Back in March, with oil at $36 a barrel, we took a look at the oil market and decided that prices might stay low for a while.
Our theory: A recovery in the price of oil would be met by an increase in production — primarily in the US — which would cap the price. On Tuesday, the price of West Texas intermediate crude rose above $50 a barrel for the first time in over a year.
So now we’ll get to see if the players and the markets react in the ways we expect. Here’s a look at some of the key factors that should determine whether the current rally might soon be doused by a wave of new supply:
(1) Supply disruptions. The world has enjoyed slightly more oil supply than demand in recent quarters, which caused oil prices to plummet. But the margin between what is produced and consumed is amazingly slim. The
EIA reports that in Q1 the world produced 95.6mbd while it consumed 94.2mbd. With little room for error, recent supply disruptions may have had an outsized effect on the market. Global unplanned outages in May reduced supply by an estimated 3.7mbd, the
EIA reported.
Last month saw big production disruptions in both Nigeria, where rebels attacked pipelines, and Canada, where wildfires near oil sands prompted the evacuation of workers. Nigerian output was reduced by about 800,000 barrels a day to about 1mbd,
the 6/6 WSJ noted. Canadian production was reduced by more than 1mbd. The Nigerian production disruptions are expected to continue, while the Canadian oil sands workers have begun returning to work and oil from the area should return to the markets this month,
Bloomberg reported on 5/22.
(2) Frackers holding & folding. Until last week, US crude production had been declining slowly as production responded to lower oil prices. In May, output averaged 8.7mbd, more than 0.2mbd below April and down 1mbd y/y, the
EIA reported Tuesday. The agency predicts that US crude production, which averaged 9.4mbd in 2015, will decline to an average of 8.6mbd this year and 8.2 mbd in 2017.
But those estimates may overstate the future decline, as surviving drillers are quickly learning how to drill less expensively and a raft of drillers that entered bankruptcy protection over the past year may emerge with less debt, helping them produce oil profitably at much lower oil prices.
The first signs that oil companies may be ready to increase production again with oil at $50 a barrel arrived yesterday, when the EIA said US output increased by 10,000 barrels last week compared to the prior week. “The report also showed stocks of gasoline and distillates, including heating oil and diesel, grew by 2.8 million barrels combined, nearly canceling out a 3.2-million decrease in crude stocks,” the 6/8
WSJ reported. “Inventories were already near historic highs. … Analysts surveyed by The Wall Street Journal had expected gasoline stockpiles to shrink by 500,000 barrels and distillates by 300,000.”
The second piece of good news came last week when the US oil rig count rose by nine to 325, according to
Baker Hughes. A nine-rig increase is far from a world record. The rig count is still down from its peak of 1,609 in October 2014. The increase is notable nonetheless because there has been only one other rig increase this year--when a single rig was added during a week in March.
Five of the nine rigs added last week were located in the Permian Basin in Texas and New Mexico. Over there, operators are enjoying 10%-30% returns based on $45 oil, noted the 6/5
WSJ. Another area enjoying those strong returns is known as “the Stack,” in Oklahoma, where Continental Resources said its wells can yield a 75% return if oil is at $45. And according to a 2/3
Bloomberg article, some parts of the Eagle Ford area in Texas can be profitable with oil at $30-$40.
Pioneer Natural Resources, one of the biggest Permian operators, is expanding. A 6/6 article in Oilprice.com reported: “Pioneer’s executive VP
Joey Hall said the company is planning to allocate $1.8 billion — about 90 percent of its total budget — to operations in the Permian. What’s more, the company is ready to ramp up its rig count in its two Permian fields — Spraberry and Wolfcamp — and has revised up its overall production growth projections to 12 percent. A bold move in a still oversaturated oil market that has just seen the re-entry of Iran.”
Pioneer’s Q1
earnings press release said the company expected to add five to 10 horizontal drilling rigs when the price of oil recovers to approximately $50 per barrel and described the outlook for oil supply/demand fundamentals as “positive.” Despite the company’s Q1 loss, Pioneer’s shares traded at $165.59 as of Tuesday’s close, up 32.1% ytd.
The Oilprice.com article continues: “Another of the majors, Occidental Petroleum, is also planning a production increase in the Permian, of 4-6 percent, to be fueled by capex of some $3 billion. The company is consistently working on lowering its production costs, which last year averaged around $40 a barrel, to ensure its profitability even if prices start sliding again.” Occidental shares are up 13.7% ytd.
(3) Zombies no more. Meanwhile, exploration and production companies emerging from bankruptcy protection may also lift production levels as healthier balance sheets and lower interest expense may improve their profitability even if crude oil prices remain low. For example, Swift Energy emerged from bankruptcy protection in April after swapping $905 million in bond debt for most of the equity in the restructured company, the 3/30
WSJ reported. It has a $320 million senior secured credit facility and plans to develop, explore, acquire, and operate oil and gas properties with a focus on the Eagle Ford area in Texas and the onshore and inland waters of Louisiana, according to a
company press release.
There have been 81 bankruptcy filings by exploration and production companies since the start of 2015, and those companies will be looking to dramatically reduce the more than $50 billion of secured and unsecured debt they had outstanding, according to the law firm Haynes and Boone's
Oil Patch Bankruptcy Monitor.
(4) Iran is gushing again. Iran has wasted no time in boosting its oil production now that economic sanctions have been lifted. “Tehran wants its production to reach pre-sanction levels of 4 mbd or more, after falling below 2.7 mbd while the U.S. and other Western nations restricted trade with Iran over its nuclear program. Iran is getting closer to the mark, (Iran’s Oil Minister Bijan) Zanganeh told reporters Thursday, with output now at 3.8 mbd,” the 6/3
WSJ explained.
As we expected, OPEC has been unable to get its members — including Iran — to reduce oil production, in part because Iran and Saudi Arabia are at odds. The above-referenced WSJ article noted: “Iran and Saudi Arabia are using oil policy as a tool in the contest for influence in the Middle East. The two countries’ diplomatic ties are at historic lows as they back different sides in violent conflicts in Syria and Yemen and represent the national embodiment of different strains of Islam.”
(5) Bottom line. Put it all together, and supply is still growing slightly faster than demand. World crude oil supply is growing 1.8% y/y (using a three-month moving average), while demand is only growing 1.4%, according to Oil Market Intelligence. If oil prices remain high, there’s no reason to expect that gap will close.
The Energy sector has been the best performing of the 10 S&P 500 sectors both on a ytd basis, up 14.8%, and so far in Q2, up 11.4% through Tuesday’s close. Forward revenue growth appears to have bottomed. After falling 34.1% in 2015, revenue is expected to drop again this year by 16.1% before rebounding next year by 23.0%. Earnings follow a similar pattern: Having tanked by 60.8% last year, earnings are expected to fall another 68.3% this year before growing an estimated 218.5% in 2017. However, earnings estimate revisions continue to be negative, and the forward P/E is elevated, at 44.6.
If high prices beget more supply, optimism about earnings next year soon may fade.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs,
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