewables, and energy efficiency. (This inter-active map from the University of Texas shows the dramatic growth in the role of gas and renewables for US electricity production).
Saudi Arabia had therefore adopted the right policy in the summer of 2014, in recognising that market share was the key to success. Anyone who cuts back on oil sales today in the hope of higher prices, risks being unable to sell in the future. But, of course, Saudi has now had to change course for geopolitical reasons, as I discussed last week. With President-elect Trump about to take office, it can no longer rely on its Oil-for-Defence deal with the USA.
Trump’s arrival will add to OPEC’s problems, as his 100-day Action Plan aims to:
“Lift the restrictions on the production of $50tn worth of job-producing American energy reserves, including shale, oil, natural gas and clean coal.”
Fracking technology is now well understood in the US, and becoming very efficient due to the introduction of horizontal drilling techniques. It is therefore unlikely that OPEC’s new quotas will have much impact on the global oil market. Most OPEC and non-OPEC producers will cheat, as usual. And today’s temporarily higher prices are simply going to further increase the overall supply glut by incentivising higher US oil and gas output:
The recent price rises have already enabled US producers to lock in very attractive margins into 2019
They will also support US oil exports into Asia, one of OPEC’s key markets. BP is currently sending the first shipment, of 3 million barrels, and others such as Sinopec and Trafigura are following
They will also support US natural gas production, where the US became a net exporter last month. US gas exports have already risen 50% since 2010, and the US Energy Department expects it to become the world’s 3rd largest exporter after Australia and Qatar by 2020. This is very bad news for oil demand, as it means gas will be even more competitive in world energy markets.
Equally important is the rise of energy efficiency as a topic for action. This was first flagged by ExxonMobil in 2009, when they argued:
“The most important ‘fuel’ of all, will be energy saved through fuel efficiency“.
Now, thanks to climate change, efficiency has reached the top of the political agenda. Smart meters will soon provide more than a billion consumers with the ability to avoid wasting energy, as the World Energy Council report this month:
“China is the leader of the smart metering market with 250 million units, in Asia plans are underway to reach 70% coverage, and 40% of American households have a smart meter. At European level, Italy and Sweden are the leading examples (close to 90% of consumers have smart meters). Furthermore, the Energy Efficiency Directive requires EU member states to deploy smart meters by 2020.”
The arrival of smart meters means that consumers now have an alternative to paying higher prices, as they can more easily identify where they are wasting energy, and cut back.
Developments such as the growth of US oil and gas production, plus the growth of smart meters, means that the energy world is going through major change. In this New Normal world, OPEC risks becoming irrelevant if it continues to try and turn back the clock to the 1970s with its pricing policies.