On Monday, I discussed how OPEC abandoned Saudi Oil Minister Naimi’s market share strategy during H2 last year.
Naimi’s strategy had stopped the necessary investment being made to properly exploit the new US shale discoveries. But this changed as the OPEC/non-OPEC countries began to talk prices up to $50/bbl. As CNN reported last week:
“Cash is pouring into the Permian, lured by a unique geology that allows frackers to hit multiple layers of oil as they drill into the ground, making it lucrative to drill in the Permian even in today’s low prices.”
Private equity poured $20bn into the US shale industry in Q1
Major oil companies were also active, with ExxonMobil spending $5.6bn in February
US oil/product inventories have already risen by 54 million barrels since January last year and are, like OECD inventories, at record levels. And yet now, OPEC and Russia have decided to double down on their failing strategy by extending their output quotas to March 2018, in order to try and maintain a $50/bbl floor price. US shale producers couldn’t have hoped for better news. As the chart shows:
US inventories would be even higher if the US wasn’t already exporting nearly 5 million barrels/day of oil products
It is also exporting 500 kb/d of oil since President Obama lifted the ban in December 2015
Nobody seems to pay much attention to this dramatic about-turn as they instead obsess on weekly inventory data
But these exports are now taking the fight to OPEC and Russia in some of their core markets around the world
None of this would have happened if Naimi’s policy had continued. Producers could not have raised the necessary capital with prices below $30/bbl. But now they have spent the capital, cash-flow has become their key metric.
The second chart confirms the turnaround that has taken place across the US shale landscape, as the oil rig count has doubled over the past year. Drilling takes between 6 – 9 months to show results in terms of oil production, and so the real surge is only just now beginning. Equally important, as the Financial Times reports, is that today’s horizontal wells are far more productive:
“This month 662 barrels/d will be produced from new wells in the Permian for every rig that is running there, according to the US government’s Energy Information Administration. That is triple the rate of 217 b/d per rig at the end of 2014.”
Before too long, the oil market will suddenly notice what is happening to US shale production, and prices will start to react. Will they stop at $30/bbl again? Maybe not, given today’s record levels of global inventory.
As the International Energy Agency (IEA) noted last month, OECD stocks actually rose 24.1mb in Q1, despite the OPEC/non-OPEC deal. And, of course, as the IEA has also noted, the medium term outlook for oil demand has also been weakening as China and India focus on boosting the use of Electric Vehicles.
The current OPEC/non-OPEC strategy highlights the fact that whilst the West has begun the process of adapting to lower oil prices, many oil exporting countries have not. As Nick Butler warns in the Financial Times:
“Matching lower revenues to the needs of growing populations who have become dependent on oil wealth will not be easy. It is hard to think of an oil-producing country that does not already have deep social and economic problems. Many are deeply in debt.
“In Nigeria, Venezuela, Russia and even Saudi Arabia itself the latest fall, and the removal of the illusion that prices are about to rise again, could be dangerously disruptive. The effects will be felt well beyond the oil market.”
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 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.