OPEC Faces Daunting Task To Drain U.S. Inventories

Friday June 2, 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. Saudi strategy to cut exports to U.S.

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- Saudi Arabia's new strategy to balance the oil market is to cut oil exports to the U.S. specifically, an effort to accelerate the inventory drawdown.
- The strategy shift comes after six months of disappointing results - surging U.S. inventories earlier this year offset the effect of OPEC's production cuts.
- Bloomberg reports that Saudi Arabia intends to cut exports to the U.S. by about 15 percent, reducing volumes below 1 million barrels per day. That would be the lowest level of exports in years.
- Because the U.S. has the most transparent and publicly-available oil storage data in the world, the strategy is intended to provide a jolt to market sentiment.
- If traders start to see weekly drops in U.S. inventories accelerate, it will likely push up oil prices.

2. Futures curve offers bullish hope

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- Goldman Sachs says that OPEC's strategy should be to induce a strong backwardation into the futures market, a situation in which front-month oil contracts trade at a premium to futures a year out.
- The idea is that lower longer-dated prices would scare away shale drillers.
- As of late May, Brent December 2017 contract is trading at a $0.35 per barrel premium to December 2018 futures. That came after the differential went negative in early May (a situation known as contango).
- Backwardation is generally bullish. The market briefly sold off after the OPEC announcement, but analysts view that as a short-term unwinding of speculative bets. The backwardation could actually strengthen going forward, which suggests higher prices are possible.
- "The fundamentals haven't changed and therefore the December spreads are still in backwardation," Jan Edelmann, commodity analyst at HSH Nordbank, told Bloomberg. "We've seen how fast the market moved, a similar path to higher prices is not unlikely."

3. Key to OPEC success is stock draw

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- The key for OPEC is to drive down crude oil storage levels to the five-year average.
- Inventories surged in January, which meant that OPEC was merely playing catch up over the course of its six-month compliance period.
- Looking forward, even OPEC expects it to be a difficult task to drain inventories. Its forecast is wildly different than the IEA, which is more bullish.
- OPEC only expects inventories to fall by 0.8 million barrels per day in the third quarter, a decline that narrows to just 0.1 mb/d in the fourth quarter. The IEA, on the other hand, sees stocks falling by a much larger 1.3 mb/d in the third and 1.7 mb/d in the fourth.
- The difference between the two forecasts is quite large. If the IEA is closer, oil prices should rise this year.

4. Drilling productivity continues to rise

- According to Goldman Sachs, the U.S. shale industry continues to squeeze more oil out of the average shale well.
- In the Delaware Basin in West Texas, for example, the average initial production for a given shale well has surged.
- Shale wells typically see a burst of output followed by a long period of decline. Those peaks have steadily increased over the years.
- Last year, the peak of the production curve surpassed 800 barrels of oil equivalent per day (boe/d), up from about 600 boe/d a year earlier and just 350 boe/d in 2011.
- More oil per well is a major factor in lowering the breakeven cost of a well.

5. Permian to flood gas market

- The Permian Basin is home to the oil drilling bonanza, with production rising to 2.5 million barrels per day.
- But all of those oil wells also produce natural gas as a byproduct. The Permian could be a massive source of new gas supply in the years ahead. Gas production in the Permian could triple between 2010 and 2020, reaching 12.5 billion cubic feet per day.
- The growth of gas production specifically from oil wells could be enough to nearly meet all of U.S. gas demand, a staggering fact that demonstrates just how important the Permian is to the nation's energy picture.
- Oil and gas companies will have so much gas on their hands that they "are concerned they can't get rid of it," Brandon Blossman, analyst at Tudor Pickering, told the WSJ. "They're not really concerned what they're going to get for it."
- The result could be flat or falling natural gas prices only a few months after many analysts predicted tighter market conditions.

6. Russia's oil production growth plans

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- Russian oil companies have been asked to cut output as part of the OPEC deal. But one cause for concern from OPEC's perspective is that they have substantial growth plans in the years ahead.
- By 2020, Russian oil companies have some 24 projects in the works, which could add 1.8 mb/d of new supply.
- The longer the OPEC deal drags on, the less likely Russia will be willing to stay on board.
- Moreover, while some might argue that output cuts are offset by higher revenues from an oil price increase, the payoff for Russian oil firms is smaller. Russian companies only capture $1.60 per barrel for every $10 increase in the oil price, according to Bloomberg Gadfly. The rest is eaten up by a strengthening currency and higher state taxes.
- As a result, Russian companies are less inclined to see the upside of the cuts.

7. Deepwater drilling gets more profitable

- Wood Mackenzie says that drilling costs for deepwater drilling are falling sharply, allowing the industry to become profitable even at today's prices.
- The average breakeven price for offshore wells could drop to as low as $50 per barrel in 2018, down from $62 per barrel in the first quarter of this year.
- Breakeven prices before the market downturn in 2014 were as high as $75 per barrel.
- Streamlined operations and upgrading to the best plays have allowed for more profitable ways to drill offshore.
- The upshot is that the Gulf of Mexico could end up seeing production rise, another bearish sign that the supply glut could take more time to abate.

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