Oil Market Rebalancing: Mixed Signals and Signs of "Skid Marks"
May 15, 2015
Ten months into the 2014 oil price collapse and seven weeks into a modest rebound, companies of all sizes continue to adjust to new economic realities. The recent run-up in oil prices, in spite of bearish fundamentals, suggests a correction is still in the wings. And while U.S. unconventional production growth appears to be slowing, the upsurge in OPEC (and non-OPEC) output and continued uncertainty around the strength of demand means the surpluses are likely to continue to grow. In addition, the longer higher prices are sustained, the prospect of new drilling will only add to the overhang—and a difficult future for producers.
In the United States, much attention has been focused on the pace of unconventionals growth, the largest source of incremental global oil supply in recent years. As of May 15, the Baker-Hughes U.S. rig count has been in continuous decline for 23 weeks, dropping by more than 1,000 rigs (or more than 50 percent) since the first week of December. But even as the rig count declined, production kept growing. In mid-March, the Energy Information Administration (EIA) posted its first weekly estimate pointing to a net decline in crude production, but since that time, the four-week moving average of U.S. crude production has fallen by only about 28,000 barrels per day (b/d). Much of this resilience can be explained by follow-through on past investments and the “high-grading” of drilling efforts that focused on increased well productivity (i.e., using “superfracks” with longer laterals and increased horsepower) in the most productive areas of the most productive basins. Companies’ desires to maintain income streams and retain leases by drilling them (“held by production”) also have spurred ongoing development.
That said, evidence of “skid marks” (indicating a slowing or braking on U.S. output) is beginning to emerge, but the impact appears to be uneven and largely tied to the strength of company balance sheets and the robustness of their asset portfolios. Recent EIA data show a drilling slowdown in several key basins, which combined with upward revisions in demand, a draw in crude stocks, high refinery runs, low global spare capacity, and continued geopolitical uncertainty may be all that a hopeful market has needed to bid up front-month futures. At the same time, however, OPEC production exceeds 31 million b/d and U.S. tight oil production (through March) was still 1.2 million b/d above year-ago levels. Nonetheless, the seeming disconnect between ballooning stocks and a (recently) bullish market raises several questions. Are we underestimating the growth in demand or alternatively the falloff in output? Are we misinterpreting “demand” strength by failing to accurately characterize consumption versus inventory build and the real reasons behind each? Are we misreading the recent draw on crude stocks and high refinery utilization rates even as refined product inventories grow?
And what about the forward curve? Are we at an inflection point where the market incentive to put additional barrels in storage is about to be reversed, and where refiners can now exercise a variety of options, including opting to draw crude (and/or product) barrels from inventory rather than purchase new crude barrels for processing, thereby reducing crude demand just as higher prices signal producers to increase output? If crude prices fall on sustained inventory builds or, in the absence of robust demand, inventory draws, how far might they go? If the recent price surge turns out to be a product of hopeful momentum getting ahead of the market fundamentals, will additional production combine with overflowing stocks to suddenly thwart the recent upward momentum, and if so, how long might prices remain at depressed/lower levels?
A lengthy price trough has severe implications for future investment, and low prices don’t just put tight oil at risk. Fast-declining unconventional fields (50–60 percent in the first year) comprise a small fraction of a global market supplied primarily by conventional resources that are also declining an average of 4–5 percent per year. Even if shale drilling stopped tomorrow, the resulting shortfall (50 percent of 5 million b/d, or 2.5 million b/d) would still add up to a smaller supply deficit than the unmitigated loss of 5 percent of the world’s remaining 87 million b/d (4.4 million b/d). Companies all over the world are responding to cash flow concerns by slashing drilling budgets for conventional and (depending on maturity) deepwater projects, too. They are deferring high-cost, technically complex, and remote projects and also have all but eliminated their spending on “research” wells that historically have helped them better understand the reservoir dynamics of unconventional basins.
To date, shale production hasn’t taken a nosedive, and the supply impact of diminished investment could take years to materialize. In fact, near-term investments may be buoyed by the recent price upturn as producers announce renewed drilling programs at $60 per barrel prices. Geopolitical risks to global supply remain ever present—insurgency in Yemen, distress in Nigeria and Venezuela, and continued instability in Iraq, Syria, and Libya—but these on-again, off-again disruptions may be offset by more enduring supply additions from Iran and Iraq.
Whatever uplift recent supply rationalizations might provide, however, the second half of this year looks to be somewhere between difficult to bleak for producers. The combination of large global inventories and the fast cycle time of drilled but uncompleted U.S. tight oil wells, plus new additions from the offshore, looks likely to set the stage for a more persistent slump. As summer approaches, and last year’s hedges come off, capital availability to support June rollovers comes into question. Lighter refinery maintenance in the first quarter of 2015—in part, because refiners were capitalizing on higher margins—could presage longer turnarounds this fall, driving demand down just as the market might otherwise be tightening. Even with pared back drilling budgets, working off the current oversupply could extend into next year unless demand comes roaring back.
Despite pockets of more positive economic growth, more robust signs of demand growth remain questionable across the globe. A decade of Organization for Economic Cooperation and Development (OECD) efficiency efforts appears to have dampened the price elasticity of the world’s price-sensitive consumers, even with greater discretionary driving, buying, and flying. EIA now forecasts stronger economic growth in 2015 and 2016 than in recent years, not least because of energy cost reductions. Average U.S. household energy expenditures projected to fall by 17 percent in 2015—providing an estimated $750–$1,000 per household in newfound surplus energy savings—at least to date have not translated into increased consumer spending. Meanwhile, weakness across non-OECD economies, where demand correlates closely with gross domestic product, undercuts rational expectations of any massive year-on-year consumption gains.
But while good for consumers in the near term, persistently low prices create obvious energy security risks down the road as today’s underinvestment sets up tomorrow’s supply shock. They also impact and are impacted by associated environmental, economic, foreign policy, and security developments and challenges. But that’s a topic for another day.
In the meantime, fasten your seatbelts.
Frank A. Verrastro is senior vice president and holds the Schlesinger Chair for Energy and Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Kevin Book and Larry Goldstein are senior associates with the CSIS Energy and National Security Program. Kevin Book is a managing director at ClearView Energy Partners, LLC. Larry Goldstein is a trustee with the Energy Policy Research Foundation (EPRINC).
Commentary isproduced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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