Specious Argument

I am updating my WTI oil price expectations for the next several weeks to range between $43–$53 per barrel, two dollars per barrel lower than before. The reasons for changing are increased production from Libya and Nigeria, Ecuador straying outside its production cap, and general cynicism toward OPEC being able to reduce global inventories as quickly as expected.

Although I have reduced my expectations, should OPEC announce significant changes to its policy after meeting this weekend in Saint Petersburg, Russia, then all bets are off.

If the current situation persists, however, then I am comfortable with my updated values.

US Weekly Oil Production Versus US Oil Rig Count

With the recent release of the US Energy Information Administration’s Short Term Energy Outlook, I have revised downward my forecast for WTI oil price to between $45 and $55 per barrel for the next several weeks, until midsummer. The reason for lowering my forecast is that the EIA has forecast more production between now and roughly the end of 2018. Furthermore, in its “Forecast Highlights” it says the following: “EIA forecasts that implied global petroleum and liquid fuels inventories will decline by about 0.2 million b/d in 2017 and then increase by an average of 0.1 million b/d in 2018.” I anticipate that the forecasted build in inventories in 2018 might keep a lid on oil prices.

Let’s take a quick review of some data. You’ve likely seen a variation of the following graph where oil production has almost recovered to pre-downturn levels, yet the number of oil rigs being used is roughly half that at the peak of production. The key point from this graph is that production efficiency per rig has increased. It’s important to remember that this graph represents all rigs involved in US oil production, not just those used for shale oil.

One of the benchmarks that I track is the US Energy Information Administration’s Short Term Energy Outlook data for US crude oil and liquid fuels production as shown in the next graph, which is an updated version from the prior month. Every month the EIA releases a new forecast. The January forecast is the lowest line along the horizontal axis, and the June forecast is the top line for much, but not all, of the graph. Solid-line portions represent historical data, and the dotted-line portions are forecasts. Because of data revisions, not all months start from the same point. Please note that liquid fuels include ethanol, natural gas plant liquids, and biodiesel, and this total volume is different from just the oil volume shown in the prior graph.

EIA Short Term Energy Outlook Forecasts

In February and March, the EIA revised substantially upward its December 2018 production forecast. In the last four months, the December 2018 production forecast remained relatively constant, but the production volume leading up to December 2018 was increased with each new forecast.

With production forecasts increasing each month and with the EIA forecasting a slight build in global inventories, I am more cautious. I want to wait for more data throughout the summer. Do global inventories draw down faster than many expect, or do they remain relatively stable?

In this weekend’s Barron’s magazine article (subscription required) “Energy Shares Could Soon Heat Up,” Andrew Bary discusses bullish comments made by Morgan Stanley’s energy analyst Evan Calio.

The Energy Select Sector SPDR exchange-traded fund (ticker: XLE), which tracks the energy stocks in the Standard & Poor’s 500 index, is off 12% so far in 2017, compared with a 9% gain in the broad market. The more volatile SPDR S&P Oil & Gas Exploration & Production ETF (XOP) is down 21% after hitting a new 52-week low last week. “This is one of the worst beginnings to the year ever,” says Evan Calio, an energy analyst at Morgan Stanley. “Investor sentiment is horrible.”

Nevertheless, Calio remains upbeat on U.S. exploration-and-production stocks, seeing about 15% upside on average from current levels. He expects oil prices to rise to the mid-to-high $50s over the summer and into the fall, supported by drawdowns of crude inventories and the effect of output reductions announced by the Organization of Petroleum Exporting Countries. A rally in energy stocks could be under way, after their 2% gain on Friday.

Calio is more bullish than I am at present. If, however, global inventories deplete faster than expected over the summer, I will reverse my current position and go back to my prior expected range of $50–$60 per barrel.

With WTI prices briefly spiking below $44 per barrel, May was an exciting month for oil prices. Even though prices dipped further than I expected, I remain optimistic and expect oil prices to generally be bound between $50 and $60 per barrel for the next few months.

One of the benchmarks that I am tracking is the US Energy Information Adminstration’s Short Term Energy Outlook data for US crude oil and liquid fuels production as shown in the graph. Every month the EIA releases a new forecast. The January forecast is the lowest line along the horizontal axis, and the May forecast is the top line. Solid-line portions represent historical data, and the dotted-line portions are forecasts. Because of data revisions, not all months start from the same point. Please note that liquid fuels include ethanol, natural gas plant liquids, and biodiesel.

EIA Short Term Energy Outlook Forecasts

To date, the largest jumps in December 2018 production volumes were from the February and March forecasts. The May forecast for December 2018 production volumes of about 15.8 million barrels per day is just over a million barrels per day greater than estimated in the January forecast. Clearly, the large increase in US production surprised many analysts and, very likely, OPEC, too.

Moving away from the graph, I came across an interesting comment from Pioneer Natural Resources chairman Scott Sheffield in a Forbes article “Up On Trump, Down On Oil, Hamm Warns Frackers Not To Spook OPEC.”

Others at CERAWeek have been more bold. Vicki Hollub, CEO of Occidental Petroleum, the Permian’s biggest producer, predicted Tuesday that output from the basin could grow from 2 million barrels per day now, to 5 million bpd. Scott Sheffield, chairman of Pioneer Natural Resources, another Permian giant, said 8 million to 10 million bpd in a decade. What’s different is that Oxy and Pioneer have a vast inventory of Permian acreage that the companies say offers good cash-on-cash returns even at $40 oil.

I haven’t seen other forecasts as aggressive. That said, Sheffield’s forecast deserves careful consideration and monitoring.

Switching to the key OPEC development, I was surprised by OPEC’s decision to extend its oil production cuts for an added nine months because I had expected only a six-month extension. As we saw on May 26 by the drop in oil prices from roughly $52 to $49 per barrel, many were disappointed that OPEC didn’t cut deeper. I agree, however, with Helima Croft’s comments in the Wall Street Journal article “Oil Prices Edge Higher Following OPEC Decision” (subscription might be required).

While the market had a “knee jerk reaction” because it “remains skeptical” on the impact of OPEC’s cuts, “we encourage investors to separate the near-term, noise-driven price gyrations and focus on the improving global fundamental backdrop,” said Helima Croft, global head of commodity strategy at RBC Capital Markets, LLC, who said she believes oil will eventually move between $50 and $60 a barrel.

So now we wait to see how this situation plays out. The summer driving season has begun and refineries are running at high throughputs. Will global oil inventories have shrunk by very much at the end of the summer in September?

Oil prices dipped below $50 late last week, tumbling since Wednesday when the US Energy Information Administration announced an unexpected gasoline build in its weekly update on inventory levels. More downward pressure came on Friday, April 21, when Baker Hughes said that the oil-rig count rose by five to 688.

On that same Friday, the Financial Times wrote (subscription required) the following:

But concerns are mounting that a ramp up in US shale production will undermine a push by Opec and other producers such as Russia to reduce excess stockpiles and bring to a close the worst price crash in a generation.

One Wall Street trader said: “There are lots of things at play. US production is surging, there are concerns about demand in Asia, hedge funds are reducing their bets on a higher oil price. It’s all coinciding and putting pressure on prices.”

While there is plenty of news to suggest that oil prices will remain soft, I continue to expect that oil prices will generally be bound by $50 to $60 per barrel. I anticipate that in late May OPEC will agree to extend its production cuts for another six months. Furthermore, more oil is expected to be consumed as driving seasons kicks into high gear over the next few months. With continued production cuts and increased consumption, prices should be supported at $50 per barrel.

Although West Texas Intermediate prices are hovering around $50 per barrel, we’ve seen oil prices dip into the high $40s in March, which is lower than I expected.

To understand oil prices better I read online newspapers and other sources. At lower oil prices there were more bearish articles forecasting $40 in the near term. Now, there are more bullish forecasts—for example, Reuters’ analyst John Kemp reported that Goldman Sachs suggests that an OPEC production cut extension might not be need to support prices.

I anticipate that OPEC will extend its cuts because it seems determined to provide support to oil prices. As evidence, the Wall Street Journal (subscription required) reported on March 29 the following:

Investors also welcomed comments from OPEC members who are showing a willingness to cut more of their supplies to make a dent in global inventories. United Arab Emirates announced plans to reduce its production by about 200,000 barrels from March to May, “which is actually more than was agreed,” said Commerzbank analysts in a recent note.

For the next couple of months, I continue to expect that WTI prices will stay between $50 to $60 per barrel.

As I expected, oil prices have remained relatively range bound in the mid-$50 range. I continue to expect this range to hold for the next few weeks.

At these prices, many are concerned that increased drilling for shale oil production will offset the recent production cutbacks and force oil prices back down again. While that might happen, I expect that it won’t.

Looking at oil production data in the US Energy Information Administration’s “Annual Energy Outlook 2017” report, note in the reference case that US total oil production from the lower 48 states is forecast to be relatively flat from 2018 to 2050. In 2018, the forecast volume is 9.32 million barrels per day. In 2029, forecast production hits a peak at 10.55 million barrels per day, and in 2050 forecast production is 9.86 million barrels per day. Oil wellhead prices are forecast to increase from $49.90 per barrel in 2017 to $72.18 in 2020 and to over a $100 by 2036. All prices are in 2016 US dollars. The key point is that even though prices are rising quickly, oil production forecasts do not rise significantly above 10 million barrels per day.

I am also closely watching “U.S. crude oil and liquid fuels production” data forecasts from US Energy Information Administration’s “Short Term Energy Outlook” monthly reports. Crude oil and liquid fuels production includes crude oil, natural gas plant liquids, ethanol, and biodiesel.

The January 2017 “Short Term Energy Outlook” report contained the following total production data, both historical and forecasts, in millions of barrels per day:

• December 2016: 13.500
• December 2017: 14.276
• December 2018: 14.810

2017 shows an increase of about 5.75 percent, and 2018 shows an increase of about 3.74 percent.

In February’s monthly report, the historical and forecast data were revised as follows:

• December 2016: 13.443
• December 2017: 14.382
• December 2018: 15.253

2017 shows an increase of about 6.98 percent, and 2018 shows an increase of about 6.06 percent.

It’s important to note that the percentage increases are increases in the average production during the month of December compared to average daily production during the prior December. This is in contrast to the average daily production increase throughout the year that is forecast to be much less. For example, in the January report, the forecast annual average daily growth in crude only, excluding natural gas plant liquids, ethanol, and biodiesel, for 2017 was 1.3 percent and for 2018, 3.3 percent. In the February report, the data was revised for 2017 at 1.1 percent growth, and 2018, 6.1 percent.

As more “Short Term Energy Outlooks” are released, I plan to track the changes to both historical and forecast production data. Will production forecasts continue to increase and, if so, more rapidly than previously thought?

On January 19, 2017, the Financial Times article “‘Permania’ grips the US shale oil industry” (subscription required) revealed estimated breakeven oil prices for Permian basin producers. Most participants have an average breakeven price of between $40 and $60 dollar per barrel. The most productive assets have breakeven prices below $40 per barrel. The least productive assets, however, require much higher prices, up to $100 per barrel for Apache, for example. I expect that companies are focused on their more productive assets now when prices are in the mid $50s. A key point, though, is that oil prices will need to exceed $60 for all Permian basin assets to be developed.

The following quote comes from the Wall Street Journal February 16 article “Oil Gains on Possible Extension to Production Cuts” (subscription required):

On Thursday, Reuters reported that OPEC sources said the cartel could extend the six-month deal to cut supply, or make more severe cuts, if oil stocks don’t drop by around 300 million barrels.

Because US production is not forecast to exceed much beyond 10 million barrels per day in the near term and because current world production is likely unsustainable at prices below $60 per barrel, Saudi Arabia will probably play a waiting game. It will likely continue to keep or deepen current cuts until such time as more OPEC production is desired.

Forecasts are always wrong—it’s just a question of how wrong. It is important to keep monitoring information and adjusting one’s forecasts.

In my December 2016 update, I wrote that I expected oil prices to be more stable in early 2017. Oil prices have been relatively stable so far, with WTI prices hovering over $50 per barrel. I further mentioned that I did not expect significant oil production cheating. OPEC and non-OPEC countries that are participating in the oil production cuts have shown solid compliance so far.

From my review of various news sources, the views of analysts and traders range from optimism where production cuts will make a meaningful difference to pessimism where increased drilling in shale plays will offset production cuts. The next few weeks will gauge the effectiveness of the production cuts in reducing worldwide oil inventories against the rate of oil production increases.

My expectation is that during the next few weeks, oil production cuts will continue to support current prices while the concerns about increased production will keep oil prices capped below $60 per barrel.

As a quick follow up to November’s post, I expect oil prices in early 2017 to be more stable. Given the recent run up of oil prices going into the New Year, I am not sure how much further they might rise in the first few months. Like everyone else, I will be watching the oil production response from the rest of the world and for any signs of cheating from those OPEC and non-OPEC countries that have agreed to reduce production. And, unlike many analysts and traders, I don’t expect significant cheating, at least not initially. After a few months of anticipated reduced production, analysts and traders should have a better understanding.

I hope everyone is enjoying their holiday season, and I wish everyone a happy and healthy 2017.

Those of us who follow oil know that at the end of November, OPEC will hold a meeting and will decide whether to follow through on its Algiers commitment to reduce members’ oil production. Most articles in the major financial newspapers indicate that many analysts, traders, and speculators are skeptical, if not dismissive, that OPEC will follow through. I, however, think that OPEC will announce a reduction, though I am not certain that it will be as large as many hope.

Helima Croft of RBC Capital Markets Research wrote a report, which Barron’s cited in an article “OPEC Must Strike Deal For Its Own Good” (subscription required), with the following key points:

• Revenue is the key item for all concerned;
• Saudi Arabia—the pivotal player in OPEC—wants a deal done for domestic reasons;
• Because most members are at or near maximum capacity, the opportunities for cheating are constrained;
• A sustainable increase in production for Croft’s “fragile five” looks challenging in the near term;
• OPEC is aware of extremely adverse price and reputational risks from failure to reach an agreement; and
• The election of Donald Trump should not dramatically alter OPEC dynamics.

I agree with all of her points.

The Wall Street Journal article “Oil Prices Await Effect of OPEC Deal” (subscription required) mentions the prices that banks expect for 2017.

Underscoring the uncertainty about the deal’s prospects, banks polled by The Wall Street Journal kept their price forecasts largely unchanged from the previous month. The 14 banks in the survey predict that international Brent crude will average at $56 a barrel next year while U.S. benchmark West Texas Intermediate will average $54 a barrel next year.

On Friday, Brent was trading at $48.54 a barrel while WTI was at $47.60 a barrel. Those prices are still down by more than half from mid-2014.

OPEC agreed in September to reduce its record output, but its members have since increased production even more, complicating its calculations for a cut. That means the nitty-gritty details of any OPEC agreement on Wednesday will be more important than usual.

The banks’ prices are likely a sweet spot—high enough to make a substantial difference in producers’ revenue while low enough to prohibit higher cost oil assets from being exploited.

For those of us interested in the oil markets, Wednesday should prove to be an interesting day.