“The Invisible Hand” or an OPEC Deal ... Which One Will Govern Oil Supply?

“The Invisible Hand” or an OPEC Deal ... Which One Will Govern Oil Supply?

19th February 2016

The onshore rig count saw another significant decline this week, down 27 (5%) as U.S. light tight oil (LTO) operators continue to slash their 2016 capital budgets and rigs are taken off the well pad.  In the three key oil basins (Eagle Ford, Permian, and Williston), the decline was 14 oil rigs (a 5% decline).  Over the past three weeks, onshore rig count has declined by 103, an average of 34 rigs per week.

Saudi Arabia and Russia, the world’s largest crude oil exporters, announced plans this week to cap their production – if other major producers follow suit.  However, OPEC’s ability to influence oil supply may prove feeble against Adam Smith’s “invisible hand” free market.

In a free market, consumers act in their own self-interest, typically by choosing to buy the lowest price products, all else equal.  Investors seek to maximize their profits.  Demand signals are known through market prices, which direct investment capital to the most profitable industries.

In the global crude oil market, Saudi Arabia’s November 2014 decision to no longer curtail its oil production to prop up prices forced crude oil suppliers into a free market, away from the cartel structure that had been in place for many years.

At global oil production levels today -- which exceed demand, and given a likely increase in future production from Iran and Iraq, U.S. LTO production will almost certainly be squeezed and continue to decline into 2017.  LTO production is vulnerable due to its cost being higher than alternative resources such as in Saudi Arabia.  In a free market, crude oil price is set by the cost of producing the marginal barrel.  Since Saudi Arabia’s crude is lower cost and Saudi Arabia is no longer limiting its production to maintain oil price, the burden of balancing oversupply lies with the highest cost resource currently in the market, and this is U.S.-based LTO production.

In addition, the required reset of global oil output, needed to bring down inventories and put a sustainable floor under price, falls squarely on the financially vulnerable private sector producers.  The stronger integrated oil companies and independent producers of LTO will not take the hit, given their strong balance sheets.  Instead, the cuts will come from the over-leveraged producers of LTO, where output has already been falling.

The EIA’s Short-Term Energy Outlook (STEO) crude forecast that is updated monthly and GCA’s December 2015 forecast show that U.S. production is in decline.  GCA’s forecast, based on the current oil rig decline rate (8 to 10 per week), shows that U.S. production will drop to ~8.3 million barrels per day by August 2016.  The EIA’s February update shows that U.S. production is forecasted to be lower than the STEO January update but higher than the December 2015 update.

It has proved to be very difficult to forecast U.S. LTO production; however, the trend is downward.  The rate of decline is the difficult bit; however, rig activity level has begun to impact LTO production and certainly will be the key indicator to future production.

GCA’s view, with Iran and Iraq having the potential to replace lost U.S. LTO production, is that LTO drilling activity is likely not going to begin recovering until the latter end of 2017.  Even then, it will be slow and highly dependent on oil price signals in the market.

Sources: EIA’s STEO and GCA’s LTO Production Model

Weekly Recaps

Drilling Activity

The total number of active onshore rigs now stands at 489, down 1,387 (~75%) from a November 2014 high of 1,876.  Across the three major unconventional basins, the oil rig total declined to 247 (down 14 last week), with Eagle Ford down 4, Williston down 3, and Permian down 7.  The horizontal rig count is now 415, down 18.

Total U.S. rig count (including the Gulf of Mexico) stands at 514, down 27 last week, with rigs targeting oil down 26 for a 25-week total decline of 260.  The average weekly decline rate now stands at 10.4 rigs per week.

Oil Price

Oil prices fell on Friday but are set for their first weekly increase this month as talk of a coordinated plan by producers to freeze output levels was tempered by a record build in U.S. crude inventories.

Brent, the global benchmark for oil, was up 26 cents to US$33.06 a barrel while WTI crude was up 31 cents to US$29.44 a barrel, reflecting slight increases on the week.

U.S. Supply and Demand

U.S. crude oil refinery inputs increased to an average of 15.8 million barrels per day, with refineries at 88.3% of their operating capacity last week.

On the supply side, EIA data indicated that U.S. oil production in the Lower 48 declined by 50,000 barrels per day, with total production at 8.623 million barrels per day.  The total decline over the past two weeks stands at 80,000 barrels per day; the data are beginning to show that the rate of decline of U.S. LTO production is accelerating and that the decline could continue into the summer months.     

U.S. crude imports averaged 7.9 million barrels per day last week, an increase of 795,000 barrels per day from the previous week.  Over the last four weeks, crude oil imports averaged 7.7 million barrels per day, ~5.8% above the same four-week period last year.

Crude oil inventories increased ~2.1 million barrels from the previous week, with the change in stocks driven by imported crude.  Crude in storage at Cushing (the main price point for WTI) remained flat, leaving total crude in storage at 64.7 million barrels (~71% utilization).

The rate of change in crude stocks for February, when compared to the same period last year, is running at only ~8% of the daily average increase (1.259 million barrels per day).  This may be an indicator that supply and demand are moving toward balance. 

Sources: EIA Weekly Update and GCA Analysis

 

Authors

“The Invisible Hand” or an OPEC Deal ... Which One Will Govern Oil Supply?

P Kevin Galvin

Principal Advisor, Field Development Planning - kevin.galvin@gaffney-cline.com
“The Invisible Hand” or an OPEC Deal ... Which One Will Govern Oil Supply?

Jeanne-Mey Sun

Vice President and Global Head of Business Consulting - Jeanne-Mey.Sun@gaffney-cline.com
“The Invisible Hand” or an OPEC Deal ... Which One Will Govern Oil Supply?

Bob George

Regional Director: Americas - bob.george@gaffney-cline.com

Signup to receive our latest articles

We're here to help