Was This Another False Oil Price Rally?

Friday, February 19, 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. OPEC and Russia production freeze means little

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- The big news this week was the historic OPEC/non-OPEC deal, which called for a production "freeze." But unless the agreement is a stepping stone to something more significant, the practical implications could be limited.
- The deal merely freezes production at historically high levels. Saudi Arabia has added more than 0.5 million barrels per day (mb/d) since 2014. Russia has added a few hundred thousand barrels per day, hitting post-Soviet highs in recent months. Iraq added over 1 mb/d.
- With further gains from these highs unlikely, the deal to "freeze" output hardly involves a sacrifice from OPEC or Russia. The one country that does matter is Iran, which plans on ramping up production after freeing itself of sanctions. Iran, crucially, avoided committing to the freeze this week.
- Oil still rallied strongly following the announcement of the deal on Tuesday and also following Iran's semi-supportive comments on Wednesday.
- The rally could be short-lived once everyone realizes it may not impact oil prices much.
- The one thing oil bulls may feel good about is the fact that the freeze may be confidence-building measure that opens up the door to a real production cut, perhaps at the June OPEC meeting. For now though, it has little practical effect.

2. Saudi Arabia sees credit downgraded

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- Saudi Arabia has a massive war chest of cash reserves, but has been burning through cash at a rapid clip. For much of 2015, the markets were hardly worried - sure, Riyadh was drawing down on reserves and suffering from widening budget deficits, but it was hardly an acute problem given the gargantuan resources at the government's disposal.
- But the pressure has grown worse. On February 17, S&P cut Saudi Arabia's credit rating by two notches from A+ to A-, citing a "a marked and lasting impact" on the economy.
- As the chart above shows, the markets suddenly became worried about Saudi Arabia last summer when oil prices first dipped below $40 per barrel. The cost of insuring Saudi credit default swaps (CDS) rose sharply after years of stability. The rising CDS can be interpreted as a fear - small but rising - that Saudi Arabia could default. S&P's credit rating cut is further evidence of the deteriorating confidence in Saudi's creditworthiness.
- To be sure, Saudi Arabia is in an enviable position relative to other oil-exporters. It still has over $600 billion in central bank reserves, but used up $115 billion last year.

3. Refined product stocks at high levels

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- Crude oil is at record highs, both in the U.S. and around the world. But refined products, such as gasoline, have also surged to incredible heights so far in 2016.
- Gasoline stocks jumped over 255 million barrels in February. What is worrying for the oil markets is the sharp rise since December. Gasoline stocks jumped by more than 38 million barrels in the past two months, roughly coinciding with the crash in oil prices below $30 per barrel.
- The worrying thing for oil markets is that elevated stocks for refined products could mean that refineries cut back on refinery runs more than they already had planned.
- With crude oil stocks already at record levels - over 500 million barrels in the U.S. - lower refinery utilization could put further pressure upstream to cut back. The storage hub at Cushing, Oklahoma is already nearly 90 percent full. Lower demand downstream could cause a bigger build in crude oil stocks, putting downward pressure on prices.

4. Oil demand at seasonal low

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- As mentioned above, refinery runs are falling. Much of that is seasonal, however.
- Refinery runs, along with demand, tend to weaken as winter gives way to spring. Between February and May, global oil demand tends to fall by more than 1 million barrels per day, before climbing again.
- That is a worrying figure, given the current state of oversupply. Demand is already expected to be much weaker in 2016 compared to last year. Lower gasoline demand means lower refinery runs, which leads to lower crude oil demand and higher stockpiles. Oil could face seasonal price pressure for the next three months.
- As a result, despite this week's price gains - stemming from the OPEC announcement - crude oil may not stage a rally until summer. From there, things look better though. Demand will rise, supply will have fallen back a bit, and the tighter market should push prices up.

5. March bond payments

- An estimated $1.2 billion in interest payments will come due in March from 61 shale companies surveyed by Bloomberg Intelligence.
- That could be a tough hurdle to clear for some indebted companies. Energy XXI Ltd. (NASDAQ: EXXI) said this week that it had missed an $8.8 million payment. Sandridge Energy (OTCMKTS: SDOC), an Oklahoma-based driller, failed to meet a $21.7 million interest payment.
- So far, 48 shale drillers have declared bankruptcy on $17 billion in debt since the downturn in oil prices began in mid-2014.
- Bloomberg says that the industry has $9.8 billion in maturing debt this year. With a chunk of that falling in March, there could be more defaults announced in the coming weeks.

6. Electric vehicles to become more competitive

- Electric vehicles are still just a rounding error in the global car market, capturing just 3 percent of the total. But Goldman Sachs sees EVs and hybrids rising to 22 percent of the market within a decade. EV and hybrid sales will jump from 1 million to 25 million in 2025. That is a 26 percent compound annual growth rate.
- Those predictions hinge on major improvements in EV technology. Batteries are expected to dramatically improve, allowing for a 52 percent reduction in weight by 2020. Battery costs are expected to fall by 63 percent between 2015 and 2020.
- At the same time, battery capacity will jump by 50 percent. That will allow the range for an EV to improve by 72 percent, from 160 km to 275 km.
- There are a lot of uncertainties, not the least of which is regulatory policy that helps or hinders EV adoption. But, Goldman Sachs sees a bright future for EVs, which could lead to structural changes in long-term oil demand.

7. Non-OPEC supply contracting

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- The markets watched closely as OPEC and Russia announced a production freeze. Iran's supportive but opaque response also helped to push prices up significantly.
- But there likely won't be a huge supply cut from OPEC in 2016. The real adjustment will come from non-OPEC countries, with outsized importance on the United States.
- Non-OPEC countries increased production by 1.32 million barrels per day on average in 2015, compared to 2014. The U.S. accounted for nearly 1 mb/d of that increase. But Brazil, Russia, the UK, Canada, China, Norway, Malaysia, and Oman also added output.
- But spending cuts means that non-OPEC supply dips into negative territory this year, led by losses from U.S. shale. Non-OPEC supply should fall by at least 700,000 barrels per day in 2016, which should take a large bite out of the 1 to 2 mb/d of oversupply. After U.S. shale, other significant losses will come from Mexico, the UK, and the former Soviet Union.

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