Oil prices have limited upside

Energy Outlook

Too much, too soon. The 36% increase in crude oil prices since August is likely to stimulate a strong production response, with a typical lag, sufficient to keep oil inventories elevated above the five-year average for all of 2018, despite the extension of OPEC’s production cut to the end of the year. It may even undermine OPEC compliance and negatively impact oil demand.  

The spike provides producers with a very attractive opportunity to hedge their 2018 production. The marginal cost of new oil supply is in the $65 to $75 per barrel range, which was well out of reach in each of the last three years. WTI averaged $49 per barrel in 2015, $43 in 2016 and $51 in 2017.

WTI crude oil is now $64, just off its recent $64.89 high — a level not seen since Q4 2014. It averaged $49 for the first nine months of 2017. The 36% spike from $47 in August was caused by pipeline disruptions in the United States, North Sea and Libya; hurricanes in the Gulf of Mexico, increased geopolitical anxiety over Iraq, Iran and the arrival of brutal cold winter weather. Without an escalation of conflict in the Middle East, these varied stimuli are unlikely to have a lasting effect. For 2018, WTI is likely to average about $58. 

Brent is $69 per barrel, with a $5.50 per barrel premium over WTI. The Brent premium averaged $2.47 for the first nine months of 2017 and $2.46 in 2016. The Brent premium is likely to slowly contract in 2018, with an average of about $4 for the year.

Aided by the unusual number of one-off events, the OPEC production cut was successful in reducing surplus Organization for Economic Co-operation and Development  (OECD) inventories to 137 million barrels above the five-year average in October, down from a 318 million barrel surplus earlier in the year and a record high in Q1 2016 of 380. The OECD accounts for 48% of total world oil demand. 

The latest data indicates a mild increase in OECD inventories in Q1 2018 with a seasonal decline in demand, followed by modest quarterly declines as non-OPEC production growth gains momentum to reach about 115 million barrels in Q4 2018 above the five-year average. 


OPEC Strategy 

OPEC has achieved the stated price goal of its production cut announced in November 2016. That may cause some of its members to reduce compliance, rather than cede market share and further stimulate the growth in non-OPEC production, which could cause surplus inventories to once again build. When OPEC announced its production cut a year ago, it said the elimination of the surplus in OECD inventories to the five-year average would increase oil prices to $60 to $65. That has now occurred.

Iraq’s future compliance with the OPEC agreement has always been uncertain. Its December production of 4.41 million barrels per day is over its quota, but its goal to raise production to five million barrels per day may be in reach as its field capacity is approaching that level due to successful partnerships with foreign oil companies. 

Saudi Arabia produced 9.90 million barrels per day in December, 560 less than before the OPEC cut was implemented. As OPEC’s leading sponsor of the cut to restore market balance, it may threaten to raise production in coming months to discourage growth of non-OPEC production. As it is, the Saudis do not expect significant inventory declines until the second half of 2018. It has more than two million barrels per day in spare capacity.

Its 2018 budget is based on production of 10.1 barrels over the year and an oil export price of $58. It requires $70 to balance its budget. Middle East producers mostly price their crude off of Brent.

Total December OPEC production was 32.4 million barrels per day, down one million from Q4 2016, when the cut was announced. OPEC production in 2018 is otherwise projected to remain near November levels except for a steady decline in Venezuela. A decline of about 213 million barrels per day in total OPEC production to 32.2 million in Q4 2018 is indicated if supplies from Iraq or other OPEC producers do not vary significantly. Current OPEC spare capacity is 3.41 million barrels. The Iranian oil minister recently warned that Brent crude over $60 would unleash more U.S. shale supplies.

OPEC is scheduled to review the progress of its production cut in June, which is scheduled to expire at the end of the year. Net-long futures positions in crude reached a record high in January. Oil traders may choose to take profits in advance of the meeting, if not sooner.

Non-OPEC production was 58.34 million barrels per day in Q4 2017, up just 439 million from Q4 2016. Declines in Russia, and other producers partly offset the growth in U.S. production. Total non-OPEC production is expected to grow 2.47 million barrels to reach 60.81 million in Q4 2018.

U.S. producers are poised to accelerate growth in 2018. A recent survey by the Federal Reserve Bank of Dallas of 134 Southwestern energy companies expects the U.S. rig count to be higher than 930 in six months. Nearly all believed it would increase substantially with oil prices above $60. The current rig count is 939 compared to an 874 average in 2017.

Growth will come primarily from the four major resource plays: Permian Basin, Eagle Ford, Bakken and DJ Basin, which combined will add about 1.33 million barrels per day in 2018, a year-over-year increase of 124%. Combined oil production from these basins increased 849 million barrels year-over-year in Q4 2017, or 18%. Break even costs in these plays are in the $33 to $35 range.

Less capital will be required to grow U.S. production in 2018. In 2017, producers substantially increased the number of drilled but uncompleted wells (DUCs) in the major shale plays. The DUC inventory in these plays reached 5,400 by the end of November — a 38% increase.

The DUC inventory build in 2017 was attributable to a lack of money to complete wells and a shortage of crews to frack. Not only will the U.S. oil directed rig count increase in 2018, but the number of completed wells will increase more. Completion levels are expected to return to levels last seen in 2014, and new wells now are far more productive than they were then.

The major constraint is whether pipeline takeaway capacity, primarily in the Permian, can keep up with growth in production. A total of 2.31 million barrels of new pipeline capacity is proposed for start-up in late 2019/early 2020, which should prevent the Midland discount to WTI from widening as production climbs. With current spare capacity of just 300 million barrels, the September Midland discount was $5.74, up from $2.06 in December 2016. 

Russia has been fully compliant with its agreement with OPEC, but has excess capacity once the agreement runs its course. Russia’s Lukoil says the OPEC deal should end in an “a very smooth way” if Brent holds $70 for six months. The biggest risk is the latest U.S. sanctions, which could be used against any company investing in Russian projects.

Other non-OPEC production outside the United States, Canada and Russia will grow. The latest estimates indicate a 530 million barrel increase in Q4 2018. Production in Brazil and Kazakhstan is expected to grow in 2018; and after decades of decline, UK North Sea production is expected to be stable to the end of the decade. 

The outlook for Norway is bullish. Operating costs have been reduced around 30% since 2013/2014 and they can tolerate an oil price as low as $30 to $40. 

Global offshore drilling, and ultimately production, will be stimulated. Offshore costs have fallen substantially since the downturn began. A number of new deepwater projects being planned now break even under $40. Some shallow water projects break even under $35. 

The spike in oil prices may also negatively impact world oil demand after winter passes. International Energy Association’s (IEA) analytics calculate that a 10% increase in expected oil prices reduces global demand by about 400 thousand barrels, all else being equal.

Since 2015, global oil demand has grown by about five million barrels per day, twice as fast as the previous three years, supported by strong global economic growth. The latest IEA estimate anticipates a 500 thousand barrel seasonal dip in demand in Q1 2018. It is then projected to increase to 10 million barrels per day. China, India and Africa lead the expansion. The question for 2018 is whether that demand increase will match the production increases expected to result from $60+ crude oil. 

Boston Energy Research provides a monthly road map of future oil prices.    

About the Author

Paul Kuklinski is the founder of Boston Energy Research. He also was a partner at Cowen & Co. and a founding partner of Harvard Management Company.