OPEC Sets the Stage for A Price Crash

Friday, September 23 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 await OPEC meeting

(Click to enlarge)

- Short bets on crude oil surged in late July, corresponding with a crash in crude to the low-$40s per barrel. Then the OPEC rumors in August forced shorts to head for the exits, and long bets soared.
- As we approach the much-anticipated meeting in Algeria, oil speculators are taking a breather. Both long and shorts were cut by mid-September.
- "There's more uncertainty than usual in the market because of the upcoming meeting. People are waiting for the outcome and a number think this is a good time to stand on the sidelines," John Kilduff, partner at Again Capital LLC, told Bloomberg.
- The outcome of the Algeria meeting will have an immediate, although likely temporary, impact on oil prices. But after the markets digest the news for a few days, speculators will shift their sights back to the fundamentals, which admittedly do not look good for the rest of this year.

2. OPEC producing near record levels

(Click to enlarge)

- Officials from OPEC and member states have gone to great lengths in recent weeks to downplay the significance of the Algeria meeting this weekend, insisting it is only for discussions and not for any decision-making.
- Even if they did agree to a production freeze, it would mean little because the top countries involved are producing at or near record levels. Iran, the one country not near its all-time high, plans on ramping up output further if it can.
- Russia (not a member of OPEC) has also reached a post-Soviet high for oil production recently at over 11 million barrels per day.
- Two OPEC members - Nigeria and Libya - are also on the verge of adding huge volumes of disrupted oil back to the market.
- All of this suggests that even if OPEC can set aside its differences and cap its production, the oil market would feel little to no effect from such a move.

3. Cost of renting an offshore rig plunges

(Click to enlarge)

- Offshore drilling at new projects has come to a standstill, leaving rig owners with an arsenal of idle rigs. With so many rigs not at work, the daily rates for rigs have plunged more than 60 percent over the past few years.
- Bloomberg reports that a growing number of rigs are getting cold-stacked - that is, parking rigs and shutting them down. That is much riskier to the hardware than warm-stacking, or setting them aside but employing a crew to keep the engines running.
- The effects of cold-stacking are unknown, but could damage the equipment. The upside is that cold-stacking is much cheaper ($15,000 per day) than warm-stacking ($40,000 per day).
- Transocean (NYSE: RIG) surprised analysts recently with better-than-expected financials because it is increasingly cold-stacking rigs.
- But some fear that the rigs could suffer permanent damage from being cold-stacked for so long. "These drillships were not designed to sit idle," Willard Duffey Jr., a veteran electrician with Transocean, told Bloomberg.

4. Russia set to ramp up oil production

(Click to enlarge)

- Russia is embarking on an ambitious drilling campaign to increase oil production. Output is already at its highest level in decades, but the Kremlin's need for more tax revenue necessitates higher volumes.
- The FT reports that Russia is focusing on producing more from its existing brownfield projects in Siberia. These fields have represented the bulk of Russian output for decades, but have generally been assumed to be in decline.
- Rosneft will more than double its drilling rate, from 750 wells in 2014 to more than 1,700 beginning next year.
- Goldman Sachs predicts that Russia will add 590,000 barrels per day over the next three years, which would break Russia's (actually the Soviet Union's) all-time high of 11.4 million barrels per day hit in 1987.
- Russia was thought to be maxed out, so the possibility of higher output would alter medium-term estimates regarding global supplies and oil prices.

5. Drilled but uncompleted wells

(Click to enlarge)

- The EIA imitated coverage on drilled but uncompleted wells (DUCs) as part of its monthly Drilling Productivity Report.
- As of the end of August, there were 4,117 DUCs across the four major oil shale basins (Eagle Ford, Permian, Niobrara, Bakken) and the three natural gas basins (Haynesville, Marcellus, Utica).
- In the oil regions, the DUC count has declined by about 400 over the past five months, an indication that oil companies started completing their wells as oil prices rebounded from the lows earlier this year.
- Due to lead times and planning, DUCs are a normal phenomenon even in times when there isn't a supply surplus. Before drilling collapsed, the ratio of DUCs to completions was about 2:1. After the crash in oil prices, the DUC-to-completions ratio spiked to about 12:1 last year.
- With drillers starting to work through the backlog, the ratio has come back down below 10:1 and falling.

6. Eagle Ford to dip below 1 mb/d

(Click to enlarge)

- Once the hottest shale basin in the country, the Eagle Ford in South Texas has fallen out of favor during the oil price collapse.
- The EIA predicts that production in the once prolific shale basin will drop below 1 million barrels per day in October, dipping by 61,000 bpd from September levels to just 0.981 mb/d.
- The Bakken also fell below the 1 mb/d mark in recent months, leaving the Permian as the last million-barrel-per-day shale basin left.
- Owing to its multiple stacked shale plays and lower breakeven costs, the Permian is attracting more rigs and capital at the expense of other shale basins.

7. Commodity-linked funds not doing well

(Click to enlarge)

- Commodity prices have rebounded sharply from the rock bottom hit earlier this year, but investors with positions in index funds linked to commodities are not benefiting.
- These indices depend on futures contracts, which tend to expire at the end of each month and must be replaced, often at a higher cost. This is a particular problem when the market for a commodity is in a state of contango - when immediate prices are cheaper than prices in the future.
- These roll-over costs, plus fees, eat away at the returns of investing in commodity-linked funds.
- For example, while oil prices gained 22 percent this year, the crude-linked index provided a return of negative 6.4 percent. In August, the "gross roll yield" for the Bloomberg Commodity Crude-Oil Index was a negative 35 percent, the largest discount to crude oil itself in seven years.
- Needless to say, investing in commodity funds carries risks, over and above the price volatility of the underlying commodity.

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