Unchanged Factors that Threaten the rise in Crude Oil Prices
The bearish pressures seen working against crude oil prices earlier are still in place, and could make it tough for crude to hold onto its gains. One thing the major forecasters agree on is that, after shrinking dramatically in 2017, oil stockpiles should be starting to build up again.
Global oil demand dips seasonally as the need for winter fuels recedes, and data from both OPEC and the International Energy Agency suggest that will tip the market back into surplus in the first half of this year. Inventories will shrink again in the second half, their data indicate.
Supply disruptions boosted oil prices in early December, when a critical North Sea pipeline was halted, and at the end of the month when a pipeline explosion curbed flows from OPEC member Libya. The suspension of the Forties Pipeline System — one of the North Sea’s biggest disruptions since the 1980s — was resolved by the end of last month, and repairs on the conduit to Libya’s Es Sider terminal were completed about the same time. Risks to production still remain, though, with Goldman Sachs Group Inc. considering Venezuela and Nigeria to be among the most vulnerable.
An even bigger boost came last month when Iran, OPEC’s third-largest producer, faced its biggest street protests in almost a decade amid discontent with the country’s economic stagnation. Though these didn’t escalate or threaten oil facilities, crude prices didn’t fall back. Another risk to Iranian exports appears to have been dodged as U.S. President Donald Trump backs away from tearing up an accord on Iran’s nuclear program, which would have slapped American sanctions back on oil shipments.
Crude Oil Prices above $60 may not remain stable so soon
U.S. oil prices are treading water above $US 60/B (WTI) again, the first time since 2015.
Crude oil prices have a northerly wind in its sails, though everybody on board this fickle ship is cautious about its compass bearing. Since 2013 we’ve seen the price of a barrel peak to $110, capsize to $26, and roll back to $60.
The gyrations make sense.
Here is what we’ve learned over the past decade:
Above $80 is too high. Cash flow is ample. Investors gladly fund more drilling rigs. Pump jacks work hard. Too much productive capacity is added. But costs inflate quickly too—competitiveness diminishes within the oil industry, and also encourages alternative energy systems. Consumers become more miserly and demand growth decelerates.
Under $40 is too low. Cash flows dry up and investors jump ship. Rigs head back to their yards with drooping masts. Costs deflate, rapidly decimating employees and equipment in the service industry. Production begins to decline in marginal regions. State-owned enterprises are unable to pay their ‘social dividends’. On the consumption side, conservation and efficiency lose meaning; consumers revert to guzzling oil like free refills of coffee.
So, simplistically a mid-range price of $US 60/B should represent what oil pundits call “market balance.” It’s the elusive price point where daily consumption is equal to production; inventory levels are neither too low nor too high; and economists’ cost curves intersect with demand.
Yet, if there is one thing 160 years of the oil age teaches us, there is no such thing as a mid-range balancing point in oil markets. Everyone either rushes to one side of the ship or the other, almost always at the wrong time.
As in any marketplace, oil producers and consumers respond to price signals. Those on the using end of petroleum products respond to the changing winds of price fairly quickly. On the other hand, much of the world’s big producers are not like nimble sailboats, rather they act like big supertankers that take time to change direction. In other words, the time between investing capital (or not) to realizing changes in production is slower.
Even in the last 10 years, the frequency of price data (WTI) shows clustering around either the $45 to $50/B grouping or the $95 to $100/B range (see Figure 1). Of course, costs have come down significantly, and the shale revolution has not only lowered the cost curve, but also shortened the cycle time of responding to price signals. So, in theory it’s easy to believe that the low end of the price spectrum may be the new norm.
But that’s theory. In the oilfields of the world, much of the changes in cost have been a result of taking margin out of the service industry, something that goes up and down with the same waves that bob price. Further, productivity gains seen in US and Canadian shale plays are not the norm in the world—most oil producing nations are rocking the boat by shutting off oil valves rather than innovating on their processes.
Today’s choppy world of lower extraction costs, process innovation, investor apathy, disruptive alternatives and environmental pressures, have made us skeptical in believing in the possibility of higher oil prices. And when prices are high our minds become landlocked into thinking about endless demand growth, geopolitics, cartel collusion, steep decline rates and the necessity of high levels of capital investment.
I’m only skeptical of one thing: That world oil markets will balance around $US 60/B. Historically, oil prices have not anchored in the calm of mid-ranges for long. So, today’s price is only a way point to either $US 45/B or much higher. – Peter Tertzakian
Will Surging U.S. Shale Kill Off The Rally in Oil Prices?
The U.S. shale industry is bringing enormous volumes of new oil supply online, breaking records each month. The U.S. could top 10 million barrels per day (mb/d) by February, and reach a staggering 11 mb/d by the end of next year.
The EIA released the latest version of its Short-Term Energy Outlook (STEO), in which the agency dramatically revised up its expectations for U.S. oil output. Previously, the EIA thought the U.S. would only surpass the 10 mb/d threshold at some point in mid-2018; now they see it happening in February.
The larger production increase occurring on an accelerated timeline means that U.S. production will average 10.3 mb/d in 2018, the EIA says, up from its prior forecast of just 10.0 mb/d. In other words, U.S. output in 2018 will be 970,000 bpd higher than last year, a larger increase than the previous estimate of a 780,000-bpd increase.
The gains keep coming—the agency expects the U.S. to average 10.8 mb/d in 2019, while surpassing 11 mb/d by November 2019. Obviously, as has been the case for some time, most of the growth will come from the Permian basin.
On the demand side, the EIA sees consumption growing strongly this year and next, with global demand rising by an average of 1.7 mb/d in both 2018 and 2019.
These are staggering figures, and if realized, it would mean the U.S. will be producing more than Saudi Arabia and Russia by the end of next year. “If the pricing environment is supportive, there is no reason” why the U.S. couldn’t match the EIA’s projections, said Ashley Petersen, lead oil analyst at Stratas Advisors in New York, according to Bloomberg. “Saudi Arabia and Russia aren’t really making new investments on the scale we would expect to be competitive at those volumes in 2019.”
The U.S. shale industry, despite promises from executives about approaching their drilling plans with caution, is clearly putting its collective foot on the accelerator. “Yesterday, the U.S. EIA revised U.S. crude oil production for 2018 up by 250 k bl/day to 10.27 m bl/day. That was the fourth revision higher in four months,” Bjarne Schieldrop, Chief Commodities Analyst at SEB, said in a statement. “We still think it is too low with yet more revisions higher to come and we think that everyone is probably able to see this with just a half eye open.”
Schieldrop cites the dramatic increase in the backlog of drilled but uncompleted wells (DUCs) from last year. The DUC list expanded by 30 percent in 2017, rising from 5,674 wells in January to a whopping 7,354. Some of that increase had to do with supply constraints in the market for completion services. If the shale industry starts to whittle away at that DUC list in 2018, it could provide a jolt to oil supply. “Last year’s shale oil activity was mostly about drilling, with fracking and completion substantially trailing the drilling activity,” Schieldrop said. “For the year to come, we’ll likely see a shift towards completions of these wells and less focus on the drilling of new oil wells.”
But to a large extent, the massive level of growth from U.S. shale that everyone is counting on is predicated on continued strength in prices. The forecast could be derailed if there is another price slump for an extended period of time. A rapid increase in supply in and of itself could cause prices to fall, killing off the price rally that started the drilling frenzy to begin with.
“It’s not completely unexpected given the price momentum,” Eugen Weinberg, head of commodities research at Commerzbank AG, told Bloomberg, referring to the recent run up in oil prices. However, “the shale rebound is also for real,” he says, risking a “massive price slump.”
But oil traders don’t want to hear that right now. Brent crude is just shy of $70 per barrel, a level not hit in about three years. The bulls are running rampant. However, that level of one-sided sentiment often precedes a sharp change in direction.
Commerzbank noted the irony of oil prices hitting fresh highs on the same day that the EIA published a report forecasting U.S. oil supply rising to 11 mb/d.
“Reading the latest U.S. Energy Information Administration (EIA) prediction of U.S. crude oil production makes it seem virtually impossible for the price to react in this way,” Commerzbank analysts wrote. “Selective perception is the reason why the market is completely ignoring this just now. Attention is paid only to news that tallies with the picture of rising oil prices.”
The report from the investment bank pointed out that oil prices surged because of the large expected decline in crude inventories, a piece of data that may seem bullish but was undercut by the fact that gasoline inventories also spiked. “Oil prices are become increasingly detached from the fundamental data and risk overshooting,” Commerzbank concluded. – Nick Cunningham
Shale Restraint Could Lift Oil Prices above $80
Brent recently hit $70 per barrel and WTI surpassed $64.50, and oil executives from the Middle East to Texas no doubt popped some champagne. The big question is whether or not U.S. shale will spoil the party by ramping up production to extraordinary heights, setting off another downturn.
The EIA made headlines a few days ago when it predicted that U.S. oil production would surge this year and next, topping 11 million barrels per day by the end of 2019.
But shale executives repeatedly promised their shareholders that they would be prudent this time around, eschewing a drill-no-matter-what mentality that so often led to higher levels of debt…and ultimately to lower oil prices. Shale executives repeatedly insisted in 2017 that they would not return to an aggressive drilling stance even if oil prices surged.
We will soon find out if oil in the mid-$60s can entice shale drillers to shed their caution and jump back into action in a dramatic way. For its part, Goldman Sachs seems to believe the promises from the shale industry.
The investment bank said that at an industry conference in Miami on January 10-11, shale executives reiterated their strategies of caution. “Shale producers are largely not looking to use $60+ oil in their budgets and spoke more proactively about debt paydown, corporate returns and returning cash to shareholders.”
This newfound restraint would contribute to still more gains in oil prices, the investment bank said. “With Discipline along with Demand and Disruptions (the 3 Ds) key drivers of Energy equity sentiment, we see potential for a grind higher as long as datapoints are favorable,” Goldman wrote. Global oil demand is set to grow at a robust rate this year, and a series of disruptions could keep supply offline in places like Venezuela, Iraq, Iran, Libya and Nigeria.
It remains to be seen if Goldman, along with the rest of us, are being taken for a ride by the shale industry. The investment bank said that guidance announcements in February will be “key” to figuring out if shale drillers will follow through on their promises of restraint for 2018.
But based on a series of comments at the conference, Goldman cited a long list of shale companies that will use extra cash from higher oil prices to either pay down debt or to pay off shareholders rather than using that cash for new drilling. “In particular, E&Ps highlighted debt reduction (SWN, CLR, RRC, DVN, APA, EOG, MRO, RSPP, WPX), dividends (OXY, COG, MRO, EOG) and share repurchases (APC) as potential options for redeploying greater cash ?ow,” Goldman wrote in its report, using the ticker symbols for the companies who spoke at the conference.
There were a few companies that signaled an openness to new drilling if oil prices continued to rise. “FANG, JAG, PDCE and XEC noted higher cash ?ows will allow their ?rms to raise drilling activity over time,” Goldman said, although they voiced caution about the recent run up in prices as evidence that prices will remain elevated. Moreover, any uptick in drilling in response to price increases might not result in production changes before the end of 2018.
Another uncertainty that could blunt the euphoria surrounding the recent oil price rally is the rising cost of production. With drilling on the upswing, oilfield services companies are looking to claw back some of the ground that they felt compelled to cede to producers in the past few years. That means higher prices for the cost of completions, rigs, sand and other services and equipment. Goldman predicts cost inflation from oilfield services on the order of 5 to 15 percent year-on-year.
The investment bank said that the winners will be the “operators that are able to mitigate higher service costs through productivity gains and more ef?cient operations will attract investor interest in 2018.” Goldman singled out Pioneer Natural Resources, EOG Resources and Occidental Petroleum, a few companies that are typically cited as some of the strongest in the shale patch.
So, at least according to the latest comments from shale titans, the industry appears resolved to stick by its word to not drill recklessly. That could lessen production gains from the U.S. over the next year or so…which would provide more upward pressure on prices. – Nick Cunningham
Crude Oil Commercials at Record Short Exposure
Tim Taschler – On April 10, 2017 I penned a piece called Taking A Look at Silver where I wrote: “When watching COT levels each week, what is important to me is the trend in the positions that Commercials and Large Specs hold. But what is also important to me is when extreme positions occur.”
A week later, as the chart below shows, silver peaked at $18.65 and started a slide that took prices to $14.34 at the low in early July.
Figure 1: Silver Continuous Contract
This reaffirmed my belief that it is important to pay close attention to COT data, especially when it is making new 52-week or all-time record readings. Today, crude oil COT data is at an extreme, meaning it is time to pay attention.
The chart below shows that Commercials are at a new 52-week-high in the number of net short futures contracts they hold, while Large Speculators (aka managed money and hedge funds) are at a 52-week-high in the number of long contracts they hold.
Figure 2: Crude Oil Net Commitments of Futures Traders
Commercials, often referred to as the ‘smart money,’ are hedgers that deal with the underlying commodity as part of doing business. Commercials are large operators with very deep pockets, and they are exempt from position limits and are allowed to post smaller margins (i.e., they are able to use more leverage). It’s important to note that this snapshot of commercial positions is as of the close Tuesday, January 2, 2018 and are reported by the CFTC on Friday afternoon of the same week.
When watching COT levels each week, what is important to me is the trend in the positions that Commercials and Large Specs hold. However, what is also important to me is when extreme positions occur. Looking at the chart below we see commercial positions back to 1993, and what jumps out at me is the fact that the current commercial short position of 1,414,461 short contracts is a record short position.
Figure 3: Crude Oil Hedgers Position
The weekly price chart below shows that $WTIC has rallied nicely from its early January 2016 low, and is sitting at the 2015 high.
Figure 4: Light Crude Oil Continuous Contract
The bottom line is that investors are excessively optimistic while Commercials are at a record level of bearishness.
The price chart (Figure 5) has a couple of divergences (RSI, MACD, volume) and might be set up for a decline, or correction at a minimum. What is unknowable is whether a pullback will be short and shallow or long and deep.
Figure 5: Crude Oil Continuous Contract