The U.S. Energy Information Administration (EIA) recently reported domestic crude oil production declined by another 200,000 barrels per day over the most recent six week reporting period. The same EIA report also showed stocks of crude, gasoline, and distillates all falling during the period. In the simplest possible terms, these developments on the supply side mean that supply and demand are finally starting to come back into balance.
For years OPEC represented essentially the lone source of incremental oil supply. In fact, an often-used analogy was Saudi Aramco turning on and off the oil spigot to match oil demand. On the other hand, oil demand is fairly inelastic in the short run. Because of these dynamics, OPEC could achieve a large positive price response in exchange for a small reduction in supply. In the last decade these monopolistic market tendencies evaporated as a new oil market reality emerged with American shale producers creating a market with multiple marginal suppliers. Today OPEC could make a large production cut, only to see American producers increase supply (and profits) at their expense. This is the dynamic OPEC leadership is referring to when you read of their unwillingness to cut supply due to their focus on “defending market share”.
The US oil supply growth of recent years was primarily driven by additional production from tight shale using horizontal drilling, fracking, injections, and other non-traditional methods. These new technologies unlocked access to large reserves that were known to exist, but were formerly thought to be uneconomical. Shale oil supply differs from traditional oil supply in two important areas. The first is that to drill and produce oil from a shale well costs more and therefore requires a much higher price of oil. Recent studies have put this breakeven price point somewhere around $50-$70 per barrel for a typical shale well, versus $20-$35 for a traditional well (this is an over-simplification for example purposes, actual well break-even levels can vary widely from well to well based on a variety of factors). The second difference is the expected production curve of the well. Traditional wells can produce for decades with little production decline, whereas typical shale oil wells expect substantial production declines within 18-24 months. In other words, shale production can be expected to begin declining less than two years after a sustained and substantial decline in drilling rig activity.
Much energy market analysis has focused on the role of OPEC in energy supply and on the recent reported failures of OPEC to agree to curb supply. However non-OPEC supply reductions (i.e. US shale producers) have continued right on schedule. Shortly after oil prices (thin gray line in the chart above) began their sharp drop in the second half of 2014, drilling activity as measured by the Baker-Hughes rig count (the bright red line in the chart above) declined precipitously by nearly 80% from the 2014 highs.
Given the relationship between drilling and production on a well-by-well basis, we might also expect the relationship to hold between drilling activity and shale production volumes in the aggregate. As shown in the chart below courtesy of Ned Davis Research via SPDR, not only does the relationship clearly hold, but the timing is spot on with what might have been our a priori expectation.
Returning now to the global oil market picture, and remembering ECON 101, as price declines, we expect to see demand increase. Demand growth has occurred as the price of oil has declined. Much of the demand increase has come from the still rapidly growing emerging market economies. The IEA now expects India to begin overtaking China as the main engine of global demand growth, but expects both countries thirst for oil to remain strong. Therefore, we now have reduced supply combining with increased demand and this has now resulted in market flipping from an oil surplus to an oil deficit. The following chart from Goldman Sachs via Bloomberg illustrates the historical and projected market surplus/deficit (using Goldman’s current forward-looking estimates):
We believe that it is reasonable to assume that the oil price lows were reached in the first quarter of 2016. While prices may certainly decline from current levels between $45 and $50 per barrel, the global supply and demand picture demonstrates that a much lower price level would be unsustainable.
However, while the physical oil markets are now re-balancing, the structural imbalance in the energy capital markets may be yet to reach such a point. While beyond the scope of this memo, it should be clear that drawing the conclusions we have about the state of the oil market is entirely different than drawing conclusions about the profit potential available to an equity investor in an oil producer. Many energy companies still must cope with large debt loads, much of which was incurred at substantially higher energy prices. While the new oil fundamental picture will continue to be constructive for many areas of the energy markets, capital restructuring adjustments may continue for some time.
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