Crude Oil Price Inflection Points

March 19, 2018 08:15 AM

The 42% spike in WTI from August to the January peak provided the United States and other producers an attractive opportunity to hedge their 2018 capital program. An acceleration of U.S. production growth is occurring, primarily from the Permian Basin. Coupled with the growth in other non-OPEC production from Canada, Brazil and Kazakhstan, and non-OPEC production in 2018 has the potential to exceed the growth in world oil demand, which would reverse OPEC’s success in reducing surplus OECD (Organization for Economic Co-operation and Development) oil inventories. 

Assuming an average WTI crude price of $57 per barrel in 2018, with a $3.50 discount to Brent and a $3 U.S. natural gas price, the most attractive stocks in the energy sector include: Anadarko (APC), Apache (APA), EOG Resources (EOG), Noble Energy (NBL), Halliburton (HAL), National Oilwell Varco (NOV) and Ensco (ESV). ConocoPhillips (53) remains a sell (COP).

WTI crude is at $59 per barrel at the time of this writing, down 11% from its January high near $67. Brent is trading at a $3.50 premium over WTI. The Brent premium blew out to more than $7 in December and has contracted since then. WTI averaged $51 in 2017, up more than $7 from 2016. 

The 42% run-up in WTI from $47 in August to its January peak was the result of OPEC’s 1.8 million barrels per day (MMBD) production cut implemented on Jan. 1, 2017, as well as an unusual number of one-off events, including pipeline disruptions, hurricanes, a brutal January cold snap and an increased geopolitical anxiety.

The OPEC cut targeted a reduction in surplus OECD inventories to the five-year average, which it calculated was 318 million barrels (MMB) greater in late 2016 and at a record high of 380 MMB greater in 2017. The OECD accounts for 48% of total world oil demand. OPEC targeted oil prices of $60 to $65 at the time it announced its cuts. 

By OPEC’s estimate, the surplus in OECD inventories fell to 109 MMB in December. The IEA calculates a surplus of 52 MMB, down from 264 MMB a year ago.

When it announced its cut, OPEC anticipated the surplus in OECD inventories would have declined much faster. Instead, production in Libya and Nigeria increased substantially. Libya and Nigeria were exempted from the cut because of internal upheavals, which depressed their production to unusually low levels in late 2016. In 2017, Iraq’s production averaged 4.47 million barrels per day (MMBD), 123,000 barrels daily above its quota under the OPEC cut.

While OPEC has since extended the cut to the end of this year, OPEC production could be higher in 2018. Libya, Nigeria and Iraq are all expected to produce more. 

When OPEC announced its cut, it also did not anticipate the robust growth in U.S. unconventional production. Total U.S. crude and liquids production increased 1.59 MMBD over the year to reach 13.89 MMBD in Q4 2017.

Rig Counts 

U.S. oil rig counts responded strongly to the announcement of OPEC’s production cuts and the resulting jump in oil prices a year ago. The U.S. oil-directed rig count increased 63% from a Q4 2016 to a July 2017 peak of 765, even after oil prices began to decline. U.S. producers used the opportunity to hedge their 2017 production before the decline.

With a typical lag, the rig count flattened and hit a low of 738 in November.

With the strong upswing in oil prices from August, again with a typical lag, the U.S. rig count increased to 791 in early February and is 33% higher than last February.

U.S. production growth accelerated during 2017 with strong momentum in early 2018. The increase of 881 MBD in Q4 2017 was the strongest of the year. It is projected to increase to 14.35 MMBD in the current quarter.

The cost per well continued to decline in 2017 and wells are now more productive, significantly improving return on investment for producers and reducing the oil price needed to break even after offsetting the cost of oilfield services inflation. The new U.S. tax law will reduce breakeven in U.S. resource plays by $2 to $4 per barrel on average in the Gulf of Mexico.

If the decline in WTI from the January peak to the upper $50s persists, past experience indicates the oil rig count may flatten somewhere near 800 in May or June where it may stabilize, if oil prices stabilize. In that event, the current explosive growth in U.S. crude and liquids would slow, but still reach 15.70 MMBD in Q4 2018. 

Permian producers are OPEC’s biggest challenge. The recovery in U.S. activity is led by the Permian Basin, where the rig count has increased from a low of 142 in late May 2016 to 437 in the latest week. It is now 55% of the total rig count. The Permian rig count is now 36% higher the 2017 average. 

If the Permian rig count flattens in May or June, Permian production will reach 3.75 MMBD in Q4 2018, up 1.10 MMBD year-over-year. All other U.S. oil production, including the Gulf of Mexico, is projected to increase moderately.

NOV expects that current investment decisions for projects around the world, including offshore, are attractive. NOV is the leading manufacturer of oilfield equipment with the broadest industry customer base, which gives it a unique perspective of current market trends. It also believes growth in U.S. production will be tempered by the tremendous pressure the exploration and production industry is under to generate a higher return on capital invested. Many of its customers also continue to struggle to obtain bank financing. It believes this could restrain the industry supply response needed in coming years, which will result in higher oil prices down the road. Rising interest rates will not help.

If weakness in oil prices approaches the $50 level so as to threaten $45, producers are likely to curtail drilling activity, and with a typical lag, the current robust growth in production will slacken. But, if WTI is able to sustain $60 for a time, the oil rig count will continue to grow. With a lag, continued robust growth in U.S. production will cause OECD surplus oil inventories to once again build at a hefty rate, ultimately driving oil prices lower.

Either way, the price of WTI is likely to range somewhere near $55 into next year. The Permian Basin is now the world’s swing oil producer, with a lag.

Even as Permian production is growing, a looming decline in aging conventional fields in 2019 and beyond will provide downside support for oil prices. In its final 2017 earnings call, Schlumberger said it anticipates a one MMBD decline in 2019 production in Latin America, Africa and Asia, which will accelerate thereafter.

In 2017, conventional oil discoveries hit a record low of 3.4 billion barrels in response to reduced spending. Conventional oil production was about 85% of world oil supply. Reserve replacement was only 11%. Global upstream capital spending peaked in 2014 around $700 billion and fell to a low of $360 million in 2016, with only a mild increase in 2017.

The marginal cost of new conventional oil supply is now in the $65 to $75 range. When the decline in production from conventional fields emerges, prices higher than $55 will be needed to stimulate a supply response.

The IEA anticipates world oil demand will grow to 100.40 MMBD in Q4 2018, an increase of 25% year-over-year. China, India and Africa lead demand growth. Global economic growth is strong. Since 2015, global oil demand has grown twice as fast as the previous three years.

Canadian production is on the rise led by the Hebron Field off Newfoundland, which will take 18 to 24 months to reach a plateau. The Fort Hills and other oil sands projects sanctioned in prior years will add 300 MBD in 2018. The breakeven price for new greenfield in-situ oil sands projects has been reduced substantially. 

Russia produced 11.31 MMBD in December, remaining fully compliant with its agreement with OPEC. Production is set to grow more with the expiration of the OPEC cut.

Other non-OPEC production outside the United States, Canada and Russia will also grow, primarily from higher production in Brazil (offshore) and the giant Kashagan Field in Kazakhstan.

The onus thus is on OPEC to reduce production from January to keep the surplus in OECD inventories from growing. Except for Iraq, compliance was high. With continuing erosion in Venezuela’s production and continued high compliance, total OPEC output is likely to fall to 32.06 MMBD in Q4 2018, which is not enough to reduce surplus OECD inventories from current levels.

OPEC is scheduled to review the progress of its production cut in June, which is scheduled to expire at the end of the year. Net-long futures positions in crude were at a record high in January. Oil traders may choose to take profits in advance of the meeting. 

About the Author

Paul Kuklinski is the founder of Boston Energy Research. He also was a partner at Cowen & Co. and a founding partner of Harvard Management Company.