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Trend Outlook: Oil Prices Face Heightened Geopolitical Risk

Relatively stable oil prices year to date have been jolted higher since Hurricane Harvey and the vote for independence in Kurdistan, reports contributing writer Paul Kuklinski. While surplus oil inventories have declined significantly since the OPEC production cut, a large surplus to the five-year average will likely remain the rest of the year without a supply disruption, he writes. Kuklinski founded Boston Energy Research in 1992. He has selected equity investments in the energy sector for institutional investors for over 30 years. The following article is a lightly edited version of a monthly commentary he writes on future oil price trends:

A significant increase in inventories is likely in the first quarter of 2018 with the seasonal decline in global demand. But in 2020 and beyond, the risk of an oil shortage is high. Without a geopolitical event, WTI is expected to remain near $53/B well into 2018 before increasing with the seasonal ramp up in demand. It is expected to average $50/B for all of 2017 compared with $43/B in 2016.

Brent is $57.50/B, $5.70/B above WTI, but down from a recent premium of $7/B. Through August, the 2017 Brent premium over WTI was $2.01/B. It widened dramatically in the aftermath of Hurricane Harvey and the Kurdish vote for independence. Gulf Coast refinery outages backed up crude supplies at Cushing, Okla., the NYMEX pricing point for WTI. The impact of Harvey on demand was negligible. At its peak, it briefly disrupted 9% of U.S. crude production and 26% of U.S. refining capacity.

Geopolitical uncertainty added a risk premium to oil prices since the overwhelming vote in favor of independence in Kurdistan including the partly Kurdish Kirkuk region of Iraq. In response, Turkey threatens to choke off crude oil exports through Turkey which approximate 520,000 barrels per day (MBD). If implemented, the quarterly impact on world oil supply would be a reduction of 47 MMB, which would accelerate the return to a market balance and likely result in higher oil prices.

Otherwise, excess global crude oil inventories are likely to remain relatively unchanged the rest of the year. A 100 MMB increase is indicated in the first quarter of 2018 with the seasonal decline in demand, which poses a temporary downside risk to oil prices.

Inventory rebalancing is underway, but at a much slower pace than originally anticipated, which kept oil relatively stable. Since implementation of the OPEC cut on Jan. 1, OECD crude and product inventories are down 53 MMB relative to the five-year average, but were still 190 MMB larger in July. When it announced its cut, OPEC believed elimination of the surplus to the five-year average would increase oil prices to $60-65/B.

Assuming OPEC sustains its current level of production, growth in U.S. production will likely meet substantially all the growth in global demand well into 2018. After a large Q/Q increase of 360 MBD in the second quarter of 2017, current drilling trends indicate U.S. liquids will increase 230 MBD in the third quarter of 2017, and a large 477 MBD in the fourth quarter of 2017. The fourth-quarter increase is driven by strong growth in the Permian Basin, new production in the Gulf of Mexico, and a seasonal increase in Alaska. Sequential growth will continue with a 280 MBD increase indicated in the first quarter of 2018 and possibly 160 MBD more in the second quarter of 2018.

Third-quarter 2017 U.S. liquids production will be about 13.15 MMBD, comprising 9.40 MMBD crude and 3.75 MMBD NGLs. It is projected to average 13.06 MMBD in 2017, up 712 MBD Y/Y.

The growth in the U.S. oil directed rig count flattened in recent weeks, which will slow the growth in U.S. land production in about 6-8 months. At 750, the latest US oil rig count is down 18 rigs from its August peak of 768. After hitting bottom at 333 rigs in the second quarter of 2016 it reached 507 the end of December. It then increased 127 rigs in the first quarter of 2017 and 113 rigs more in the second quarter of 2017. After an 18-rig increase in July, it increased just one rig in August. The crude oil futures curve has flattened and the benefit from hedging is reduced.

Leading U.S. producers have adjusted their 2017 capital budgets to a $51/B WTI oil price. In their August earnings calls, they left their 2017 production guidance intact. They remain as bullish about their production growth as before.

Increased drilling efficiencies this year have been able to offset higher oil field costs which are up 5-15% in 2017. The current oil price required to breakeven in both the Permian Delaware and Midland sub basins and the Williston Basin is $33/B and $34/B in the Eagle Ford.

But in the long run, Pioneer Natural Resources, a leading producer in the Midland basin, believes “$50 oil isn’t going to get it done” because it doesn’t generate enough cash flow and the industry has too much debt. “U.S. production may grow for two [to] three years and a few independents may grow, but we are in a $60 long-term price environment.”

Outside the U.S., other non-OPEC production is expected to remain relatively flat through 2018. It was 45.3 MMBD in the third quarter of 2017 and 45.1 MMBD in 2016. In the Americas, moderate production growth in Canada and Brazil is offset by declining production in Mexico and Colombia. Ramp up of the super-giant Kashagan Field in Kazakhstan is largely offset by declining production in China. Russia produced 11.3 MMBD in the third quarter of 2017, fully compliant with its agreement with OPEC to cut production. It produced 11.3 MMBD in 2016. Outside the U.S. and Canada, the global rig count is also relatively flat Y/Y.

Going forward, OPEC production will likely be somewhat volatile but remain near current levels for the foreseeable future. Its August production was 32.75 MMBD, down 90 MBD from its 2017 high in July. It was 32.3 MMBD in the first quarter of 2017 and 32.64 MMBD in 2016. OPEC estimates demand for its crude will average 32.67 MMBD in 2017 and 32.83 MMBD in 2018. There is no OPEC talk from credible sources of a further cut in its production, only the possibility of an extension past its March expiration date.

Compliance with its cut was 82% in August and 86% YTD. Iraq is the biggest cheater, consistently exceeding its quota. It produced 4.45 MMBD in August; its quota is 4.35 MMBD. It has ambitions of increasing its production to 5.0 MMBD.

With a substantial reduction in militant activity, Nigeria’s crude oil production in August was able to reach 1.66 MMBD, near capacity and up from 1.46 MMBD in the fourth quarter of 2016 when it was exempted from participation in the OPEC cut.

Domestic unrest in Libya also declined significantly. August production was 870 MBD, down from 1010 MBD in July but up from 570 MBD in the fourth quarter of 2016 when it was also exempted from the OPEC cut.

Venezuela is imploding. Its state oil company PDVSA reported 2016 earnings in August. 2016 liquids production declined 11% from 2015 to 2.6 MMBD and exports were down 9% to 2.2 MBD. But after contributions to anti-poverty campaigns, earnings declined nearly 90% to $828 mil from $7.3 bn the previous year. August production was lower at 2.02 MMBD.

The outlook for world oil demand has increased, supported by strong global economic growth. Relatively low and stable oil prices are also supportive. In its latest estimate, the IEA expects an increase of 1.6 MMBD this year to 97.7 MMBD and 1.4 MMBD in 2018. Demand in the fourth quarter of 2018 is expected to reach 100 MMBD. China, India, and Africa are leading the expansion. Demand grew 1.1 MMBD in 2016.

Adequate future world oil supply requires higher prices. While U.S. shale oil production is growing, it is only 8% of world oil supply; 52% of world oil supply is vulnerable to serious decline the next few years.

Schlumberger estimates 2016 discoveries added less than 5 bn B to global reserves versus produced volumes over 30 bn B. The 2017 e&p spend on the global production base outside the Middle East, Russia, and U.S. land, which still accounts for 50 MMBD of world oil supply, will be down 50% from 2014. It recently said “Given the size of this production base, it will be difficult for the rest of global producers to compensate for this pending supply challenge. The longer the current underinvestment carries on, the more severe the cliff-like decline trend will likely be when producers run out of short-term options to maintain production. Come 2019 or 2020 we will have significant supply challenges.”

Production has been supported primarily by producing wells in these fields at a higher rate than in the past, which is depleting their reserves faster. Yet there is little in the way of confirmation in the latest data.

In the long run, OPEC also needs higher oil prices. Saudi Arabia’s oil revenues dropped from $284 bn in 2014 when Brent was $99/B to $134 bn in 2016 when Brent was $44/B. Its total monetary reserves dropped from $750 bn to $500 bn in April. To balance its 2017 budget, the IMF estimates it needs a price of $78/B. Other OPEC producers are even less resilient. Venezuela is impoverished.

Paul Kuklinski can be reached by email at: bostonenergyresearch@msn.com.

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