Oil Supply Concerns Return

Friday, July 1, 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. Delaware basin in West Texas sees more attention

- The Permian Basin is the most prolific shale region in the U.S., accounting for more than 2 million barrels per day of oil production. Within the Permian, there are several basins where drilling takes place.
- For years the Midland Basin in West Texas received much of the attention of drillers. But in recent months, the Delaware Basin – a basin in West Texas that also stretches into New Mexico – has seen a sharp rise in drilling as oil is plentiful and acreage is much cheaper.
- Bloomberg reports that Devon Energy’s wells in the Delaware Basin are producing twice as much oil as wells drilled a few years ago. Delaware acreage sells for as much as a 60 percent discount to the Midland Basin.
- More than a few companies see the undeveloped Delaware basin as one of the most attractive in the country. Chris Kettenmann, chief energy strategist at Macro Risk Advisors, told Bloomberg that more than 100 private equity firms are “chasing acreage” in the Delaware.

2. Currencies drive oil prices

- The collapse in oil prices following the Brexit result was severe but fleeting. Oil traded down by more than 7 percent for a brief moment, but moved back up in the days following the shocking result.
- But one of the key mechanisms that drives sharp price swings like we saw on June 24 is the currency effect: with oil priced in dollars, the sharp selloff in the British pound and the subsequent strengthening of the dollar pushed down oil prices (see top chart).
- That makes the next moves from central banks crucial to understand when analyzing oil prices.
- Bloomberg reports that traders in money market derivatives don’t see a rate hike from the U.S. Fed anytime soon. The markets see a rate cut a much likelier outcome than an increase this year (see chart 2). In fact, the markets do not put a greater than 50 percent chance of a rate hike until January 2018.
- That is a sharp departure from the multiple rate hikes the markets expected for this year. With the weakening pound and euro, and the uncertainty in financial markets caused by the political turmoil in Europe, the Fed will likely hold off on rate hikes in the near future.

3. Stripper wells account for 1/10th of U.S. oil production

- Stripper wells are tiny wells that only produce around 10 to 15 barrels of oil per day. Often run by mom and pop operations, these micro oil wells with “nodding donkey” pumpjacks are often thought of as an early 20th century phenomenon.
- But the estimated 380,000 stripper wells in the U.S. collectively produce upwards of 1 million barrels per day, or roughly 10 percent of the nation’s oil supply. There are about 90,000 non-stripper wells in the U.S.
- While still important, the rise of shale production over the past decade has led to a declining overall share of the pie for stripper wells. As recently as 2008, stripper well production accounted for 19 percent of U.S. supply.
- Producing a dozen barrels per day only yields a few hundred dollars to an owner, who must cover the cost of maintenance and electricity. An industry trade group for stripper wells said earlier this year that $30 oil put many wells in the red. But the recent rebound in oil prices likely means that many survived and will continue to produce for years.

4. Oil volatility subdued

- The CBOE Crude Oil Volatility Index (OVX) measures the volatility of oil prices.
- Between 2012 and late 2014 oil prices were sky-high, often above $100 per barrel. But they were also relatively stable, as the low value of the OVX index indicates.
- Volatility began to spike as oil prices started to crash in 2014. The highpoint for the volatility index occurred in February when crude prices plunged to $27 per barrel.
- Volatility appeared poised to return last week following the Brexit vote. The OVX jumped by 10 percent over the two trading days following the Brexit result. But with the markets calming, OVX fell back again.
- Oil price volatility remains elevated compared to previous years, but it is sharply down from earlier this year.

5. China’s SPR filling could end

- China took advantage of cheap oil prices, aggressively stepping up imports to fill its strategic petroleum reserve on the cheap. That extra demand above and beyond its daily consumption provided a bit of a floor beneath oil prices.
- However, China is now close to filling up its SPR facilities, according to JP Morgan, after doubling oil purchases for its stockpile this year. The bank estimates that the facilities could be full by August, meaning a slump in demand from China could be coming in the third and fourth quarters of 2016.
- Once the facilities are full and China no longer needs that extra crude, imports could fall by about 15 percent. Lower demand for oil from China represents a downside risk to oil prices.
- “We do not believe the 16 percent growth in oil imports year-to-date is sustainable despite a domestic oil production decline, as demand is weak, if inventory capacity reaches the limit,” JP Morgan concluded.

6. Big Oil going small

- With the collapse of oil prices, the oil industry is becoming much more risk averse, preferring to focus on smaller oil fields at the expense of very large fields. The above chart shows spending on oil fields with greater than 1 billion barrels of proved plus probable (2P) reserves to oil fields with less than 300 million (2P) reserves.
- In years past, the large fields were in favor. Between 2000 and 2014, spending on the billion barrel plus fields rose 12.5 percent on average each year. But smaller fields saw investment rise at a quicker percentage rate, and since 2008, smaller fields saw more investment.
- In 2013, small oil fields between 30 and 300 million barrels alone saw more combined investment than the billion-barrel-plus fields.
- Part of this has to do with the difficulty of finding elephant oil fields at this point in our oil history. Another reason is the rise of shale drilling, where fields hold smaller pools of oil.
- Also, Bloomberg notes, the megaprojects of the recent past – which attracted tens of billions of dollars – have not gone according to plan, scaring away Big Finance. Finally, low oil prices are forcing a rethink of yesteryear’s high spending levels. From now on, Big Oil will be going small.

7. Widening contango a bearish signal

- The oil market contango – in which front-month futures contracts trade at a discount to contracts farther off into the future – widened in recent weeks.
- The contango indicates worries about near-term oversupply issues. One way of looking at it is that there is too much oil floating around, so sellers need to discount their oil for immediate delivery.
- The contango narrowed in recent months as oil prices rose – a trend that occurred because supply outages eased the glut, demand continued to rise, and the markets moved towards balance.
- But the contango widened again in June, suggesting the markets are still oversupplied. Inventories are expected to be slightly higher at the end of 2016 than previously expected.
- Nigeria and Canada are bringing back lost supplies, which could ultimately delay the market balance until later this year.

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