Fundamental Shifts

Oil prices shrugged off OPEC's bullish announcement last week as the Organization of the Petroleum Exporting Countries (OPEC) agreed to extend its production cuts for nine months (through March 2018) at its semiannual meeting. The agreement was generally expected given prior meetings and comments from various countries involved. The cuts, representing about 2% of global supply, come mostly from Saudi Arabia and its Arab member nations, as well as a few nonmember nations, most notably Russia. The extension had been broadly communicated in recent days and oil was down after the news broke as some market participants likely expected a bigger cut or a longer extension into mid-2018. Much of the weakness in energy prices has been due to the surprising (to some) rebound in American production even in light of $45 $55 oil. This production growth is coming from both shale oil and increasingly offshore oil.

Improvements in offshore oil production technology are driving the cost of deepwater
oil production in a similar fashion to the way fracking and horizontal drilling drove down the cost of shale oil production. According to Wood Mackenzie Ltd, pumping crude from sea beds thousands of feet below water is turning cheaper because producers are implementing cost improvements and streamlining operations in core wells. That means oil at $50 a barrel could
sustain some of these projects by next year, down from an average breakeven price of about $62 in the first quarter of 2017 and $75 in 2014, the energy consultancy estimates.

The falling production costs make it more likely that investors will approve pumping crude from such large deepwater projects, the process for which is more complex and risky than drilling traditional fields on land. That may compete with OPEC’s oil to meet future supply gaps that the group sees forming as demand increases and output from existing wells naturally declines. Over the next three years, eight offshore projects may be approved with breakeven prices below $50, according to a Transocean Ltd. presentation at the Scotia Howard Weil Energy Conference in New Orleans in March. Eni SpA could reach a final investment decision on a $10 billion Nigeria deepwater project by October.

While costs for shale production, known as tight oil, are edging higher now, expenses associated with deepwater drilling are finally coming down. Rental rates for drilling rigs have been cut in half since 2014, and companies are redesigning projects to be more cost efficient instead of to maximize output.

According to Fitch Group’s BMI Research, deepwater exploration will see “renewed momentum” over the rest of 2017 as large integrated oil companies look to capitalize on lower service costs and strengthening fiscal positions. In the U.S. Gulf of Mexico, a more costefficient
design for deepwater projects has reduced the breakeven cost at many wells to below $40 a barrel.

(Additional investment specific comments follow for client subscribers)

Sources:

https://www.bloomberg.com/news/articles/20170530/
troublebrewingforopecasoncecostlydeepseaoilturnscheap

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