On Sunday, OPEC and non-OPEC producers got together and discussed some things.
Specifically, how the supply cuts are going (i.e. who’s cheating and who’s not and by how much) and whether it makes sense to extend those cuts given the fact that soaring US production and record US stockpiles have created a decidedly bearish fundamental backdrop. For those who missed it, you can read everything you need to know about the meeting here.
Well, as regular readers are aware, Wall Street is pretty wedded to the bullish oil thesis and to the general idea that this market is going to balance, record US production or no record US production. We’re obviously skeptical.
On Monday, Goldman is out with its take on yesterday’s pow wow in Kuwait, and the banks’ analysts now say a “data-dependent” OPEC doesn’t need to extend the cuts in order for the market to balance. In other words, “nothing to see here” with record US production and inventories as “demand pull” will eventually carry the day, giving OPEC some optionality in terms of opening up the spigots without causing prices to plunge back to a 20-handle.
The key question then is whether such an extension of the cuts will be necessary. While weekly inventory data in the US, Europe, Japan and Singapore will provide OPEC with an estimate of the rebalancing process through the spring, it will fall well short of the stated target of “5-year average OECD levels”. Although this suggests that an extension would be necessary, our assessment of oil fundamentals and the rationale behind the production cuts do not warrant such an extension, in our view, barring either a sharp deceleration of demand growth or a sharp rebound in Libya/Nigeria production:
- We believe that the rebalancing of the oil market is making progress despite the record high US crude inventories with non-crude US inventories and non-US inventories down yoy.Further we forecast that OECD inventories on a days of demand cover will reach their 5-year average level by year-end even with OPEC bringing production back online in 2H17. While the shale production rebound has surprised to the upside, it will be offset in our view by the high compliance to the production cuts through 1H17 and most importantly, strong demand levels. The OECD stock draws we project would be further accelerated – as was the case through 4Q16 – if the recent strength in survey activity indicators, pointing to 4% yoy global GDP growth, translates into stronger oil demand growth than our above consensus 1.5 mb/d forecast. This demand pull is important in our view as the supply response to only slightly higher oil prices has been faster and larger than expected.
- We believe it is beneficial for low cost producers to accelerate the normalization of oil inventories but not target too high a price rebound. Lower inventories imply backwardation – helping low cost producers grow market share by preventing higher cost producers from selling their production forward at a premium. However, oil prices above $60/bbl would prove self defeating in our view given the flattening of the oil cost curve and the unprecedented velocity of the shale supply response. It is useful to understand OPEC’s incentive through the lens of our pricing methodology which compares OECD inventories (as measured vs. OECD demand) to Brent timespreads (Exhibit 5). At the stated 5-year average OECD inventory level target, this relationship would imply a 1-mo to 5-yr backwardation above 20% and, at current 5-year forward Brent prices, spot prices of $65/bbl, a price level where we expect an excessive global drilling response.
We therefore believe that OPEC should be wary of extending its production cuts unless (1) fundamentals weaken sharply driven by transient headwinds such as a ramp up in Libya or a weakening of global demand, or (2) long term oil prices decline further, limiting the rally in spot prices and the incentive to ramp up activity. Absent such conditions, the larger-than-expected ramp up in US activity and the sooner than expected shift by the oil majors to refocus on growth observed so far this year should ultimately be the incentive for an only short duration cut. While this does not preclude an extension of the cuts from being initially announced in May, such a decision would only exacerbate the backwardation that we project, creating upside risks to our 2H17 $57/bbl Brent forecast but in turn downside risk to our 2018 $58/bbl forecast.
Incidentally, this seems like an opportune time to recall our post from last week regarding the deflationary dynamic in crude and the interplay between shale, OPEC, and the cost curve.
We’ve written exhaustively about the deflationary dynamic that grips crude markets.
Indeed, what you’re seeing from US producers is effectively what happens when QE and central banks inadvertently create deflation as opposed to inflation.
It’s very simple, really. The central bank-inspired hunt for yield drives investors down the quality ladder, creating artificial demand for HY debt and equity follow-ons. This relentless appetite for anything that offers investors some semblance of yield allowed otherwise insolvent US production to remain online as operators tapped capital markets to plug funding gaps. Here’s how Citi put it way back in 2015:
Easy access to capital was the essential “fuel” of the shale revolution. But too much capital led to too much oil production, and prices crashed. The shale sector is now being financially stress-tested, exposing shale’s dirty secret: many shale producers depend on capital market injections to fund ongoing activity because they have thus far greatly outspent cash flow.
Capital markets remained open to many of these operators during the OPEC-engineered price downturn, allowing US production to effectively go into hibernation (as opposed to going clean out of business) until prices rose again. Now, they’re back pumping, sowing the seeds of their own demise by offsetting the very OPEC production cuts that allowed them to start pumping again in the first place. This is a circular, deflationary dynamic that can only be short-circuited by capital markets finally slamming shut on US operators and as we saw with the $6.64 billion US energy companies raised in 13 equity offerings in January, that doesn’t look like it’s imminent.
Well, speaking of oil and circular, deflationary deathtraps, Goldman is out Tuesday with an expansive new piece on crude and more specifically on OPEC. We’ll get to the details later, but for now, consider Goldman’s take on how shale has “transformed the cost curve” creating a “structural deflationary cycle.”
Short-cycle shale has transformed the cost curve
Shale’s short time to market and ongoing productivity improvements have provided an efficient answer to the industry’s decade-long search for incremental hydrocarbon resources in technically challenging, high cost areas and has kicked off a competition amongst oil producing countries to offer attractive enough contracts and tax terms to attract incremental capital. This is instigating a structural deflationary change in the oil cost curve, as shown in Exhibit 2. This shift has driven low cost OPEC producers to respond by focusing on market share, ramping up production where possible, using their own domestic resources or incentivizing higher activity from the international oil companies through more attractive contract structures and tax regimes. In the rest of the world, projects and countries have to compete for capital, trying to drive costs down to become competitive through deflation, FX and potentially lower tax rates.