Rude awakening for those who ignored the energy markets' warning signs

Back in February (see post) numerous equity investors refused to believe that a crude oil recovery is likely to be unsustainable. Many viewed this as a buying opportunity - just as they did in 2011 when such "bottom fishing" strategy worked. "Look at the declines in oil rigs" many argued - US crude production is about to dive. Even some in the energy business were convinced that crude oil recovery is coming and we will be back at $70/bbl in no time. It was wishful thinking.

There is no question that North American production of crude oil is stalling. However for now it remains massively elevated relative to last year.

Source: EIA

More importantly, many fail to understand just how flexible US crude production has become - the time to bring capacity on/off-line has shrunk dramatically. Furthermore, a great deal of production in the US is now profitable at $60/bbl and even lower as rig efficiency rises. Many view this as unsustainable because new exploration is halted and existing wells are being reused. But there is enough staying power here to continue flooding the markets for some time to come.

Source: EIA

The ability to bring capacity back online quickly is the reason we saw US rig count unexpectedly increased last week. This creates a natural near-term cap on crude prices, above which production can rise quickly.

Source: Baker Hughes

To add to the market's woes, the Iran deal threatens to bring materially more crude into the market in 2016, while immediately releasing a great deal of stored crude the nation currently holds.

Source: WSJ

Moreover, the Saudis are ramping production to record levels, as the OPEC members are left to fend for themselves. The Saudis will attempt to recover some of the lost revenue with higher volumes.

Crude prices in the US fell below $50/bbl in response to some of these developments. So much for the "recovery".

Source: barchart

All of a sudden, as investors realize that crude oil price recovery could take years, energy firms, particularly those focused on exploration and production (upstream), don't look that attractive. The chart below shows the relative declines of the overall energy sector as well a the upstream companies' shares over the past year (down 29% and 51% respectively).

Source: Ycharts

And even those who were betting on the M&A activity providing support to share prices are having second thoughts, now that the Backer Hughes acquisition by Halliburton may face challenges.

Source: Bloomberg

To make matters worse, many energy firms continued to borrow as prices declined. With no recovery in sight, credit markets are becoming much less forgiving. In traded credit markets for example we see spreads widening out again - with oil services and equipment getting hit particularly hard.

Source: Credit Suisse

The US energy industry is undergoing its most challenging period in decades and for many firms the worst is yet to come.

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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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Declining volatility in crude oil - is it all about to change?

Since posting this chart of WTI crude oil price (sent by a reader) on Twitter, we've received a number of constructive replies. The technical trading term for this pattern is "symmetric triangle", which would typically result in a breakout to either side. Usually such breakouts are accompanied by rising volatility.

Here are some replies (thanks!):

One thing that is certain about the chart is that crude oil volatility has been declining since the financial crisis. Here are three measures that prove it.

1. Crude oil implied volatility is hovering around at least a decade low.

Source: DB

2. The same applies to historical volatility (as to be expected).

3. The CBOE Crude Oil Volatility Index, which is derived from the implied volatility of oil ETFs, paints a similar picture.

Source: CBOE

Now that we've established this fact, what are some of the fundamental reasons for this decline? One of the more credible explanations is the recent diversification of supply sources from the rise of non-OPEC producers, particularly in North America. These new sources of crude reduce the potential impact of any single supply disruption.

Another explanation for declining volatility is a much more modest and a somewhat more predictable global demand growth. This is to a large extent the result of China ending the global commodities "super-cycle" (see discussion here and here). In fact we saw some evidence for this trend today:

Reuters: - The International Energy Agency (IEA) said modest economic growth was limiting oil demand worldwide, and that some developed economies would see absolute declines in oil consumption in 2013.

In China, the world's No. 2 oil consumer, "weaker economic growth and lower than previously forecast March/April consumption data" support the view that demand is weakening, the IEA said.

Both OPEC and the U.S. Energy Information Administration (EIA) cut their global oil demand growth forecasts on Tuesday.

The fundamentals therefore argue for some permanency to this low volatility regime - especially a lower risk of a major spike in prices. From the technical perspective however, we are about to enter the "tip" of the multi-year symmetric triangle and should expect the pattern to break toward higher volatility.

We should know who is right fairly soon.

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From our sponsor:

What's causing sharp declines in crude oil prices? Visit ND lately?

Staying with the theme of bearish sentiment in commodity markets, crude oil came under severe pressure recently. Based on today's data, US crude inventory actually declined last week, surprising some forecasters who expected crude stocks to continue rising. One would expect lower inventories to result in higher prices, but that did not occur.

Source: EIA

Instead WTI futures took a 2% hit today, reaching a 10-month low.

May WTI futures

Here are some of the explanations from market participants for these violent moves to the downside:

1. Weaker than expected growth in China has precipitated a negative sentiment in commodity markets (see discussion).

2. Major commodity investors such as hedge funds have been unwinding positions.

3. Today we saw what could amount to weaker than expected demand for gasoline in the US, as more drivers stay home.

EIA: - Over the last four weeks, motor gasoline product supplied has averaged over 8.4 million barrels per day, down by 3.3 percent from the same period last year.

4. The non-OPEC crude oil production, particularly out of North America continues to surprise. The Deutsche Bank chart below, showing North Dakota's oil production, is giving some long oil investors a pause for concern (in some cases nightmares).

Source: DB

DB: - The latest production data out of North Dakota, home to the prolific Bakken shale, reflects the strength of US production as output hit a record 780kbd in February after dipping in January as cold weather hindered operations. Production in the state is up nearly 40% YTD. According to Lynn Helms, Director of North Dakota’s Department of Mineral Resources, the state is likely to reach 800kbd in May once weather conditions improve. Helms also said the state is on track to reach production of 850kbd by early 2014. We note that if North Dakota’s production averages about 800kbd this year, which would be up from last year’s average production rate of 663kbd, this would be equal to over 70% of non-OPEC’s estimated total supply growth for this year, according to the IEA.

All this is good news from the Fed's perspective, giving the central bank incremental room for monetary expansion. It's unclear where the Fed-induced bubble will show up, but for now it's not in commodities.

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From our sponsor:

Latest data from OPEC: Iraq's output catching up with Iran's

The recent OPEC report is showing that Iran's oil production continues to decline, apparently falling to a 20-year low.

FT: - Iran’s oil production has fallen to its lowest level since the aftermath of the Iran-Iraq war 20 years ago as western sanctions threaten Tehran’s economic lifeline.

Oil traders and western policy makers who monitor Iranian oil production estimate that Tehran pumped 3.2m barrels last month, the lowest amount since 1992. That is below the depressed level of 1999, when members of the Opec oil cartel implemented draconian production cuts to shore up oil prices, which had fallen below $10.

Iran's lower production is dragging down the overall OPEC output,

OPEC production tb/d

... changing the production distribution among the OPEC members. This is what the output breakdown looked like in 2010.

and here is what it looks like now.

A couple of observations from this data:
1. The Saudis are pumping considerably more on an absolute and on a relative basis.
2. Iraq's crude output is now catching up with Iran's.

Iraq vs. Iran output (source: OPEC, tb/d)

See this OPEC report for the latest data, including the demand side.

OPEC report

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Brent - WTI curves are not converging any time soon

The Brent-WTI crude oil spread has dropped materially from the peak, but managed to stay above $11/barrel. It has now recovered to $13. What's more interesting is the difference in the shapes of the two curves - particularly given that Brent and WTI are essentially the same products.

Brent and WTI futures curves

Brent is in backwardation, while WTI is in contango. Backwardation generally means tighter supply (more demand for the spot product) - a bullish indicator, while contango tends to indicate the opposite. It says that the crude market in the US (particularly in Cushing, OK) is well supplied, which is not the case with Brent (at least not nearly as much).

There is talk however that the gap between these two curves will close fairly soon (ht John A).

Bloomberg/BW: - The energy guys at Goldman Sachs, led by analyst David Greely, think that by the end of 2012 the price of WTI will be just $5 below Brent, largely because new pipeline projects, such as the recently reversed Seaway, will allow more domestic crude to reach refineries along the Gulf Coast, making WTI more valuable. In essence, the more domestic crude that reaches the Gulf Coast, the stronger the floor beneath the price of WTI becomes.

Some people doubt Goldman's forecast however. If traders truly believed in this rapid convergence, the two curves above would be approaching $5 spread six months out. Instead the difference in the January 2013 contracts is above $11. Analysts instead are looking at brisk US crude production that has been on the rise this year (we had signs of that increase earlier in the year).

US crude oil production (thousands of barrels per day; source EIA)

It means that in spite of the reversed Seaway pipeline that is delivering US crude to the Gulf Coast (to the large US refineries), there is still not enough pipeline capacity to accommodate this increased production, putting downward pressure on WTI.

Bloomberg/BW: - “Five dollars is not likely,” says Fadel Gheit, an analyst at Oppenheimer. “And even if it does go to $5, it’s not going to stay there.” Gheit points out that as long as WTI stays above $70, drilling companies can still make money producing new wells, which in turn, he says, will keep WTI anywhere from $8 to $12 below the price of Brent.

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So much for peak oil being just around the corner

Those who keep professing that "peak oil" is just around the corner or has already been reached should take a look at this Harvard paper (ht John A). The author (Leonardo Maugeri) analyzed oil exploration and development projects field by field globally to determine how oil production is expected to grow. Assuming oil price stays above $70 per barrel, here is what the increase in production will look like by 2020 (in Million Barrels per Day).

Source: Belfer Center for Science and International Affairs, Harvard University

Here is the breakdown of changes in production by country. The largest capacity increases will come from Iraq (whose reserves are thought to be the largest in the world), followed by (interestingly enough) the US, Canada, and Brazil.

Source: Belfer Center for Science and International Affairs, Harvard University  (click to enlarge)

Enjoy!
Oil - The Next Revolution

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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.

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The Saudis tightening the noose around Iran

Saudi Arabia is putting severe pressure on Iran by pumping record amounts of crude. It is starting to look more like a geopolitical move rather than an OPEC based targeting of supplying the market. The Saudis have gone beyond simply marginalizing Iran as a major oil producer.

SFGate: - Traditional rivals Saudi Arabia — a Sunni Muslim nation — and Shiite Muslim Iran are jockeying for influence in the Middle East as well as in OPEC.

Iran has warned the Saudis not to use the oil weapon against it by increasing supplies to countries that no longer get Iranian crude due to the sanctions. Saudi oil minister Ali Naimi has denied such intentions, telling reporters his country sells to whoever buys.

"We don't sit and say `we want to sell to this country or that country (or) whatever," he said.

But Saudi overproduction is clearly rankling the Iranians. In comments to Iran's Mehr news agency, former Iranian oil minister Gholam Hossein Nozari noted that "political issues have overshadowed OPEC," while analysts say the political implications of Saudi Arabia's production policy cannot be ignored.

"You do wonder what's tied up perhaps with the Iranian political issue," said Neil Atkinson, director of Energy & Utilities Research and Analysis. "Of course the lower the price at the moment the more damage that does to Iran."

It's happening at the time when Iranian crude production is at multi-year low and Brent is below $98/barrel. By severely limiting Iran's financial strength, the Saudi's will certainly be able to increase their influence in the region.

Source: OPEC/Bloomberg

Iran is clearly feeling the pain. The World Bank has moved its Iran GDP forecast for 2013 growth from positive 2.9% just six months ago to negative 0.7% now. Iran's banks are isolated as SWIFT (Society for Worldwide Interbank Financial Telecommunication) - the international money transfer system - has cut them out of its network. Inflation (even the official number) is closing in on 25%. The Israelis now believe Iran's economy is near collapse.

Arutz Sheva: - "The Iranian economy is near collapse, therefore it is time to continue to tighten the sanctions without letting up," Finance Minister Dr. Yuval Steinitz told visiting the Italian Prime Minister Monday.

With this backdrop in place, tensions between Iran and Saudi Arabia are escalating. Apparently the Saudis recently executed some Iranian citizens for "drug trafficking".

Tehran Times: - Iran will send a “legal-consular” delegation to Saudi Arabia to probe the recent execution of a number of Iranian prisoners in the Arab country, a Foreign Ministry official told the Persian service of IRNA on Wednesday.
...
The Mehr News Agency also reported on Wednesday that the planned visit of the Iranian deputy foreign minister to Saudi Arabia had been cancelled over the executions.

In spite of the current international focus on Syria, it is Iran that poses the greatest risk to the region. Isolated and denied a great deal of its foreign currency revenue, Tehran can become highly unpredictable and possibly quite dangerous. It is also possible that the current leadership's grip on power is somewhat tenuous. The Saudi'd may be closer to a destabilized Iran than the bargained for.

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OPEC is pumping at near record levels to plug the Iran hole and meet domestic demand. Spare capacity is a concern.

Big Asian oil consumers (other than India) continue to cut oil purchases from Iran.

WSJ: - China, Japan and South Korea, Asia's largest oil consumers, significantly cut imports of Iranian crude in the first quarter of 2012 after the U.S. and the European Union moved to tighten sanctions against Iran over its nuclear program, opening the way to rival suppliers.

Iran is the world's fifth-largest oil producer, exporting about 2.26 million barrels a day of crude in the first half of 2011, according to the U.S. Energy Information Agency.

China, Japan, India and South Korea made up the bulk of its customers, accounting for 59% of its exports or 1.46 million barrels a day. Iran, on the other hand, accounts for about 10% of each of those countries' crude imports.

Between January and March 2012, China cut Iranian crude purchases by a third to about 350,000 barrels a day because of a pricing dispute which has since been resolved--it has consistently said that it respects only U.N.-imposed sanctions.

Japan and South Korea cut imports by more than 20% to 330,000 barrels a day and 200,000 barrels a day, respectively, as political pressure from the U.S. mounted.

Japan cut imports from Iran in 2011 and said it would accelerate cuts this year. South Korea has moved more slowly, saying it will review planned cuts with the U.S, and it is in talks with Washington over how much it will need to trim to avoid retaliation

To compensate for the Iran cuts, OPEC (ex-Iran) and in particular Saudi Arabia is pumping at recent record levels.

Source: Barclays Capital

In addition to the hole left by the Iran sanctions, the Saudis are pressured to pump more in order to meet their own rising domestic demand. This is putting strains on OPEC's spare capacity. Even though the Saudis are reporting some 1.8 mb/d of capacity, according to Barclays Capital, the sustainable component of this is closer to 1 mb/d.

OPEC spare capacity (Source: Barclays Capital)

Aware of the capacity constraints and concerned about not being able to meet demand, the Saudis are rapidly increasing oil in storage.

GS: - Inventory building consistent with our view that Saudi effective spare crude oil production capacity is limited .

Saudi Arabia oil inventory (kbbl, source: Joint Organisations Data Initiative)

The Saudis are preparing for prolonged Iran sanctions, rising domestic demand (the Saudis are part of the BICS demand growth with close to 7% GDP growth), and possible supply disruptions should tensions with Iran escalate. Above all, this tells us that OPEC's limited spare capacity is becoming a concern.

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Why high gas prices at the pump? The answer is BICS

Here is a simple question: where is the growth in crude oil consumption coming from? According to Barclays Capital it's driven by four nations. They are Brazil, India, China, and somewhat surprisingly (and yes, we are talking about demand growth) Saudi Arabia, the so called BICS nations.

Barclays Capital: The reason for bringing together Brazil, India, China and Saudi Arabia is that once one has disaggregated global oil demand into BICS and non-BICS, it becomes clear which element is the key to predicting global oil demand. If you get BICS right, you have normally got the shape of the whole picture right. By contrast, if you get the US, EU or OECD right, you quite often can still miss the big picture. Perhaps the focus should be shifting to getting a better handle on BICS.

Last year BICS generated all the growth in global demand for oil. Given the economic malaise in the developed world, this year we expect the same. So the next time someone asks why people in the US and the EU pay such high gasoline prices all of a sudden, the answer is simple - BICS.

Demand growth in mb/day (Source: Barclays Research)

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Iran is now marginalized by increased OPEC production

Iran as an oil producer is becoming increasingly marginalized. Libya is finally bringing its production online and the Saudis are pumping at record highs.

Reuters: Exports from Saudi Arabia rose by 143,000 barrels per day (bpd) in January, as the world's leading crude seller boosted sales to the United States. The kingdom pledged to work individually and with other Gulf countries to return oil prices to what it called "fair" levels.

"Up until now, Saudi Arabia has not done much to ease the oil prices ... We have however to consider the risk that the combination of the Vela fixtures and the Saudi cabinet statement could signal a change of policy," said Olivier Jakobs of Petromatrix in a note.

Libya is also ramping up production as it plans to export almost 1.4 million bpd of crude oil in April, exceeding deliveries in February 2011 before the uprising that ousted Muammar Gaddafi.

This boost in global supply has helped easedconcerns about the standoff between the West and Iran over Tehran's nuclear program, which has lifted oil prices this year and kept oil markets on edge.

China and India, being the only major buyers of oil from Iran, will squeeze Iran on pricing, forcing it to sell substantially below market. Once that happens (the ban on Iranian oil starts July 1), China and India will reduce purchases from OPEC. That combined with lower expectations for global GDP growth should cap the oil price rally. Oil is selling off sharply this morning on the news of this increased production.

Having said this, with Iran shut out, oil producers' spare capacity remains extremely tight. An unexpected global GDP acceleration or more likely a geopolitical disruption, could create a violent spike in prices.

SoberLook.com

Rapid increases in US oil production

As discussed before, with the domestic demand lower and production higher, the US is importing an increasingly smaller portion of its fuel consumption. A good discussion on lower demand for diesel fuel can be found here. A similar trend exists in the US demand for gasoline, jet fuel, and in particular heating oil (given the warm winter).

Again, just to bust a few myths on this topic, the US oil production/exploration activities continue to increase sharply. This activity can be seen in the increases of the number of rigs.

Source: Barclays Capital

Here is how the recent as well as the foretasted changes in US production of crude oil and liquid fuels compares to other non-OPEC nation.

For some reason this upsets some people who are looking for signs of "peak oil". But whatever the long term forecasts, these are the facts today.

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Six common myths about global and US energy issues

At times politicians, bloggers, and even financial professionals make comments about US domestic and global energy issues that are factually inaccurate.  When you are having a cocktail at the New Year's Eve party in a week, ask around what people think about energy dependence, production, global supplies, etc. and you may hear some of the following six myths:

Note: wherever units are not provided, the assumption is million barrels per day

Myth #1: US crude oil comes from the Middle East/Persian Gulf.

Not true. A large portion of imports is coming from Canada and other non-OPEC nations.  Only about 18% is coming from the Persian Gulf

Imports from OPEC nations - million barrels per day (source: EIA)

Imports from non-OPEC nations (source: EIA)

Here is the OPEC vs non-OPEC trend for the last 3 years:

Source: EIA

Myth #2: The US domestic energy production continues to dwindle.

Not true. The US domestic energy production is in fact increasing.

US domestic production  (source: EIA)

Eurasia Review: Oil extracted from shale deposits in North Dakota, Montana, and Texas has reversed years of decreasing American oil production, leading to increased domestic extraction and thus reducing dependence on overseas oil from 60 percent of U.S. consumption in 2005 to a little less than half now.

Myth #3: If the US produced more of its energy requirements, the price at the pump would be lower.

This is a common misconception and is not true in the global economy.

Eurasia Review: ... it would not matter much if the United States produced 100 percent of what it consumed or whether it all came from the Persian Gulf, because the price at the pump is determined by the worldwide oil market. If more oil is put on market from anywhere around the globe, the price will go down; similarly, if oil production is cut anywhere in the world and not offset by increases elsewhere, the price will go up.

Myth #4: US energy needs are constantly growing.

Not true.

WSJ:   U.S. customers have been pulling back in part because an anemic economic recovery has left millions still looking for work. In August, U.S. drivers burned 7.7% less gasoline than four years earlier, when gasoline usage peaked.

Here is a chart showing the US energy consumption for the past three years (see the attached EIA document for more detail).

US energy consumption (source: EIA)

Myth #5: The US is not an energy exporter because it has no excess energy to export.

This is true on a net basis (imports less exports), but just the energy exports have been on the rise.

Source: EIA

In particular the US exports a great deal of coal and refined products because of efficient refining capabilities:

Source: WSJ

With higher exports, the net imports (imports minus exports) have been declining:

US net imports (source: EIA)

Myth #6 - this one will get the conversation really going: World's oil production has already peaked and as the reserves dwindle, more wars will be fought over the scarce energy resources.

Not true.

Eurasia Review  First of all, “experts” have been repeatedly predicting the depletion of the world’s oil reserves since the late 1800s, but it never seems to happen. New technologies and periodic higher prices make previously uneconomic deposits viable—such as the tar sands and shale oil that have recently become economic—thus sustaining world production. Second, academic research has indicated that conflicts are much more likely over allocation of money received from abundant natural resources (for example, fighting in Nigeria over who gets proceeds from oil exports) than conflict over scarce resources that can be priced in a market. That is, it is cheaper to pay the market price than to go to war.

For those interested in more detail about the data presented here, please see the attached EIA Monthly Energy Review (below).

Enjoy that New Year's Eve party...


EIA -

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