2017: The year fundamentals and oil prices improve...finally

As I sat down to write this article, I thought about making a case that the fundamentals were improving as demand growth continues, non-OPEC supply is sputtering (driven by U.S. production declines), and visible OPEC production capacity is limited to Saudi Arabia after post-sanctions Iran increased to 3.7 MMbopd. This argument is most often met by a lot of “yeah but…” and “why hasn’t price responded more definitively”?

So instead, I will start with the bear argument(s):

• OPEC increased production 2.3 MMbopd since fourth-quarter 2014, with Saudi, Iran and Iraq accounting for all of the net growth within the group. And what if Saudi keeps its foot on the gas—Iran and Iraq won’t agree to a production freeze.
• Demand fears are omnipresent. Greece/EU fears in early 2015 were replaced by China slowdown fears (on Shanghai Index volatility), which gave way to Brexit uncertainty. Presently, Trumponomics has created further uncertainty. Peak demand conversations are more lively with oil at $40/bbl, than when oil was over $100/bbl...go figure.
• U.S. supply is deemed to be resilient, and the rest of non-OPEC surprised some observers by growing in 2015 and into 2016.

Fig. 1. U.S. inventories outperforming normal during recent 12 weeks.

If all of these are true, then how can the oil market be rebalanced? Wait…what? U.S. inventories over recent weeks were trending slightly better than normal (Fig. 1)…strongly suggesting that the global oil market is balanced or even slightly undersupplied. Yes, U.S. inventories are important, because even though they typically comprise 45% of total OECD stocks, they have accounted for ~70% of the OECD inventory build over the past two years.

The reality? Even with the ever-growing list of demand fears over the past two years, global demand has been growing at an annual pace of ~1.5 MMbopd, and it’s worth noting that global demand has only contracted twice since 1986 (in 2008 and 2009).

Production—onshore U.S. output has declined 1 MMbopd since March 2015. This is anything but resilient. After growing 1.5 MMbopd in 2015, total non-OPEC supply is poised to decline 1 MMbopd in 2016. Even though active U.S. rig count has shown signs of life recently, international activity and drilling budgets are still declining. The ability of non-OPEC supply (except the U.S.) to grow through 2020 is impaired significantly, based on the large number of project cancellations and/or deferrals.

Bottom Line—starting with the premise that the global market is balanced, ongoing demand growth (+1.0 MMbopd) and sluggish non-OPEC supply growth will lead to improving fundamentals and significantly improved oil prices in 2017, and beyond. Hence, our price outlook calls for $80/bbl in 2018, forward.

Near-term considerations. Keep in mind the following items, as the market moves forward:

• At the OPEC meeting on Nov. 30, the group agreed to limit its production to 32.5 MMbopd, which basically is what was agreed to in Algeria during late September 2016. October 2016 production was 33.8 MMbopd, which implies a ~1.3-MMbopd production cut, Fig. 2.
• OPEC production cuts will merely accelerate OECD inventory drawdown (currently ~350 MMbbl above normal). OPEC production of 33.0 MMbopd puts OECD stocks back to normal in second-half 2017.
• U.S. production will likely grow in 2017 (exit to exit) and show year-to-year growth in 2018 and beyond. To achieve this growth, the U.S. rig count will need to increase in late 2016 and into 2017.

Fig. 2. OPEC production history.

Things that make us say “wait…what”?Can long-cycle projects (as in deep water) compete for capital against short-cycle projects (as in onshore U.S. tight oil)? This has significant implications for non-OPEC (except the U.S. onshore) production growth through 2020 and beyond. If long-cycle projects can’t compete, then non-OPEC supply will be in structural decline…putting more pressure on the U.S. and OPEC.

How much excess capacity does OPEC really have? The market has been focused on whether OPEC would cut at their Nov. 30 meeting. However, we forecast OPEC production to be nearly 35 MMbopd in 2020. We wonder how much excess capacity is contained in OPEC? Outside Saudi Arabia, visible and sustainable excess capacity is illusive (Libya and Nigeria have capacity, but sustainability is a real question). Iran and Iraq can grow, but they will require incremental capital to establish meaningful growth from current levels.

As upstream activity returns in the U.S., there are lots of opinions on the magnitude of oil service inflation. E&P companies seem confident that much of the cost-savings achieved over the past two years is structural. Although we believe a fraction of the cost-savings is structural, a large portion of the completion costs will see significant cost pressure (sand, pressure pumping, coiled tubing, etc.). A 10% change in well costs will result in a change in break-even oil prices by at least $5/bbl.

President Trump? The industry is in wait-and-see mode on his cabinet appointees, to assess how a Trump White House will impact energy markets. Generally, fewer regulations are positive. Stay tuned.