Have the Saudis miscalculated the impact of lower crude prices on US production?

In 2014 the Saudis could no longer accept the loss of crude oil market share as the North American production levels shot up sharply over a three-year period.

Source: Yardeni Research

The Saudi response was quite rational. Rather than cutting production to support crude oil prices, the Saudis announced that output will remain the same. In private they were planning to actually increase production in order to meet rising domestic demand as well as to regain market share. The idea was to put a squeeze on the high-cost North American oil firms, halting production growth and ultimately getting prices back into a more profitable range. Other OPEC nations reluctantly agreed to play along.

CNN (November, 2014): - One motivation is to squeeze higher-cost producers in North America, including the booming U.S. shale industry that has reshaped the global energy landscape.

It's a move Tony Soprano would be proud of. OPEC is betting lower oil prices will force U.S. producers to throw up the white flag and cut back on production because they won't be able to turn a profit.

"The gauntlet has been thrown down for Western Hemisphere producers like Brazil, Canada and the United States," Bespoke Investment Group wrote in a note to clients on Friday.

Is it working? So far the results have been less than what the Saudis had hoped for. After a bounce from the lows, crude oil has been trading in a relatively tight range, with WTI futures fluctuating around $60/bbl.

Source: barchart

How is this price stability possible when the common wisdom was that oil prices below $70/bbl will force most US producers to close shop and North American production would collapse? After all we've seen a spectacular decline in active oil rig count. The answer has less to do with rigs that have been taken offline and more with the technology that remains. After the inefficient rigs have been shut, US rig count is starting to stabilize.

Source: BH

US crude producers are achieving record efficiency with the remaining equipment. The charts below show new-well oil production per rig.

Source: EIA

From multi-well padding (multiple wells in a single location) to superior drill bits, technology is helping to keep production levels high. Well completion costs and the speed of drilling have improved to levels many thought were not possible.

Source @PlanMaestro

With the inefficient rigs mothballed, the remaining capacity is quite lean. It seems that $60/bbl can now sustain a good portion of current production capacity and even turn a profit.

Platts: - ... [US oil producers] have wrung astonishing efficiencies from their operations in a very short period of time, as the number of days to drill a well keeps contracting while initial well production rates and estimated hydrocarbon recoveries expand.

Also, corporate efficiencies, coupled with cost concessions of around 15%-25% granted by oil services and equipment providers this year, have also lowered well costs and driven up internal return rates in the best plays to the point that operators appear comfortable with the current price environment, even if they privately hope for an eventual return to $80/b oil.

To be sure, there is a significant chance that US production slows in the coming months. Thus far however the results of the recent Saudi efforts to diminish US production have been less than satisfactory.

Source: EIA

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SoberLook.com

Crude oil vs. US equities: dislocation continues

In this recent post we discussed the seeming dislocation between levels of crude oil price (in this case WTI) and US equities (S&P500). Some readers have pointed out however that this may be driven by unusually high US crude inventories (particularly in Cushing OK, where WTI futures settle). The US crude stocks have indeed been on the rise, materially above the 5-year range.

Source: EIA

OK. Point well taken. But let's do the same analysis using Brent crude (instead of WTI), which should not be directly impacted by US crude inventories in Oklahoma. Here we have the last 3 years of price data on a scatter chart - and the same anomaly still exists (in fact it's even sharper today than before).

Brent crude (instead of WTI) vs S&P500 (red asterisk indicates where we are today)

Again, it may be an issue related to global supply. But that should simply be a reflection of world economic activity. One would think the equity markets would be reflecting this contraction in growth as much as the energy markets have. That has not been the case, as US equities continue to be resilient in the face of the slowdown. It's not clear however if this dislocation is sustainable going forward.

SoberLook.com

Peak oil is nowhere to be found on the WTI futures curve

As predicted back in February the crude oil rally has stalled. WTI reached $110 in late February, which so far has been the high for the year.

MarketWatch: And despite ongoing Middle East threats to global supplies and a complicated background comprised of market manipulation talk, government oversight proposals and pipeline changes and expansions, many analysts don’t believe prices are where they should be — simply because there’s too much oil in the market.

Spot crude is of course higher than it was 3 months ago, driven primarily by the Iran fears.

MarketWatch:“The economic price for (West Texas Intermediate) oil is in the $80-$85 range,” said Mickey Cargile, managing partner at Cargile Investments, basing his estimate on where he sees supplies locally and in Cushing, Okla., the delivery hub for Nymex oil.

“Our range valuation suggests a 15%-20% risk premium priced for potential supply disruption from Iran,” he said.
...
Europe and Asia have been hoarding supply in the last few months, according to Phil Flynn, a vice president at PFGBest. “The market and countries were basically pricing in and expecting war” with Iran.

Interestingly enough that "economic price" prediction is roughly where the long-term WTI futures are in fact trading. The chart below shows how the WTI crude futures curve has moved in the last three months. As Iran fears drove up the front end, the back of the curve came down materially.

WTI futures curve - now (orange) and 3 months ago (blue)

Part of the driving force behind this subdued view on prices is the reassessment of growth in emerging markets. A component of this reassessment is China shifting to domestic demand and reduced infrastructure investment. But the supply side of this dynamic is also changing.

Forbes: But just when we thought the global hydrocarbon map was complete, another serious player has cropped up, and it comes in the form of East Africa. This is the new African oil rush, and the race to secure regional riches between East and West is on.

The market has now priced in declining oil prices at least through 2020. If "peak oil" dynamics are still at play, they are nowhere to be found on this futures curve.


Update: Please note the following
1. This is not a forecast. The chart is showing what the market is currently pricing in - a big difference.
2. Three months ago the market was indeed implying price increases starting in late 2016. It no longer does.
3. Ignoring what is priced into the market is a mistake many economists make. Not paying attention to "wisdom of crowds" could be costly.

SoberLook.com

ISDA and CFTC are fighting it out over commodity limit rules

Many readers were upset with the Sober Look post from two years ago named Energy speculation vs. hedging - regulate it all, ask questions later. Supposedly oil prices in the summer of 2008 had nothing to do with China’s and India’s rapid growth. It was all speculators. Right.

In fact a 2009 study showed that there is no evidence that futures trading impacts physical commodity pricing. We quote that study again here:

...the results indicate that in recent years the relationship between futures and physical commodity markets for industrial metals was not disturbed by financial investors. Instead, commodity spot prices changes are driven by world economy activity and financial investors are merely responding to these price changes. This conclusion is strongly confirmed by the economic developments in 2008.

But publicity driven politicians and zealous regulators (CFTC) continued on their war path to limit futures position holdings and impose other restrictions. Even without those limits in place, the threat of such action cause distortions in the market place such as ETFs trading at substantial premium to NAV (see Another ETF giving Larry a headache)
Today with the CFTC rules finalized, ISDA and SIFMA (Securities Industry and Financial Markets Association) finally filed a legal challenge to the CFTC’s new rules.

MarketWatch: The Associations believe that the Position Limits Rule may adversely impact commodities markets and market participants, including end-users, by reducing liquidity and increasing price volatility.
…
"The evidence is overwhelming that position limits are, at best, unnecessary and may, at worst, negatively impact commodity markets and users," Mr. Voldstad said. "Numerous studies have been conducted by government agencies and others into commodity price volatility and little, if any, support exists for the idea that speculation causes that volatility or that position limits curb speculation."
…
The Associations have filed suit in federal court in the District of Columbia, alleging that the CFTC:

• Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary; 
• Failed to present a reasoned analysis or consider all evidence in setting position limits;
• Failed to conduct an adequate cost-benefit analysis as required by law;
• Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

Markets regulation is vital in order to build investor confidence that in turn provides financing to corporations, municipalities, individuals etc. But we need smart regulation, not just what makes for good publicity or sells newspapers.

Energy speculation vs. hedging - regulate it all, ask questions later

From Bloomberg:

U.S. regulators say they may clamp down on oil and gas price speculators by limiting the holdings of energy futures traders, including index and exchange-traded funds.

The rationale is that speculators artificially inflate energy prices. So where is the evidence that "speculators" control energy prices? There is more money under management in energy index and exchange-traded funds now than there was a year ago, while oil price is now less than half.

The argument is that oil speculators hurt the consumer. Then why stop at oil and gas "speculators"? Why not hit property speculators? Treasury bond speculators? Stock market speculators? The stock market was the largest speculative bubble out there, but nobody was proposing regulation to stop the speculators because we call them "investors".

Gensler said the CFTC is reviewing exemptions from position limits for “bona fide hedging,” after seeking public comment on whether the exemption should continue to apply to traders who are in the market for financial reasons, rather than those that actually use the commodity.

"Bona fide hedging"? How do you define that? If someone owns a large airline/transportation portfolio of stocks, would buying gasoil or crude to hedge fuel price exposure be a "bona fide" hedge? How about a REIT that owns properties and wants to buy heating oil or natural gas forward to hedge against heating expenses spiking in the winter? What about a pension fund that wants to hedge against inflation by buying crude (as many pensions and endowments do)? Where do you stop?

There are two ways to address the energy price spiking issue:
1. keep the dollar stable to avoid a run-up in commodity prices due to inflationary fears
2. diversify away from crude oil as the key energy source

Sounds as though the US is not seriously interested in either one. The proposed regulatory measures will destroy liquidity and reduce companies' and institutions' ability to manage risk. But they do present an excellent opportunity for politicians and bureaucrats to make a name for themselves.

Speculating on oil? Go for it.

A nice write-up R S Eckaus discusses the oil price bubble that we've experienced last summer and may be experiencing now. He disputes the argument that we have this tremendous new demand from China as well as some other justifications for oil price being where it is. As we discussed earlier (Oil price will stall on fundamentals), we've had some real demand destruction due to this financial crisis. Some of that destruction is also driven by substantial increases in production and delivery capabilities of liquefied natural gas (LNG) around the world. The Russians wanted to diversify from pumping gas to Europe via the Ukraine (Ukrainians can get a bit "restless" at times) as well as sell their natural gas to other markets. So they are completing some LNG capability, while consumers like China and the US have been building de-liquefaction capacity to diversify from oil. With natural gas prices at current levels, energy users are shifting wherever they can away from oil.

With all this, the IEA finally admitted that the demand will be lower than what thay have been predicting all along. They are now in line with the Credit Suisse forecast of under 90 million barrels per day by 2013.

So why are oil prices on the rise given such demand destruction? Eckaus argues it's speculation. Then what , if anything, can be done about it? Some would argue speculation in oil should be prohibited. Well, that could become a slippery slope. If you buy a piece of land as an investment, that's speculation. Should that be prohibited also? How about buying gold? What about the largest speculative bubble of all, the stock market?

Also, speculating on oil is generally done via futures, unless you own an oil storage facility. That means that eventually you will either have to sell your futures contract or someone will deliver you physical oil in Cushing, Oklahoma and make you pay for it. Plus being long oil futures is expensive because the curve is quite steep, making contracts worth less as time goes on (negative carry). That means that it's not the "fast money" that is doing all the buying but some more strategic players who store oil or hold it in tankers. Controlling or prohibiting that would be ridiculous - we would all be standing in lines to buy government issued gasoline. Socialism anyone?

So oil speculation can definitely hurt the consumer and corporations, but controlling trading is not the answer. It is no more productive than controlling speculation in the housing market that ended up hurting everyone - you just can't legislate whether people can buy or sell homes and at what price. The answer is to prove to the market that diversification away from oil is possible and it works. That will be the most effective way to burst the bubble.