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The Counterintuitive Cure For Low Oil Prices

Dan Steffens

Before I get into the reasoning for my belief that oil prices must go higher very soon to avoid a serious supply shortage next summer, let’s get a few things straight.

- Demand for oil is seasonal and October marks the low point for demand each year.  Over the next eight months global demand for oil is expected to increase by 1.5 to 2.0 million barrels per day.

- It is impossible for U.S. oil production to keep going up if the active drilling rig count is dropping like a rock. 

- The higher the percentage of U.S. oil that comes from horizontal shale wells, the more wells we need to complete each year just to hold production flat.

- Demand for oil continues to go up each year, because nothing has the energy density of gasoline and diesel.  This world runs on hydrocarbon-based liquid fuels and there is nothing on the horizon that can replace it.

Oil Demand

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Demand for oil-based products has gone from 75 million per day in 1999 to 101 million barrels per day in 2019.  So, simple math [(101-75)/20] tells us that we need to add about 1.3 million barrels per day of new supply each year.  There is no evidence of “Peak Demand”.

It is my opinion that the FEAR that the U.S. vs China Trade War will significantly reduce oil demand is over-blown.  So far, the slowdown in the global economy has not caused a recession and the International Energy Agency (“IEA”) has only reduced their oil demand forecast by a few hundred thousand barrels per day.  That may sound like a lot, but we live in a world that consumes over 101,000,000 barrels per day of oil-based liquids.  So far, the Trade War’s impact on oil demand is not much more than a rounding error.

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In their October “Oil Market Report” IEA said: “Global oil demand recovered from earlier low levels, rising 800,000 barrels per day (“b/d”) year-on-year (“YOY”) in July and 1,400,000 b/d YOY in August. Demand growth is expected to quicken to 1,600,000 b/d YOY in 2H19, benefitting from a lower base in 2018 and oil prices currently 30% lower YOY. Our demand growth forecasts for 2019 and 2020 are both reduced by 100,000 b/d, to 1.0 million b/d and 1.2 mb/d, respectively. For 2019 this reflects changes to 2018 data and for 2020 it reflects a lower GDP outlook.”  

The current oil price does not reflect how tight the physical market is.

The oil price you see in the business news each day is set by a bunch of day-traders.  Actually, it is set by a bunch of computer models set up by the day-traders.  There is a belief among the Wall Street Gang that there is plenty of oil in the world that can and will be produced even if oil prices stay in the $50s.  That “paradigm” is false, but the assumption has been supported by high production forecasts being put out by EIA and IEA. 

I expect the active rig count to keep falling.  I follow over 50 publicly traded upstream oil & gas companies.   They are “For Profit” entities that are not going to drill & complete new wells just to break even.   Most of them are “hunkering down” to live within cash flow from operations, which is putting the brakes on U.S. oil production growth.  Oil in the low $50s is an unsustainable price.

There is a saying that “The cure for low oil prices is low oil prices” and this cycle is not going to be an exception.

The U.S. Energy Information Administration’s (“EIA”) website says that they provide “Independent Statistics & Analysis”.  I’ve been using EIA data for four decades.  During that time, I noticed that they miss the turns in a cycle because the formulas that they use to make supply & demand forecasts are heavily weighted to the trend.  In other words, if supply has been increasing 100,000 barrels per day each month for the last two years, they assumed that it would keep going up at the same rate in 2019 and 2020. 

For the first seven months of 2019 the EIA’s oil supply forecast have been too high.  We only have actual production through July.  Here is actual production by month over the last eight months (thousand barrels per day):

EIA Forecast

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Does that look like strong growth to you?  Despite oil prices increasing steadily in the first four months of 2019, from December 2018 to June 2019 U.S. oil production increased less than 100,000 barrels per day.

In their most recent U.S. oil supply forecast, EIA told the market that they expect U.S. oil production to be 1.2 million barrels per day higher in December than actual production in July (the most recent month for which we have actual data).  You may recall that July’s production was down 350,000 barrels per day because of Hurricane Barry related shut-ins in the Gulf of Mexico.  Even if we adjust July production, EIA’s December forecast is still 850,000 barrels per day higher than a normalized July.  In my opinion, if the number of rigs drilling for oil increased by 200 tomorrow, it would be difficult to achieve EIA’s forecast of production by year-end.

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I believe that EIA will be forced to “face reality” and lower their extremely high U.S. oil production forecasts for 2019 & 2020.  Once oil traders see serious downward revisions to U.S. supply forecasts it should result in a major step towards an oil price where U.S. E&Ps will be properly incentivized to grow production.  This is why I keep saying that the “Right Price” for WTI is somewhere in the $65 to $75 per barrel range.

This totally ignores the high geopolitical risk to oil supplies coming from the Middle East.

U.S. oil supply growth over the past decade has been driven in large part by per-well productivity gains; primarily the result of a vast improvement in drilling technology and well completion methods. Simply put, the industry has needed fewer wells to produce more oil - while at the same time also drilling more wells.  Productivity gains have dropped like a rock and so has the number of new wells being completed. 

“In our U.S. oil supply model, this has shown up as a "beat and raise" for U.S. oil production, where supply typically comes in ahead of expectations, and consensus estimates for supply growth must increase. This has been the case for the past eight years; however, starting in January of 2019, EIA actuals have started to come in BELOW our forecasts, in fact for seven consecutive months.  In our April and September Energy Stat Reports we have discussed why the well productivity trend has started to slow and may even go negative. The market's apparent belief in perpetual improvement in well productivity underpins a naive optimism that U.S. oil supply can grow indefinitely - thus, a "surprise" in this trend will drive U.S. oil supply forecasts lower.” – Raymond James Energy Industry Brief October 21, 2019.

Another “False Paradigm” is that there is a large inventory of drilled but uncompleted wells (“DUC”) that can be quickly put online to meet growing demand.  The DUC inventory is back to normal and about a 3rd of them are “Dead Ducs” that will never be completed.

Oil Supply

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As I have told my subscribers many times this year, at the current active drilling rig count it is unlikely that U.S. oil production can grow and if the active rig count keeps falling it is likely that U.S. oil production will decline in 2020.  EIA seems to be ignoring the fact that upstream companies are slashing their capital expenditure budgets.  None of the upstream companies that I follow are expected to increase drilling & completion spending in 2020.

“The EIA's projected onshore growth begins to ramp up in August, when it expects newly opened pipelines out of the Permian to allow for additional takeaway capacity - and thus additional production. The combined capacity of these two pipelines, just over 1.0 million bpd, certainly allows additional production to be brought online. However, we are skeptical that production capacity was "waiting in the wings" for these pipelines. Beyond August, the EIA projects 280,000 bpd of growth in September, another 190,000 in October, and another 100,000 in November, just coming from the Lower 48 states (the "shale basins"). The EIA's total onshore growth of 700,000 bpd into December is close to the fastest growth we've seen at any point in the past five years. Furthermore, this is by far the fastest acceleration in growth at any point since the commodity downturn.” - Raymond James Energy Industry Brief October 21, 2019.

Schlumberger (SLB) and Haliburton (HAL) both recently reported sharp declines in their North American business units during the 3rd quarter; another indication of fewer well completions.

If the price of oil spiked to $100/bbl tomorrow, I doubt that the onshore active drilling rig count would increase until the upstream companies are convinced that the oil price will remain elevated.  If WTI stays in the $50s, and the active rig count averages 850 in 2020, Raymond James’ 2020 production forecast is 1.1 million b/d lower than EIA’s forecast 2020 exit rate of 13.4 million b/d.  What happens if the active rig count keeps falling, which is more likely if WTI stays in the low $50s?

Rig Count Oil Price

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Last week, EIA’s weekly report estimated U.S. oil production at 12.6 million barrels per day.  My guess is that actual production for October is closer to 12.2 million barrels per day.  On October 31st EIA will report actual production for August, and it will show a significant increase from July.  Just remember that the rebound in the Gulf of Mexico after Hurricane Barry is a one-time event.

Conclusion: They call them “cycles” for a reason and this one has pushed the oil price way below where the fundamentals tell me it should be.  As of the date of this article, EIA is forecasting a 2020 exit rate for U.S. oil production of 13.4 million barrels per day.  That is more than 1.0 million barrels per day higher than where it is today.  Unless there is a big increase in the active rig count, which will only happen if oil prices move into the $70s, I see no chance of U.S. production increasing that much.  The longer that oil stays in the low $50s the higher the chance that U.S. oil production will go on decline in 1H 2020.

By Dan Steffens

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