From Art Berman: An OPEC production cut offers oil producers hope for higher prices in 2017. But there is a dark cloud hanging over that expectation. Global storage inventories must be substantially reduced before higher oil prices can be sustained. Some of U.S. tight oil has nowhere to go but into storage because it can neither be refined nor exported.
If all OPEC cuts take place as announced, it will be at least a year before sufficient inventory reductions allow prices to move much higher than current levels. If not, lower oil prices will last even longer.
The OPEC Production Cut and Spare Capacity
OPEC agreed to cut production in November partly because it was incapable of sustaining output at 2016 levels. Announcing a cut is a good way to cover the reality that commercial reserve limits have been reached.
Analyst narratives have created the unfounded but widely accepted belief that OPEC has a strategy, and that strategy involves a price war with U.S. tight oil producers. The cartel’s inaction since 2014 more probably reflected an unwillingness to repeat the mistake of cutting output between 1980 and 1985: those cuts had little effect on world over-supply and damaged OPEC market share and revenue.
The possibility of a production freeze was suggested in February 2016 when oil prices were less than $30 per barrel. Expectation of OPEC action and improving fundamentals lifted prices to an average of $43 per barrel in 2016.
Failure to act in November probably would have sent prices into the mid-$30 range. As my colleague Allen Brooks remarked just after the cut was announced, this is more about setting an oil-price floor than about raising prices.
By July 2016, OPEC surplus production capacity had fallen to only 0.92 mmb/d (million barrels per day). The all-time low was 0.71 mmb/d in late 2004 (Figure 1).
Figure 1. Low surplus production capacity was a key factor in the OPEC output cut. Incremental spare capacity volumes are shown relative to the minimum levels in the time series; in this case, December 2004. Source: EIA and Labyrinth Consulting Services, Inc. Source: EIA and Labyrinth Consulting Services, Inc.
The negative correlation between oil price and OPEC spare capacity is obvious. Low OPEC surplus after 2004 along with increased demand from China corresponded to rising oil prices that reached $146 per barrel in June 2008. The exception to the correlation in late 2006 resulted from demand destruction when real oil prices (2016 dollars) exceeded $85 per barrel for the first time since 1982.
A production cut may bring higher short-term prices but it should also result in higher OPEC spare capacity, a negative factor for higher prices.
Massive Oil Inventories Are The Problem
After the 2008 Financial Collapse, declining OPEC spare capacity, falling OECD inventories, low interest rates, and record-high oil prices produced a classic oil-production bubble.
The bubble burst in 2014 as over-production resulted in swelling inventories (Figure 2).
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Figure 2. Oil prices collapsed because of inventory imbalance and will not recover until balance is restored. Incremental inventory volumes are shown relative to the minimum levels in the time series; in this case, November 2013. Source: EIA and Labyrinth Consulting Services, Inc.
There is little chance that oil prices will return to the $70-80 range that many analysts predict until OECD storage falls approximately 400 million barrels to its 5-year average. If all the announced output cuts take place and extend beyond the 6-month term of the agreement, that will take at least a year.
The idea that there was a price war between OPEC and tight oil producers arose largely from a story line that analysts promoted. It was accepted and maintained largely by American hubris.
An over-supply of oil was the enemy if there was one and it negatively affected OPEC as much as other world producers. It resulted from the longest period of high oil prices in history. Brent was more than $90 per barrel from October 2010 through October 2014.
It is true that tight oil over-production was the biggest single offender in the supply glut and price collapse but all global producers contributed their share. It is likely that OPEC would have cut production in late 2014 if Russia had agreed to participate.
Ali Al-Naimi, the Saudi oil minister at that time said, “We met with non-OPEC producers, we asked ‘what are you going to do?’ They said nothing. We said the meeting is over.”
Tight Oil Is Not A Threat To OPEC
Tight oil has never been a long-term threat to OPEC because the reserves are relatively low. EIA year-end 2015 data indicates that U.S. tight oil proven reserves are less than 12 billion barrels.
Canada’s and Venezuela’s combined oil sands reserves exceed 350 billion barrels. Oil sands are Saudi Arabia’s and OPEC’s chief reserve competition, not U.S. tight oil (Figure 3).
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Figure 3. Oil Sands Are Saudi Arabia’s Chief Reserve Competition, Not U.S. Tight Oil. Source: EIA, Hyper-dynamics and Labyrinth Consulting Services, Inc.
In fact, tight oil production is a plus for OPEC. The U.S. must import increasing amounts of OPEC heavier oil for blending in order to refine the ultra-light oil produced from tight oil plays.
OPEC’S share of U.S. imports has increased 9 percent since January 2015. Total U.S. crude oil imports have increased about 1 million barrels per day and most of the increase has come from OPEC countries (Figure 4).
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Figure 4. U.S. Total Imports of Crude Oil and Imports From OPEC Countries Have Increased 1 Million Barrels Per Day Since Early 2015. Trend lines represent polynomial fits. Source: EIA, Labyrinth Consulting Services, Inc. and Crude Oil Peak.
Canada could provide almost unlimited amounts of heavy oil to the U.S. but the Obama Administration’s decision to block the Keystone XL Pipeline means increasing reliance on OPEC.
OPEC members leaked the possibility of a production freeze in early 2016 when oil prices were $26 per barrel. Fears of further price collapse began to fade reinforced by improving fundamentals.
The U.S. horizontal rig count fell almost 250 rigs (44%) between the end of 2015 and late May 2016. The world production surplus peaked in January 2016 and moved unevenly toward market balance throughout 2016 (Figure 5).
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Figure 5. The World Production Surplus Peaked in January 2016 and Has Since Moved Unevenly Closer To Market Balance. Source: EIA and Labyrinth Consulting Services, Inc.
Oil prices rose to more than $50 per barrel by June but prices fell below $40 in August when an OPEC meeting in Doha failed to produce a production freeze agreement (Figure 6). Increased global output, slowing demand growth and higher petroleum products inventories also weighed on prices.
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Figure 6. $10-$15 of Expectation Premium is Included in Current Oil Price. Source: EIA, CBOE and Labyrinth Consulting Services, Inc.
In late September, OPEC abandoned its market-based approach begun in 2014 and agreed to cut production. Prices moved up and down as the likelihood of a production cut waxed and waned through October and November. A deal was announced on November 30 and prices have increased from $43 to $54 per barrel mostly on sentiment. Without participation by Russia, there probably would have been no agreement to cut production.
It is clear that like the global economy, the oil-price recovery has been weak and fragile. Hope for some OPEC action has been a significant support for prices throughout 2016. There is probably $10 to $15 of “expectation premium” built into current oil prices.
Some analysts forecast $70 oil prices in 2017. I won’t recite the litany of reasons why OPEC members may cheat or that Libya and Nigeria may increase production. I am focused on the U.S. horizontal tight oil rig count that has increased 34% (85 rigs) since mid-September, 65% of which are in the Permian basin.
If two years of low oil prices have taught us anything, it is that shale companies will produce oil at almost any price provided that investors give them money to drill. There does not seem to be any limit to investors’ willingness to believe that tight oil is a good bet.
There never was an over-riding strategy behind OPEC’s unwillingness to cut output over the last 2 years. More probably, it was based on a pragmatic recognition that cutting production without participation by Russia would not meet the cartel’s needs. Now that surplus capacity is exhausted and Russia has agreed to participate, a production cut makes sense.
U.S. output will rise but imports of heavier oil will be needed for blending. Excess tight oil will go into storage keeping U.S. inventories high and U.S. crude prices at a discount to Brent. OPEC will sell heavier oil to the U.S. at higher international prices. OPEC knows this but those who are celebrating what they believe is OPEC’s surrender in a make-believe price war, apparently do not.
The United States Oil Fund LP ETF (NYSE:USO) rose $0.08 (+0.72%) in premarket trading Wednesday. Year-to-date, USO has declined -5.55%, versus a 1.31% rise in the benchmark S&P 500 index during the same period.
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