OPEC Will Not Blink First

An OPEC production cut is unlikely until U.S. production declines by about another million barrels per day (mmbpd). OPEC won't cut because it would accomplish nothing beyond a short-term increase in price. Carefully placed comments by OPEC and Russian oil ministers about the possibility of production cuts achieve almost the same price increase as an actual cut.

Bad News About The Oil Over-Supply from IEA and EIA

The International Energy Agency (IEA) and U.S. Energy Information Administration (EIA) shook the markets yesterday with news that the world's over-supply of oil has gotten worse rather than better in recent months. IEA data shows that the global liquids over-supply increased in the 4th quarter of 2015 to 2.24 million barrels per day (mmbpd) from 1.62 mmbpd in the 3rd quarter (Figure 1).

Figure 1. IEA world liquids market balance (supply minus demand). Source: IEA and Labyrinth Consulting Services, Inc.

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Supply increased 70,000 bpd and demand decreased 550,000 bpd for a net increase in over-supply of 620,000 bpd. The sharp decline in demand is perhaps the most troubling aspect of IEA's report. The agency forecasts tepid demand growth of only 1.17 mmbpd in 2016 compared with 1.61 mmbpd in 2015. The weak global economy is the culprit.

EIA's monthly data showed the same trend. Over-supply in January increased to 2.01 mmbpd from 1.35 mmbpd in December, a 650,000 bpd net change (Figure 2). Supply fell by 370,000 bpd but consumption dropped by a stunning 1.02 mmbpd.

Figure 2. EIA world liquids market balance (supply minus consumption). Source: EIA and Labyrinth Consulting Services, Inc.

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The January 2016 Oil Price Head-Fake

Recent comments about a possible OPEC cut were largely responsible for the late January "head-fake" increase in oil prices (Figure 3). WTI futures increased 27 percent from $26.55 to $33.62 per barrel between January 20 and 29. As hopes for a production cut faded, prices fell 8 percent last week and have fallen below $28.00 as reality regains control of market expectations.

Figure 3. NYMEX WTI futures prices, October 2015-February 2016. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.

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There were, of course, other factors that boosted oil prices for that brief period. These included the usual questionably substantial suspects: a lower-than-expected build in U.S. crude oil inventories, sharp declines in U.S. land rig counts, and a weaker U.S. dollar on expectation that the Federal Reserve Board may slow planned interest-rate increases. What happens in the U.S. continues to drive oil markets.

Oil markets reflect a psychological conflict among investors between reality and hope. The reality is that the world is over-supplied with oil. The hope is that oil prices will increase without resolving that fundamental problem.

An OPEC production cut fulfills that hope. Deus ex machina.

Blame It On OPEC

Many believe that OPEC caused the global oil-price collapse by failing to rescue prices in its role as swing producer. This narrative also contends that OPEC and Saudi Arabia are producing at maximum capacity to destroy U.S. shale producers. The data do not support this narrative. Related: Could Gasoline Drop Below $1 Per Gallon?

January 2016 Saudi crude oil production (9.95 mmbpd) increased slightly from December (9.90 mmbpd) but has declined since the August 2015 peak of 10.25 mmbpd (Figure 4).

Figure 4. Saudi Arabia crude oil production and change in production since January 2008. Source: EIA and Labyrinth Consulting Services, Inc.

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Total OPEC crude oil production in January production was 31.61 mmbpd, almost half-a-million barrels per day less than in July (32.09 mmbpd) and only somewhat more than its 4-year average of 31.28 mmbpd.

Figure 5. Total OPEC crude oil production. Source: EIA and Labyrinth Consulting Services, Inc.

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OPEC crude oil production since the Financial Crisis in 2008 has been remarkably balanced (Figure 6). Overall, increases by Iraq (+2.35 mmbpd) and Saudi Arabia (+0.6 mmbpd) have largely offset decreases by Iran (-1.0 mmpbd due to sanctions) and Libya (-1.4 mmbpd due to civil war). Renewed export by Iran with the lifting of sanctions is part of what pulls the oil market back to reality after its flights of sentiment-based hope.

Figure 6. OPEC crude oil production compared to January 2008 production levels (minus Indonesia). Source: EIA and Labyrinth Consulting Services, Inc.

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Although it appears unlikely that Libya will resolve its civil unrest any time soon, renewed Libyan production and export is a sobering factor to ponder.

OPEC and Saudi Arabia increased production aggressively from March through August of 2015. Since then, however, production has declined to near average levels for 2012-2016.

The United States and Non-OPEC Are The Problem

OPEC did not cause the oil over-supply in early 2014. Over-production by the United States and other non-OPEC countries caused the problem. This is still the case.

The U.S. is responsible for more than 70 percent of the increase in non-OPEC liquids production since January 2014 (Figure 7). Brazil and Canada along with China and Russia account for the rest.

Figure 7. Non-OPEC liquids production compared to January 2014 production levels. Source: EIA and Labyrinth Consulting Services, Inc.

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Until the structure of non-OPEC production decreases, there is little that OPEC can do to remedy low prices. Cuts by OPEC might temporarily increase prices but this would lead to more over-production outside of OPEC that would further collapse world oil prices later on.

Why U.S. Production Has Not Declined More

U.S. crude oil production has only declined by approximately 570,000 bpd from its peak of 9.69 mmbpd in April 2014 to 9.13 mmbpd in January 2016-about 60,000 bpd each month (Figure 8).

Figure 8. U.S. crude oil production and forecast. Source: EIA and Labyrinth Consulting Services, Inc.

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EIA forecasts that production will fall another 820,000 bpd (about 100 kbpd each month) to 8.31 mmbpd by September 2016 before increasing again. The forecast provides hope that the oil market may balance later in 2016 or in 2017 but history to date suggests that it is probably optimistic.

Tight oil production in the U.S. has not declined nearly as much as many anticipated based on falling rig counts. Most explanations invoke increases in drilling and completion efficiency but I believe the truth lies in the continued availability of external capital to fund drilling of an ever-increasing number of producing wells until quite recently. Related: Rising OPEC Oil Production Worsens Glut

In the Bakken, Eagle Ford and Permian basin plays, the number of producing wells has declined or flattened in the last reporting months of October or November 2015. The plays are different and so are the patterns for production decline. Nevertheless, the decrease in new producing wells suggests that either capital is less available or that companies are choosing to drill and complete fewer wells.

Reporting in the Bakken is better than in the other plays. Bakken production only declined 51,000 bpd between the December 2014 and November 2015, the last reported data from the North Dakota Department of Mineral Resources (Figure 9).

Figure 9. Bakken production and number of producing wells. Source: North Dakota Dept. of Mineral Resources and Labyrinth Consulting Services, Inc.

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Over the same period, the horizontal rig count fell by 111, from 173 to 62 rigs. Yet, the number of producing wells increased by 943, from 12,134 to 13,077 (the number of wells waiting on completion (WOC) increased by 219 from 750 to 969).

As long as more wells were added each month, production continued to increase. The number of producing wells only began to decline in October 2015. Each completed well cost approximately $8 million so capital spending did not decrease until then despite fairy tales about ever-increasing efficiency.

The resilience of tight oil production in the Bakken, therefore, reflected the continued availability of external capital to fund more drilling and completion. The impact of reduced capital is apparently a recent phenomenon in the Bakken.

The Eagle Ford and Permian basin plays show similar patterns of flattening rates of well completions in recent months. Eagle Ford production has declined 183,000 bpd since March 2015 while Permian basin production may just be peaking.

It is too early to draw concrete conclusions from the tight oil play data presented here but, in a way, that is the point. Production has only begun to decline because external capital was available until late 2015 despite low oil prices. If companies are forced to rely increasingly on cash flow for new drilling then, U.S. production should decline sharply. If, on the other hand, the recent $2 billion in equity raised by Permian basin operators becomes more the norm in 2016 then, production declines will be more modest.

The U.S. Crude Oil Storage Problem

There is little chance that oil prices will increase beyond the head-fakes and sentiment-driven price cycles of the past year until U.S. crude oil storage begins to decrease. Oil stocks are currently 154 million barrels more than the 5-year average and 131 million barrels more than the 5-year maximum (Figure 10).

Figure 10. U.S. crude oil stocks. Source: EIA and Labyrinth Consulting Services, Inc.

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The Cushing, Oklahoma pricing hub and nearby Gulf Coast storage facilities make up almost 70 percent of U.S. working storage capacity. These crucial storage areas are currently at 85 percent of capacity (Figure 11).

Figure 11. Cushing and Gulf Coast crude oil storage. Source: EIA and Labyrinth Consulting Services, Inc.

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Although the correlation between Gulf Coast and Cushing storage utilization, and WTI oil price is not perfect, it is as good as any single price indicator (Figure 12).

Figure 12. Cushing and Gulf Coast Storage Capacity and WTI oil price. Source: EIA and Labyrinth Consulting Services, Inc.

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Despite considerable hype about 3 billion barrels of oil in storage around the world, Matt Mushalik has shown that OECD storage is only about 300 million barrels above the 5-year average based on IEA data. More than half of those 300 million barrels are in U.S. storage so, again, the U.S. drives the world oil market. Related: IEA: No Oil Price Rally In The Short Term

As long as storage volumes remain above 80 percent of capacity, oil prices will be depressed. Until U.S. oil production declines substantially, storage will remain near capacity. No OPEC production cut will be able to offset this powerful market factor for long.

Saudi Arabia Is Not Going Broke

Euan Mearns has presented a compelling case that OPEC made a gigantic blunder by letting oil prices fall below $40 per barrel for the sake of market share. I believe, however, that there is more at stake than market share.

The capital providers who enable high-cost oil projects are the market-share target of Saudi Arabia's gambit. Oil sands are the primary focus because these have gigantic reserves. Deep-water and tight oil are secondary objectives because their reserves are smaller and shorter lived.

OPEC's larger objective is to postpone the end of the Oil Age as far into the future as possible. This is accomplished by an extended period of low oil prices that puts renewable energy at a price disadvantage to oil and gas, and slows the climate change-based flight from fossil energy. It is further achieved by stimulating the global economy through low energy prices that may in turn increase oil demand.

The commercial present and future for the Saudis and their Gulf State comrades depend on oil. They take the long view that near-term losses are justified by longer-term gains.

I am not defending their stratagem but merely trying to understand it.

The press has been focused on the imminent financial demise of Saudi Arabia as a result of their production and price strategy. Although the strain on the Kingdom is considerable, I do not believe that these criticisms are completely realistic.

Saudi Arabia's year-end 2015 foreign reserve accounts totaled $636 billion, an amount almost equal to its cash reserves in 2012 when Brent prices averaged $112 per barrel (Figure 13).

Figure 13. Saudi Arabia international reserve assets. Source: Saudi Arabia Monetary Agency and Labyrinth Consulting Services, Inc.

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Its estimated cash reserves through 2017 of $443 billion are still above or nearly equal to levels from 2007 through 2010 and exceed the current accounts of all countries except Switzerland shown in Figure 14 (China ($3513 billion) and Japan ($1233 billion), not shown in the figure, are higher than Saudi Arabia).

Figure 14. International reserves and foreign currency liquidity. Source: International Monetary Fund and Labyrinth Consulting Services, Inc.

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The Way Forward

Oil prices will not increase or stop falling until the current 2 mmbpd over-supply is consistently reduced for a period of many months. I do not expect a formal OPEC production cut until that happens. That means that U.S. production and storage inventories must fall. That may happen in 2016 if EIA's forecast shown in Figure 8 is close to correct.

There are some considerable wild cards that might keep the world mired in over-supply and low oil prices beyond 2016. Renewed supply from Iran and Libya are the most obvious candidates. Continued supply of external capital to U.S. tight oil production is a second important wild card. The weak global economy and associated oil demand below the forecasted range of 1.2 mmbpd of annual growth represent other important uncertainties.

Without a meaningful forward reduction of U.S. oil production of around 1 mmbpd, an OPEC cut would only have a limited, short-term effect on prices. The focus going forward must be on the source of the problem. That is the United States and not OPEC.

By Art Berman for Oilprice.com

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