Oil Prices Will Recover: Market Fundamentals Are Working

On St. Patrick’s Day the U.S. Energy Information Administration (EIA) reported that oil production from three of America’s largest shale plays is in decline. The EIA is forecasting that total U.S. oil production will be in decline in the 3rd quarter.

The South Texas Eagle Ford, North Dakota’s Bakken/Three Forks and the Niobrara in Colorado & Wyoming are in decline. Since horizontal shale wells have very steep production decline rates (more than 50% in the first year), the oil supply “glut” will be corrected by market forces. Shale plays require continuous drilling or they quickly go on decline.

Note: In the EIA chart above, the government’s production forecast is based on an active onshore rig count of 1,300. Baker Hughes reported March 13, 2015 that the land rig count was down to 1,069. I am forecasting the active onshore rig count in the U.S. to fall below 800 by the end of April.

The price of West Texas Intermediate (WTI) crude oil is testing the 5-year low as I write this article. Oil traders are dealing with some facts and a lot of fiction these days. The physical market is obviously oversupplied today, but the word “glut” is being way overused.

There is no doubt in my mind that some of the “narrative” coming from Wall Street analysts is purposely meant to drive down the price of oil. More than 90% of the NYMEX futures contracts are now held by non-commercial “speculators”. Many of them are now “short” oil, hoping the price of WTI will fall. Once Wall Street gets oil prices as low as they can, they will suddenly change their tone and point out that demand for oil is going up and supplies are falling. I have seen this happen several times in my 35+ years in the industry. What’s happening now is not new.

Related: Big Changes Needed For Big Oil To Survive

During February, WTI rose off the low of around $45/bbl that was set in late January. Oil seemed to have found a home in the $50 to $55 per barrel range a few weeks ago. Investors moved some money back into the upstream sector; pushing several of my favorite E&P companies up more than 20% year-to-date. They have now pulled back in lock step with oil prices.

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On March 13, the International Energy Agency (IEA) published their monthly Oil Market Report. It cause quite a stir on Friday the 13th and oil dropped more than $2.00/bbl. You can read the highlights of the report here: https://www.iea.org/oilmarketreport/omrpublic/ 

I thought the IEA report contained some rather bullish long-range forecasts, not the least of which is that the IEA believes global demand for refined products will increase 2.0 million barrels per day from where demand is today by the 4th quarter. They believe low fuel prices will continue to increase global demand, pushing demand for refined products up over 95 million barrels per day by year-end. I think their estimates may prove to be quite conservative. A year after the last big drop in oil prices that occurred in 2008, demand for liquid fuels increased by 3.3 million barrels per day in 2009.

Note: The chart above is labelled “World Oil Demand”, but it is really a chart of demand for refined hydrocarbon based liquids (fuel and feed stock). It includes demand for biofuels (only a small percentage).

So, why are oil prices still so low?

1. There is a lot of “FEAR” being generated by concerns over the rapidly rising amount of oil in storage. In my opinion, this is way over-blown.
2. U.S. oil production continues to rise, despite the sharp drop in the active rig count.
3. Seasonal and unplanned refinery outages have lowered demand for oil.
4. Traders are worried that President Obama will agree to a deal with Iran and lift the sanctions that are keeping an estimated million barrels per day off the market.
5. Strength of the U.S. dollar continues to weigh on commodity prices.

Let’s take these issues one at a time.

Oil Storage: At the end of February, the EIA reported that working oil storage capacity in the U.S. was 40% empty. The most talked about storage location – Cushing, Oklahoma – still has about 20 million barrels of working capacity remaining. As the tanks at Cushing approach capacity, the storage fees go up and oil will be directed elsewhere. There are many pipelines that take oil out of Cushing, so the oil is not “stranded” there. Oil will not start overflowing the tanks in central Oklahoma or anywhere else.

Related: The Truth About U.S. Crude Storage

It is very important to understand that the weekly EIA oil storage reports (published on Wednesdays) includes pipeline fill and field level storage. Although it is somewhat hazy, it is estimated that the U.S. oil pipeline system and upstream field tanks have approximately 120 million barrels of above ground oil in “storage”. It is not included in the ~525 million barrels of commercial storage capacity that many analysts compare to the oil inventory number each week.

So, the real storage capacity in the United States is approximately 645 million barrels, compared to the 458.5 million barrels the EIA reported on March 18th as the crude oil inventory level. Therefore, we have almost 180 million barrels of storage capacity remaining and this does not include floating storage. Plus, we are only a few weeks away from the time refiners will draw more feedstock from storage.

When we combine U.S. commercial storage, other OECD storage and floating storage, there is no risk that the world will run out of places to store oil before demand starts to exceed supply. However, the weekly EIA storage reports are likely to remain bearish for at least six more weeks. The speculators that want oil to go lower will keep beating this drum.

U.S. Production Growth: Investors are puzzled by the reports that U.S. production continues to rise while the number of rigs drilling for oil has dropped more than 45% in six months. The reason for this is simple; the drilling of new wells is not what increases production. It is the connection of those wells to a gathering system that adds production. The lag time from spudding a horizontal well to completing it to connecting the supply to a pipeline can be over six months. There was a large inventory of wells “waiting on completion” when all of this started back in June and it takes time to work through this inventory.

Several of the companies I follow are now saying they plan to drill wells and hold off on completing them until oil prices move higher. Although I agree with this strategy, it is impossible to estimate how much this will impact daily production rates. My guess is not very much.

U.S. onshore production should peak this summer and go on decline in the 3rd quarter. There are several Gulf of Mexico projects coming on-line this spring that will increase total U.S. production by approximately 200,000 barrels per day. Gulf of Mexico production is expected to peak at close to 1.7 million barrels per day (BOPD) in the first quarter of 2016, up from 1.4 million BOPD currently.

Seasonal and unplanned refinery outages have lowered demand for oil: The real “consumers” of crude oil are refineries. Refiners are required to do annual maintenance and reconfigure their processes to go from producing winter blends of transportation fuels and home heating oil to producing summer blends of gasoline and diesel. Most of the maintenance related slowdowns occur in March and September. There was also a fire at a large California refinery a few months ago and a workers’ strike that lowered crude oil demand. More crude will be “taken” by refiners in the second quarter.

Related: Why Oil’s Recent Drop Indicates Strength, Not Weakness

Iran: President Obama and Mr. Kerry seem “hell bent” on getting a deal done with Iran. In my opinion, this is very dangerous territory. Iran is a known sponsor of global terrorism and they supply weapons to several groups that want to kill us. I trust them about as far as I can throw an ICBM. They are taking control of Iraq as you read this and will soon have Saudi Arabia surrounded. Deals with the “devil” seldom work out well.

Based on the letter 47 senators sent to the leadership of Iran last week, I doubt any deal Obama and Kerry come up with leads to a lifting of sanctions anytime soon. Even if it does, it will take several months for Iran to ramp up their crude oil output.

Strength of the U.S. Dollar: This is a real concern.

The spike in the value of the dollar compared to a basket of other currencies can be viewed at: http://www.marketwatch.com/investing/index/dxy/charts 

The dollar is up approximately 25% from where it traded during the 2nd quarter of 2014 and is responsible for at least $25/bbl of the drop in the price of WTI crude oil. Since oil trades in U.S. dollars, there is an inverse relationship between the dollar and the price of oil. This tops my list of “real” concerns when it comes to my long-term outlook for oil prices.

Conclusion: Your guess as to where oil prices are heading in the next few months is as good as mine. Even though there are plenty of places to store oil, the record high U.S. oil inventories will continue to give the bears support for lower price forecasts. In my opinion, we are nearing the mid-point of the bottoming process for oil. At the beginning of the year I predicted that oil would test the lows several times during February to May, and then begin to rise. I’ve seen nothing yet to change my opinion.

In the short-term, I am expecting energy investors to remain on the sidelines until they see U.S. production growth slow and demand increasing.

By Dan Steffens for Oilprice.com

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