Justin McCrann, Aegis Energy Risk, Houston
As we discussed in our publication Fundamentals Poised to Flip the Trend, the Crude Oil market has woken up to the implications of sub-$60 prices suffered by producers for the last 18 months. As expected, low capital expenditures in the US (and globally) have begun to carry over to production. Demand, in the meantime, has remained on pace for healthy growth, driven mostly by China and India. Those components of the supply/demand equation, along with a few other variables, have changed the sentiment from terminally bearish to optimistic. The shift in perception led to a 90% rally in front month WTI and Brent. So the question now is, what lies ahead?
US production began to decline in earnest starting mid-January, shedding an average of 26 thousand Bbl/day each week. Substantially lower drilling budgets, and the resulting multi-decade low rig count (both leading indicators to production), finally translated into lower output. The declines were enough to eclipse exponential drilling efficiencies and a backlog of non-producing wells. So far, US production has declined by over 843 thousand bbl/day since the 2015 highs.
On the demand side, despite much lower refining spreads here in the US, inputs are still hovering near five year highs. At the same time, US gasoline demand, despite a 60c increase in prices at the pump, seems unfazed. Airline travel has increased, as we have all been seeing in the news lately. Internationally, the market shrugged off concern over Asian GDP growth estimates. China appears to be in line with 6-7% growth, which will produce 350-400 thousand bbl/day of additional liquids demand. India has been surprising to the upside, overtaking China as the largest segment of demand growth for petroleum.
Lastly, the market caught a card on the river, with supply disruptions in Canada as a result of the fires in Alberta, as well curtailments in Nigeria due to both terrorism and a drilling accident. Once you throw the Venezuelan and Libyan situations into the mix, we suddenly have 3.7 million bbl/day of global production offline, some of which will creep back into the market over the next few months. We are also expecting to see Iranian production levels increase slightly as light infrastructure investments increase capacity.
So now what? Price, the most important variable of all, has risen significantly. What will the implications be? How will supply react? And demand? Generally, the aircraft carrier that is US production will not turn on a dime. As we discussed in February, the producer framework for increasing supply has been damaged. With 60 E&P bankruptcies in the US and access to capital markets remaining tight, it will take several months of $50+ prices to increase rig counts substantially. That being said, we expect to hear rumblings from well-capitalized public companies, as well as newly formed/recapitalized companies, that budgets will increase, even if just slightly. IRRs, particularly in the Permian and SCOOP/STACK plays are healthy enough to justify accelerating completions and the adding of a few rigs here and there. The Eagle Ford and Bakken will follow should we see higher prices. Moreover, expect the chances of an OPEC freeze to be less likely after the recent price rally. OPEC, Russia and other exporting countries are more likely to cite a "natural balancing" in the market and no need for production cuts. Thanks for nothing, again.
Bottom Line: Although the longer term fundamentals still look favorable, at $50/bbl the upside/downside price risk has become more equally weighted. Is the rally over? Perhaps not…but expect to see some congestion in oil prices should global supply disruptions ease and as the market digests the implications of higher prices.
ABOUT THE AUTHOR
Justin W. McCrann, is President of Aegis Energy Risk, which provides hedge advisory services to a broad range of upstream clients, including both public and privately held firms. He has served in the industry the past 18 years with experience in all aspects of energy trading and price risk management. Prior to co-founding Aegis, he spent over a decade as an energy trader at BNP Paribas, GDF Suez and Merrill Lynch/Allegheny Energy Global Markets. McCrann is a graduate from the College of Business at James Madison University.