By Dan Steffens
The price of oil has been trapped in the mid-$50s because of fear:
1) Fear that OPEC+ would break ranks and flood the global market with oil.
2) Fear of weaker oil demand thanks to a global recession, which now looks extremely unlikely.
3) The belief that the United States can ramp up oil production at will to meet global demand
Fear #1 was eliminated on December 6th: Now that the OPEC Cartel members and Russia have agreed to lower their output by another 500,000 barrels of oil per day through March, oil traders can check that box and we can focus on debunking the “Fear of Recession”.
FEAR and GREED drive the markets. FEAR draws more viewers to the over-rated cable news networks, so we are bombarded by terrible predictions of gloom & doom. The oceans aren’t rising, the polar bears are still producing little polar bears, the planet isn’t burning up, and demand for oil is not slowing down anytime soon.
In my opinion, the “Right Price” for West Texas Intermediate (WTI) is $65 to $75 per barrel. However, all oil price cycles overshoot the market and this one is on-track to cause an oil shortage within nine months.
The U.S. vs China trade war and Brexit “noise” out of Europe have been the driving forces behind the global recession fear. Only a prolonged and severe recession will cause a decline in demand for oil-based transportation fuels and feedstock. So far, there has been no decline in oil demand in the real world, primarily because the U.S. economy is expanding.
The U.S Economy is expanding:
– Nonfarm payrolls surged by 266,000 in November, better than the 187,000 expected by economists polled by Dow Jones.
-The unemployment rate ticked down to 3.5% from 3.6%, back to the 2019 low and matching the lowest jobless rate since 1969. The unemployment rate for African Americans is the lowest it has ever been.
– The end of the GM strike had a big effect, boosting employment in motor vehicles and parts by 41,300, part of an overall 54,000 gain in manufacturing.
– Average hourly earnings rose by 3.1% from a year ago, slightly above the 3% expected by economists polled by Dow Jones.
– In addition to the robust November gains, revisions brought up totals from the two previous months. September’s estimate went up 13,000 to 193,000 and the initial October count increased by 28,000 to 156,000. Those changes added 41,000 more jobs to the previous tallies and brought the 2019 monthly average increase to 180,000, compared with 223,000 in 2018.
“These are blowout numbers and the U.S. economy continues to be all about the jobs,” Tony Bedikian, head of global markets for Citizens Bank said in a note. “The unemployment rate is at a 50-year low and wages are increasing. Business owners may be getting more cautious due to trade and political uncertainty and growth may be slow, but consumers keep spending and the punch bowl still seems full.”
It is impossible to believe that there will be a global recession if the world’s largest economy is this strong. With or without a trade agreement between the U.S. and China, the November jobs report should push WTI over $60/bbl. If a “Phase One” agreement is signed with China, look for WTI to move over $65/bbl within weeks.
Fundamentals do matter and global oil supply & demand are going to be much tighter by next spring.
– S. oil production growth has slowed and will likely go on decline in the first quarter.
– S. sanctions against Iran and Venezuela aren’t going to be lifted anytime soon; keeping a lid on OPEC’s ability to raise production even in the unlikely event that they don’t extend their production limits beyond next March.
– Non-OPEC Non-U.S. oil production, which accounts for approximately 48% of global oil supply hasn’t grown in 2019 and is forecast to go on terminal decline after 2020. There is some growth coming from Norway & Brazil, but most of it is being offset by declines elsewhere.
– On the demand side, IMO-2020 regulations that require all ships to use low-sulfur fuels or install scrubbers is going to increase demand by an estimated 500,000 barrels per day.
– Everything points to massive draws from global crude oil inventories in the 3rd quarter of 2020. Keep in mind that demand for oil-based products is seasonal; with most of each year’s demand growth coming in the Northern Hemisphere summer months. 90% of humans live in the Northern Hemisphere and we all drive more in the summer.
Every human on this planet is an energy consumer and we sure like to reproduce. You can see how fast the Earth’s human population is increasing here.
The U.S. Energy Information Administration (“EIA”) has been reporting increasing U.S. oil production in the estimates that they put out in their weekly reports. It is very important to understand that their weekly numbers are just EIA’s “best guesses” and that they have a long history of over-stating production growth. There is a two-month lag before the first “actuals” come out, which are based primarily on state reports. The monthly produced volumes keep changing for up to a year because upstream oil & gas have a year to submit adjustments to their original state filings. As you can see in the chart below, EIA’s weekly estimates (blue line) have been 200,000 to 300,000 barrels of oil per day above the actual volumes (red line).
The U.S. production growth had been running at more than 20% year-over-year through 2018, but it has slowed to under 8.5% year-over-year in September. Despite a 25% decline in the number of rigs drilling for oil, U.S. oil production has continued to grow because upstream companies have been completing more wells than they have been drilling. This is possible only because we entered the year with a very large inventory of Drilled but Uncompleted (“DUC”) wells. Obviously, this disconnect cannot and will not continue. Well completions will decline sharply in the 1st quarter because (a) winter weather always impacts oilfield work and (b) upstream companies have slashed their drilling & completions budgets. The number of wells completed in December are expected to drop about 20% from November because of budget exhaustion.
There are more wells being connected to new pipelines in the Permian Basin, but the impact on production of oil is going to be less than most people expect. The larger impact on production and realized commodity prices will be for natural gas and NGLs. Better access to markets is going to give all of the Permian Basin companies a big revenue boost in the 4th quarter.
Another thing that limits U.S. production growth is the annual increase in well depletion rates. More and more of our production comes from horizontal shale wells that have steep first year decline rates. After massive frac jobs, horizontal wells (some with more than two-mile laterals) come on strong, payout quickly and then decline by 50% to 70% within twelve months. It is not uncommon for a Permian Basin oil well to produce over 1,000 barrels of oil per day in the first 90 days and then decline to less than 100 barrels per day within two year. Well level economics are great, even at $55/bbl oil, but upstream companies in the shale plays must have an aggressive development drilling program to hold production flat.
It is impossible for U.S. oil production to increase if we are completing fewer wells than we did the year before and that is what is going to happen in the first half of 2020.
If the U.S. stopped all drilling today, a year from now the U.S. oil production would have declined by more than 3 million barrels per day or more than 20% within one year. The global decline rate for conventional wells is approximately 6%.
The title of this article indicates that I believe the OPEC+ Agreement signed last week puts us on the path to triple digit oil prices. Like all previous oil price cycles, this one will overshoot the mark and cause a global oil shortage. Upstream companies don’t need $100/bbl oil to make money. Most of the oil & gas companies that I follow are profitable with oil at $55/bbl and natural gas at $2.50/mcf.
The oilfield services companies have been forced to lay off a lot of good people. Thanks to a booming U.S. economy, most of them will find new jobs and they will not return to the oilfield. We’ve also idled a lot of equipment that cannot be replaced quickly. Even if the skilled workers and equipment can be replaced, it won’t happen fast enough to reverse the massive crude oil inventory decline (1.5 million barrels per day) in the 3rd quarter of 2020.
Conclusion: This world now consumes over 3 Billion barrels per month of hydrocarbon-based liquids, most of which are refined from crude oil. The oil & gas industry has a massive supply chain that most people cannot comprehend. It only takes a crude oil shortage of 1% to cause a very large price spike. All previous price spikes, including the one to $147/bbl in early 2008, caused a bidding war between refiners for the world’s important commodity – black oil.