Fundamentals Starting to Underpin Oil Price Rally

Friday, May 20, 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. Speculators start to liquidate long bets

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- All of the oil price metrics can't seem to get on the same page at the same time. A massive increase in net-long speculative bets since the beginning of the year occurred as the supply/demand fundamentals only changed incrementally.
- But just as some of the fundamentals started to substantially improve - in part due to major unexpected outages - oil speculators have started to retreat.
- The record net-long position started to be unwound in early May. Net-long positions for Brent and WTI fell by 43 million barrels for the week ending on May 3, or a roughly 13 percent decline.
- On the other hand, the data on speculative positions is released with a bit of a lag, so the bull run could regain momentum. Huge supply outages in Canada and Nigeria are hard to ignore.
- As Reuters notes, stagnant or falling supply is bumping up against strong demand for crude. As a result, the market contango is shrinking, refining margins are widening, and front-month futures are rising.
- The markets are essentially driving on a road by looking through the rear-view mirror - it is unclear if the four-month increase in net-long positions is going to fall back significantly, or if the recent decline is only a momentary correction.

2. Drilling productivity continues to improve

- The Eagle Ford, one of the most prolific shale regions in the U.S., has been hit hard by the downturn in oil prices.
- The rig count in the South Texas shale basin has plunged from nearly 230 in mid-2014 down to just 33 as of last week.
- But efficiency gains helped to slow the decline in output. Oil production from an average well at the start of operations continues to climb. In June, the EIA projects that an average new well will produce 994 barrels of oil per day in its first month of output, which is up from 971 barrels per day in May.
- Nevertheless, absolute production is falling because of the dearth of drilling. The Eagle Ford is expected to lose 58,000 barrels per day in output in June, taking total production down to just 1.21 million barrels per day, about 0.5 mb/d down from its peak in early 2015.

3. Rampant delays and cost overruns

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- The oil industry likes to pride itself on meeting project timelines and budgets. But Bloomberg reports that it is rare that companies complete projects on time and within the original budgetary guidelines.
- Only 8 percent of oil projects sanctioned between 2007 and 2010 came in on time and on budget and also met the production target. That means that 92 percent missed one of those objectives.
- More than 40 percent of the projects were both late and suffered from cost inflation.
- This poor track record is no longer acceptable in a world of $50 oil. Megaprojects are likely a thing of the past as even the largest oil companies focus on short-cycle projects.

4. Gas, renewables destined to overtake coal

- Coal has dominated the U.S. electricity sector for a century, but that is rapidly coming to an end.
- Gas rose to parity with coal generation in 2015, but the EIA sees that as temporary in the short-run. Rising gas prices will allow coal to hold on a little longer. But the long-term fate of coal is clear.
- The EPA's Clean Power Plan, which places limits on greenhouse gas emissions from power plants, will ensure that gas and renewables permanently overtake coal in the electricity sector sometime in the 2020s.
- Without the Clean Power Plan, gas still overtakes coal in the latter part of the next decade. Renewables will eventually do the same, but it will take longer - clean energy doesn't surpass coal until 2040.
- One large caveat to keep in mind - the EIA is notoriously conservative with these projections, which only incorporate current law. They have tended to under-predict the growth of renewables and over-predict the market share for coal. There is a large possibility that the shift in the market happens faster than the EIA projects in its current outlook.

5. The price differential between crude oil and natural gas set to grow

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- The chart above tracks the ratio of prices between Brent crude and Henry Hub spot prices on an energy equivalent basis.
- The ratio widened in the long super-cycle for commodities between 2005 and 2014, a bull run that saw crude oil prices hit peaks in 2008 and 2012, with Brent trading in triple digits. That corresponded with a time of cheap natural gas as the shale gas revolution was at its height.
- In 2012, Brent cost 7.1 times more than Henry Hub. The ratio shrank dramatically to just 2.5 in 2016 as oil prices crashed.
- But the EIA expects oil prices to rebound in the years ahead, while natural gas should stay (relatively) cheap indefinitely. The price ratio will widen again.
- This creates various business opportunities - the use of natural gas in vehicles could offer lower fuel prices, for example.

6. Nigeria has lost 800,000 barrels per day

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- The Niger Delta Avengers have attacked pipelines and platforms in Nigeria, knocking 800,000 barrels per day offline.
- Between 2006 and 2009 Nigeria suffered a similar level of attacks and outages, and a sweeping amnesty policy helped bring an end to the violence. The new President Muhammadu Buhari has taken a tougher line, ending patronage that existed in security contracts for many militia members, a move that has contributed to the resurgence in pipeline attacks.
- Nigeria's cash reserves are running low as its economy slows. Reserves have plunged from $49 billion in 2013 to $27 billion recently.
- Eni (NYSE: E) suffered the latest attack this week. Fellow oil majors Royal Dutch Shell (NYSE: RDS.A) and Chevron (NYSE: CVX) have also seen their infrastructure taken out from explosions.
- Nigeria's oil production is at its lowest level since the 1980s. The attacks show no sign of letting up, and as of now the Nigerian government is unwilling to back down.

7. Offshore exploration spending has plunged

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- Large expensive offshore oil projects are a luxury today that few oil companies are willing to shell out for.
- Offshore spending has crashed from $339.6 billion at a peak in 2014 to just $233.6 billion in 2016, or a roughly 33 percent decline in two years. The industry will trim another $21.1 billion next year, falling to $212.5 billion, according to Rystad Energy.
- In this context, oilfield service companies are in a state of crisis, Bloomberg says. With severe cuts to offshore exploration, companies like Schlumberger (NYSE: SLB), Baker Hughes (NYSE: BHI) and Halliburton (NYSE: HAL) are in trouble. Consolidation is needed, which is why Halliburton and Baker Hughes wanted to tie the knot.
- It is helps explain why FMC Technologies and Technip just announced a $13 billion merger.

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