The Global Oil Surplus Is Gone

Friday May 18, 2018

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. Inventory surplus officially gone

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- The IEA concluded that OECD oil stocks fell by 26.8 million barrels in March, declining to 2,819 million barrels.
- Importantly, stocks now stand 1 million barrels below the five-year average, officially hitting the highly-anticipated threshold that OPEC has held up as the motivation for keeping 1.8 million barrels of oil per day off of the market. Since the deal was inaugurated, stocks have declined by 233 million barrels.
- Stocks are now at a three-year low and could continue to decline, raising the odds of higher prices ahead.
- In a warning, however, the IEA revised down demand growth for 2018 from 1.5 mb/d to 1.4 mb/d, as high oil prices are taking a "toll."

2. Venezuela drains oil market

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- Venezuela's oil production declined by more than 40,000 bpd last month, falling to just over 1.4 mb/d.
- The South American nation is now producing 550,000 bpd less than its production limit, which means it has taken more than the equivalent of Saudi Arabia's pledged cut off of the market.
- Venezuela, combined with the smaller but still significant losses in Mexico, account for nearly 40 percent of the 2.5 mb/d of supply that was cut as part of the OPEC agreement.
- That has magnified the effect of the OPEC/non-OPEC cuts, helping to balance the oil market much faster than everyone predicted.
- Venezuela's losses are expected to continue and could even accelerate with creditors, particularly ConocoPhillips (NYSE: COP), beginning to seize oil assets from the country.

3. Permian drillers suffer steep discounts

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- The discount for crude oil in Midland relative to Houston continues to widen because of pipeline constraints.
- Texas shale drillers have added so much new supply to the market that pipeline companies can't keep up. Pipelines are essentially full and there won't be relief until late 2019.
- The discount for WTI Midland to WTI Houston has exploded to as much as $16 per barrel. Pioneer Natural Resources (NYSE: PXD) has even stated that the new projects in the works won't be enough to relieve congestion when they come online and that a new round of pipelines will be needed to handle the expected growth in output.
- The pipeline bottleneck might make it easier for shale companies to exercise some capital discipline, a new priority for shareholders.
- Goldman Sachs estimates that if a sampling of 39 shale E&Ps spent only 80-90 percent of their cash flow, compared to spending 110 percent, it would translate into about 0.7-0.8 mb/d of lower annual U.S. oil production.

4. Refining mix getting lighter

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- If the U.S. PADD 3 - a region that encompasses the Gulf Coast, including Texas and Louisiana - was an independent country, "it would be the world's third largest crude producer after Russia and Saudi Arabia," the IEA noted in a report. PADD 3 produces 6 mb/d of oil and has 9 mb/d of refining capacity.
- But the mix of oils is changing as light sweet oil from shale has surged in recent years. The average API gravity has increased from 29.72 in 2010 to 32 degrees in 2017 (the higher the number, the lighter the mix).
- While, at first glance, a surge of domestic light sweet oil would displace light sweet imports, the IEA says that "in fact, due to the sheer scale of imports into PADD 3, it is the medium-heavy grades that have been hardest hit." Indeed, light imports have fallen to nearly zero, but imports of crude under 35 degrees have declined by a massive 1.4 mb/d, falling to just 2.8 mb/d.
- The U.S. Gulf Coast has increased its diet of lighter oils, cutting imports of medium and heavy blends. There are questions, however, about how far this "lightening" of the mix can go.

5. Shale companies still not cash flow positive

- With WTI rising to its highest price level in more than three years, the U.S. shale industry is doing better than at any moment in recent memory.
- However, surprisingly, much of the shale industry is still not cash flow positive, despite individual wells breaking even at lower costs.
- The Wall Street Journal surveyed the top 20 U.S. shale companies, and all but five were cash flow negative in the first quarter of 2018.
- The unexpectedly poor performance can be attributed to a number of factors, including hedges that locked them into lower sale prices, as well as bottlenecks for labor, fracking crews and other materials.
- The 20 companies collectively spent $1.13 for every $1 they took in, the WSJ says.
- Oasis Petroleum (NYSE: OAS) spent $3.27 for every $1 of revenue.

6. Oil cycle back in "boom" phase

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- Brent oil breached $80 per barrel for the first time since late 2014 this week, and the market now appears solidly back in the "boom" phase of the cycle.
- According to John Kemp of Reuters, oil prices averaged $75 per barrel in real terms between 1998 and 2016, the last full cycle for the oil market.
- That puts Brent in the top half of the cycle, which suggests the tone and psychology of the market is shifting from one of surplus and a need to reduce inventories to one where high prices send a "strong signal about the need for more production and slower growth in oil consumption," Kemp writes.
- The short-term nature of the market, defined by inelasticity of supply and demand, likely suggests that the market will overtighten in the short run, pushing prices higher, before a supply response (higher output from new projects) or a demand response (lower consumption) is fully realized.

7. Hedge funds cut bullish bets

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- Hedge funds and other money managers have reduced their bullish bets on Brent futures since mid-April.
- The net-length in the futures market had reached record levels, so a liquidation of some kind was not unexpected.
- However, Goldman Sachs warns investors getting out of bullish bets that they are following a "dangerous" strategy.
- Goldman says oil is the "best performing asset class," which is now posting the best year-to-date returns in a decade, and the "rally likely has room to run, particularly from a returns perspective."
- Goldman raised its forecast for 12-month returns on commodities from 5 percent to 8 percent.

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