An OPEC Induced Supply Deficit Looms

Friday December 9, 2016

In the latest edition of the Numbers Report, we'll take a look at some of the most interesting figures put out this week in the energy sector. Each week we'll dig into some data and provide a bit of explanation on what drives the numbers.

Let's take a look.

1. Shorts liquidated on OPEC deal

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- The oil market has gone through five cycles of speculative movements, as John Kemp of Reuters describes it. Each cycle involves a large build up in short bets, which end when bullish news squeezes out the short positions.
- The first cycle that Kemp describes began in early 2015, after oil prices first descended to a low point and rebounded on hopes that the downturn would be short-lived.
- Each cycle has lasted for several months…until recently.
- A large increase in short bets began in October 2016 when it looked as if the OPEC deal would not come to fruition. OPEC had talked and talked for much of this year, keeping oil prices afloat, but speculators began to run out of confidence in the weeks leading up to the Vienna summit. Short positions grew from the equivalent of 85 million barrels on October 18 to 196 million barrels on November 15 - investors were betting that OPEC would fail.
- The surprise OPEC deal left short betters out in the cold. As they scrambled for the exits, oil prices shot up. Short positions plummeted to the equivalent of 147 million barrels on Nov. 29.
- It remains to be seen where investors think oil is heading next. The OPEC deal should induce some net-long investment flows, but there are doubts over how precisely the deal will be implemented.

2. Hedging is flattening futures curve

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- The more than 10 percent gain in oil prices since the OPEC deal was sealed sparked a rush of hedging among U.S. shale drillers. Companies are locking in oil sales for 2017 and 2018.
- That is flattening out the futures curve. The futures curve tends to rise the farther out in time it goes, but the curve has temporarily flattened out for contracts through 2019.
- Locking in oil sales means a certain volume of oil contracts will be sold right around $50 per barrel for the next few years. With that price certainty in hand, shale companies can begin drilling with confidence, which should result in higher production for the next few years.
- The market is moving towards balance, but hedging could cap the extent to which oil prices will rally.

3. Shale production fell, but now stabilized

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- U.S. shale production has declined from 4.69 million barrels per day at its high point in early 2015, down to roughly 4.09 mb/d today.
- But the year and a half of monthly declines appears to have stabilized. Production has been relatively flat since the end of the summer.
- The rig count has climbed by roughly 50 percent since May, as rising oil prices induce more drilling.
- As drillers improve techniques (and as oil production declines), the number of new shale wells needed to keep output constant has declined. In other words, by the fourth quarter of 2016, the U.S. needs about half of the shale wells that it did in 2014 to keep output constant.
- According to Rystad Energy, production stabilized because the U.S. needs roughly 450 to 480 new wells per month to maintain production, a figure that was reached in the third quarter.

4. Contango shrinking

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- The OPEC deal and speculation about a tighter oil market has led to a shrinking of the market contango. A contango is a situation in which front-month oil contracts trade at a discount to contracts for future delivery.
- Reuters depicts the 1-to-7 month time spread (above). The negative differential is a contango, a positive number is backwardation - in which front-month contracts trade at a premium to future delivery.
- The 1-to-7 spread hit its lowest point during the financial crisis in 2009, when there was a crisis of short-term oversupply because of the meltdown in the global economy.
- The second deepest contango occurred in February 2015, as the oil downturn was just getting underway.
- More recently, the contango has narrowed even further, to as low as $1.77 per barrel the day after the OPEC agreement was announced. Although it has widened again since December 1 (as doubts grow over the agreement), the overall trend towards a narrower contango demonstrates an oil market on the mend. Near-term concerns surrounding oversupply are waning.

5. Natural gas inventories converging towards average levels

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- Since the end of 2015, the U.S. has seen natural gas inventories hit record levels, both due to rising production and because of a drop off in demand last winter from mild temperatures.
- That raised fears of low natural gas prices for years to come. But production began declining earlier this year, allowing inventories to take a breather. Rising natural gas consumption in the electric power sector is also creating a structural increase in demand.
- A mild start to the winter is leading to tepid declines in inventories. Natural gas stocks fell by estimated 42 billion cubic feet (Bcf) in the week ending on December 2nd, bringing total natural gas storage levels down to 3,953 Bcf.
- But icy temperatures in the coming weeks will be pushing the blue line in the graph above back towards the running five-year average.
- Inventories are still 254 Bcf above the five-year average, but the prospects of gas overflowing are no longer present.
- It is no coincidence that natural gas prices are rising as the pace of growth in inventories slowed over the course of 2016. NYMEX prices for January delivery are up to $3.69/MMBtu, the highest level in two years.

6. OPEC/non-OPEC deal hinges on Russia

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- OPEC negotiators sit down with a handful of non-OPEC countries this weekend to discuss the 600,000 barrels per day of promised cuts from the non-members.
- Non-OPEC countries, led by Russia, offered the first coordinated production cut with OPEC in more than a decade. Russia alone promised 300,000 bpd in reductions.
- But there are reasons to doubt Russia's sincerity. First of all, Russian officials said the cuts would proceed gradually. Secondly, there are no details on who exactly will cut within Russia. There have been no statements from Igor Sechin, the head of Rosneft, about the state-owned firm's willingness to cut.
- However, in a sign of Russia's willingness to expand relations with the Middle East, Russia announced a deal to sell off 19.5 percent of Rosneft to Qatar and Glencore (LON: GLEN) a deal worth about $11.3 billion. The primary motivation is to bring in much needed cash, but it also expands the business relationship with a key OPEC member.
- We will know more about Russia's willingness to work with OPEC after this weekend. A solid agreement will be bullish for oil prices. "If this works, we have a more powerful game," said Johannes Benigni, founder of JBC Energy. "When OPEC meets and wants to do something, they ask Russia too. There's a new era."

7. OPEC deal could lead to supply deficit

- OPEC has agreed to limit its output to 32.5 million barrels per day (mb/d). That was supposed to lead to a cut of 1.2 mb/d from its output, but given that several countries ramped up output in November, OPEC may need to cut 1.7 mb/d or so.
- That raises doubts about the cartel's ability to actually hit the 32.5 mb/d target, especially considering that the rising output is coming from countries exempted from the deal (Libya, Nigeria).
- However, if OPEC succeeds, they will create a looming supply deficit. The "call on OPEC," or the oil production needed from the group to meet global demand, will reach 33.5 mb/d in the middle of 2017, or 1 mb/d above what the group says it will produce. The call on OPEC rises to 33.8 mb/d in the fourth quarter of 2017, setting up the oil market for higher prices.
- But the shortage could come as soon as the first half of next year - the IEA sees the call on OPEC in the first half of 2017 at 33.0 mb/d. If OPEC adheres to its target, inventories will drawdown quickly to patch over the supply deficit.

That's it for this week's Numbers Report. Thanks for reading, and we'll see you next week.