The Petroleum Truth Report

My goal is to offer clear and direct explanations of energy reality. These posts are data-driven interpretations of oil and gas topics that often challenge conventional thinking.
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Oil Prices Plunge: Over-Reaction or Turning Point?

Oil prices plunged yesterday. Is this an over-reaction or a turning point?

WTI futures fell $2.86 from $53.14 to $50.28 per barrel, and Brent futures dropped $3.81 from $55.92 to $52.11 per barrel. WTI is trading below $49 and Brent, below $52 per barrel at this writing.

The official narrative was that a larger-than-expected 8.2 million barrel (mmb) addition to U.S. crude oil inventories pushed prices lower. That explanation is not consistent with larger recent additions to storage that had little effect on oil prices. The timing of the price slump also seems to be at odds with positive developments in the global market balance and demand growth.

Something more fundamental is happening. In part, the price slump reflects a growing realization that the OPEC production cut is unlikely to quickly resolve the problem of outsized global oil inventories. Perhaps more importantly, a major downward shift in the term structure of oil futures contracts suggests that headwinds in the global economy are driving the end of the present oil-price rally.

Over-Reaction

The drop in prices was an over-reaction to recent storage data based on history since the OPEC production cut was finalized in late November 2016. WTI has fallen below the $50 to $55 per barrel range in which oil futures have traded for the last 3 months (Figure 1).

Figure 1. Oil prices have not exceeded $55 per barrel since early 2015. Source: EIA, CBOE and Labyrinth Consulting Services, Inc.

An 8.2  mmb addition to crude oil storage is actually fairly normal during the annual re-stocking season that we are in now (Figure 2). Inventories increased more–10.4 mmb–during this week in 2016 and the 5-year average for this date is 5.3 mmb.

An 8.2 million barrel addition is fairly normal for re-stocking season. Source: EIA and Labyrinth Consulting Services, Inc.

The fact that inventories have been in record territory since the beginning of 2015 has not kept oil futures from going through several rallies or from trading near $55 per barrel since November. The 13.8 mmb addition to storage a month ago was larger than yesterday’s amount yet prices barely responded.

Comparative inventory–the crucial price indicator–only moved up 2.4 mmb (Figure 3). That is because we are in the re-stocking season and compared with previous years, this addition to storage is not that big. Other key measures of gasoline and diesel volumes fell by more than 1 mmb each.

Figure 3. Comparative crude oil plus refined products inventory increased only +2.4 mmb. Source: EIA and Labyrinth Consulting Services, Inc.

And there was some good news this week that the markets ignored. EIA’s Short-Term Energy Outlook (STEO) showed that the global market balance (production minus consumption) moved to a deficit last month. The world consumed almost a million barrels more than it produced in February (Figure 4).

Figure 4. The world liquids market balance (production minus consumption) was -1 mmb/d in February 2017. Source: EIA March 2017 STEO and Labyrinth Consulting Services, Inc.

This is a one-month data point and should not be seen as a trend. Still, it is a positive sign that seems to have been overwhelmed by an otherwise normal addition to U.S. storage.

The March STEO also had good news about world demand. Average liquids consumption growth for 2016 was 1.5 mmb/d and 1.6 mmb/d for the first two months of 2017 (Figure 5).

Figure 5. 2016 global liquids consumption growth: +1.5 mmb/d, early 2017: +1.6 mmb/d. Source: EIA March 2015 STEO and Labyrinth Consulting Services, Inc.

In mid-2016, there were indications that consumption was only growing at only about 1.2 mmb/d but particularly strong year-over-year performance from August through January have brightened that outlook.

Turning Point

Although yesterday’s price plunge may have been an over-reaction, it may also represent a turning point for prices to adjust downward.

I have written for months that global oil inventories must fall before prices can make a sustainable recovery yet they remain near record levels. OECD inventories fell 15 mmb in February but are nearly 550 million barrels above December 2013 levels (Figure 6).

Figure 6. OECD incremental liquids inventories are near record high levels. Source: EIA and Labyrinth Consulting Services, Inc.

Brent was probably $10 over-valued at $55 and WTI was at least $6 over-valued at $54 per barrel as Figure 1 shows.

The other negative weighing on oil prices is the increase in U.S. crude oil production. Output has increased 420,000 b/d since September and EIA forecasts that it will exceed 10 mmb/d by December 2018 (Figure 7). That is higher than 1970 peak production and 1.1 mmb/d more than current levels. In short, this would more than cancel the U.S. decline since oil prices collapsed in late 2014.

Figure 7. EIA U.S. crude oil forecast is 10.1 mmb/d and $59 WTI by December 2018. Source: EIA March 2017 STEO and Labyrinth Consulting Services, Inc.

There has been a change in the term structure of futures contracts since the OPEC production cut was finalized. In the last week, the maximum WTI near-term price has fallen $2.81 to $51.36 per barrel and prices do not reach $52 until mid-2021 (Figure 8).

Figure 8. The term structure of WTI futures contracts has changed. The maximum near-term forward price has fallen $2.81 per barrel in the last week. Source: CME and Labyrinth Consulting Services, Inc.

The term structure of Brent futures has changed also. Near-term forward prices have fallen $3.39 from a week ago to $53.15 per barrel then, fall and do not reach $53 again until late in the third quarter of 2020 (Figure 9).

Figure 9. Figure 8. The term structure of Brent futures contracts has changed. The maximum near-term forward price has fallen $3.39 per barrel in the last week. Source: CME and Labyrinth Consulting Services, Inc.

Although the forward curve of futures contracts is hardly a predictor of oil prices, it appears that a major downward shift in oil prices is occurring. This reflects something far more consequential than a higher-than-expected U.S. crude oil storage report.

Over-Reaction or Turning Point?

In part, this week’s price downturn reflects waning confidence that OPEC production cuts will result in higher prices. Much of the discussion until now has centered on whether OPEC will deliver on the announced cuts or if output increases by Libya and Nigeria will offset those cuts.

There seems to be a growing awareness that global oil markets are incredibly complex, and that there are so many moving parts that a single, simple solution is unlikely.

The problem may be about expectations. Many believe that the OPEC cuts will increase prices but the cuts may be more about establishing a floor under those prices.

There is no good reason why a normal addition to U.S. inventory should affect prices so much. The timing of this price adjustment may be an over-reaction but the direction may also represent a turning point.

A larger issue is the inexorable relationship between stocks and prices. It’s not so much about this week’s change in inventory. It’s about how much inventory needs to be reduced and how long that will take in the most hopeful scenario.

If OECD stocks must fall by approximately 550 million barrels to support $70 prices, it will take more than a year to get there if production is cut by 1 mmb/d. If the production-consumption balance fluctuates, it will take even longer.

The change in the term structure of oil futures contracts suggests that causes for the recent price slump transcend oil market supply-demand fundamentals. Larger forces in the global economy are operating here. These may include reduced levels of credit creation that signal a slow-down in economic growth. If true, lower oil and other commodity prices are likely along with lower oil-demand growth.

For more than two years, the industry has believed that higher prices are possible without extreme reductions in inventories. Great expectations were placed in an OPEC production cut to rescue the industry from a weak oil market.The fallacy lies in thinking that the problem stems from a simple imbalance between production and consumption and is unrelated to a fragile and debt-dependent global economy.

That hope was a dream. It appears that oil markets have woken up from that dream.

 

The Beginning of the End For The Bakken Shale Play

It’s the beginning of the end for the Bakken Shale play.

The decline in Bakken oil production that started in January 2015 is probably not reversible. New well performance has deteriorated, gas-oil ratios have increased and water cuts are rising. Much of the reservoir energy from gas expansion is depleted and decline rates should accelerate. More drilling may increase daily output for awhile but won’t resolve the underlying problem of poorer well performance and declining per-well reserves.

December 2016 production fell 92,000 barrels per day (b/d)–a whopping 9% single-month drop (Figure 1). Over the past two years, output has fallen 285,000 b/d (23%). This was despite an increase in the number of producing wells that reached an all-time high of 13,520 in November. That number fell by 183 wells in December.

Figure 1. Bakken Production Declined 92,000 bopd (9%) in December. Source: North Dakota Department of Mineral Resources and Labyrinth Consulting Services, Inc.

Well Performance Is Declining

Well performance was evaluated for eight operators using standard rate vs. time decline-curve analysis methods. These operators account for 65% of the production and also 65% of producing wells in the Bakken play (Table 1).

Table 1. Operators, Cumulative Oil Production, Total Producing Wells and 2012-2015 Wells Used for Decline-Curve Analysis (DCA) in this study. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Estimated ultimate recovery (EUR) decreased over time for most operators and 2015 EUR was lower for all operators than in any previous year (Figure 2). This suggests that well performance has deteriorated despite improvements in technology and efficiency.

Figure 2. Bakken EUR (Estimated Ultimate Recovery) Has Generally Decreased Over Time. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Figure 3 shows Bakken EUR and the commercial core area in green. The map on the left shows all wells with 12-months of production history and the map on the right, all wells with first production in 2015 and 2016.

Most 2015-2016 drilling was focused around the commercial core area. The fact that EURs from these core-centered locations were lower than earlier, less favorably located wells indicates that the commercial core is showing signs of depletion and well interference.

Figure 3. Bakken EUR map showing all wells with 12-months of production and all wells with first production in 2015 and 2016. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Well-level analysis indicates a fairly systematic steepening of decline rates over time. Figure 4 shows Continental Resources wells with first production in 2012 and 2015. 2012 wells have a shallow, super-harmonic (b-exponent = 1.3) decline rate but 2015 wells have a steeper, weakly hyperbolic (b-exponent=0.2) decline rate.

Oil reserves for 2012 wells averaged 343,000 barrels but only 229,000 barrels for 2015 wells–a 33% decrease in well performance. Steeper decline rates result in lower EURs.

Figure 4. Well-level analysis shows steeper decline rates for more recent wells than for older wells. Source: Drilling Info and Labyrinth Consulting Services, Inc.

In fact, a successive increase in oil production decline rates can be seen for all of the major operators evaluated in this study. Decline rates for 2014, 2015 and 2016 are higher than for previous years for these operators despite higher initial rates (Figure 5).

Figure 5. Oil production decline rates for recent years are greater than for previous years for the top 8 Bakken producers. Source: Drilling Info and Labryinth Consulting Services, Inc.

Gas-oil ratios (GOR) for most operators increased from 2012 through 2014 and then, decreased for wells with first production in 2015 (Figure 6).*

Figure 6. Bakken gas-oil ratios generally increased over time but then decreased in 2016. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Changing GOR is important because it suggests decreasing reservoir energy. The Bakken has a solution gas drive mechanism. Initially, oil is produced by liquid expansion across the pressure drop from the reservoir to the well bore. Later, gas dissolved in the oil expands and this is the mechanism that lifts oil to the surface.

Rapidly increasing GOR in the Bakken probably indicates partial reservoir depletion and subsequently decreasing GOR suggests more advanced depletion accompanied by declining reservoir pressure, declining oil production and increasing water cut (Figure 7).

Figure 7. Increasing gas-oil ratio indicates partial reservoir depletion–Decreasing gas-oil ratio indicates advanced depletion. Source: Schlumberger and Labyrinth Consulting Services, Inc.

The sequence of events summarized in Figure 7 is demonstrated in Bakken field production shown below in Figure 8. Gas increased before oil production peaked in December 2014 and continued increasing through March 2016, and then declined.

Figure 8. Bakken gas production increased as oil production peaked and then it declined. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Water cut—water as a percent of total liquid produced—has increased for most operators over time (Figure 9) and this provides additional support for progressive Bakken depletion.

Figure 9. Bakken water cut has generally increased over time. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Company Performance, Break-Even Prices and Future Drilling Locations

Well performance for the 8 key operators shown above in Table 1 provides a framework for company performance and break-even prices for the Bakken play.

Reserves were estimated for more than 4,400 wells with first production in 2012 through 2015 using standard rate vs. time methods. Decline-curve analysis (DCA) was used to evaluate wells with at least 12 months of production history for key operators. Production group DCA was done separately by operator and year of first production for oil, gas and water.

Results are summarized in the following tables.

Table 2. Summary tables of key operator EUR and break-even prices and economic assumptions. Source: Drilling Info and Labyrinth Consulting Services, Inc.

None of the key operators’ average well breaks even at current Bakken wellhead prices of $42.50 per barrel although ConocoPhillips ($43.08 break-even price) is very close. EOG, XTO and Marathon all break even at prices less than $50 per barrel but other operators need higher oil prices to break even. It is worth noting that Bakken wellhead prices are about $10 per barrel less than WTI benchmark prices.

Current well density was calculated by measuring the area of the $50 commercial area (406,000 BOE cutoff) and dividing by the number of horizontal wells within that area. There are 5,500 producing wells within the 1.2 million acre commercial area shown in Figure 10. That equates to a current well density of 215 acres per well.

Figure 10. Bakken EUR map showing the $50 (406,000 BOE EUR) commercial area and well density table. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Tight oil operators describe infill spacing of 40 to 120 acres per well favoring the lower end of that range. Current well density in the Bakken core of 215 acres per well suggests substantial infill locations remain yet declining EURs, increasing water cut and falling GOR do not support further infill drilling.

The Bakken is unique because of the extraordinary lengths of lateral wellbores compared with other tight oil plays. Laterals are commonly more than 10,000 feet in length and often approach 12,000 feet.

Figure 11 shows lateral lengths in the Bakken. It is clear that within the commercial core area, most laterals exceed 8,000 feet. Available evidence suggests that current well density is sufficient  to fully drain reservoir volumes. That implies that further drilling will not result in producing new oil volumes but will interfere with and cannibalize production from existing wells.

Figure 11. Bakken lateral length map. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The Downside of Technology

The Bakken play represents the fullest application of modern horizontal drilling and hydraulic fracturing technologies. The Middle Bakken and Three Forks reservoirs are tight, naturally fractured sandstones that respond exceptionally well to long laterals and multi-stage fracture stimulation. Field rules allowed long laterals well before these were feasible in other plays.

The downside of efficiency and technology is that depletion has accelerated. Resulting higher initial rates masked underlying field decline that is becoming apparent only in wells with first production in 2015. The evidence for depletion is compelling but pressure data is not publicly available and is needed to complete the case.

The most appealing aspect of resource plays is their apparent lack of risk. Source rocks are the drilling target so finding oil and gas is given. Because the plays are continuous accumulations, there is no need to map and define a trap. Since the reservoirs are tight, seals are not an issue either. But commercial risk should be more of a concern for investors than it seems to be so far.

The downside is that there is no way to stay away from water and it is produced from day one in large volumes. The Bakken has produced 1.5 billion barrels of water along with its 2.2 billion barrels of oil over the decades. Where are they putting it and what does that cost?

Investors should be worried. As analysts cheered the resilience of shale plays after the 2014 price collapse, nearly a billion barrels of Bakken oil were produced at a loss–about 40% of total production since the 1960s.Vast volumes of oil were squandered at low prices for the sake of cash flow to support unmanageable debt loads and to satisfy investors about production growth. The clear message is that investors do not understand the uncertainties of tight oil and shale gas plays.

And all major Bakken producers continue to lose money at current wellhead prices. If observations presented here hold up, there may be nowhere for the Bakken to go but down. Higher oil prices may not help much because the best days for the play are behind us. Future profits were sacrificed for short-term objectives that lost the companies and their shareholders money.

The early demise of the Bakken should serve as a warning about the future of other tight oil plays.

 


*Statoil and Marathon depart somewhat from this general observation. GOR for these companies is lower than average and peaked earlier than most operators although Marathon’s GOR has been relatively flat.

Sincere thanks to Lynn Pittinger for his many useful comments during research for this post.

Don’t Hold Your Breath For $70 Oil

It is more likely that oil prices will fall below $50 per barrel than that they will continue to rise toward $70. Prices have increased beyond supply and demand fundamentals because of premature expectations about the effects of an OPEC production cut on oil inventories.

Last week’s 13.8 million barrel addition to U.S. storage was the second largest in history. It moved U.S. crude oil inventories to new record high levels.

Meanwhile, 130 horizontal rigs have been added to tight oil drilling since the OPEC cut was first announced in September.  That means that U.S. output will surge and will continue to be a drag on higher prices.

Comparative inventory analysis suggests that the current ~$53 per barrel WTI oil price is at least $6 per barrel too high. Don’t hold your breath for $70 oil prices.

Inventory Is The Key

Most analysts believe prices will increase steadily now that OPEC has decided to cut production. Their logic is that over-production caused lower oil prices and lower output should bring markets into production-consumption balance.

The problem is that production is not the same as supply and consumption is not the same as demand. Inventories lie in-between and modulate the flows from both sides of the production-consumption equation.

Inventory is clearly part of supply but is also a component of demand. Excess production goes into inventory when demand is less than supply. When consumption exceeds production, oil is withdrawn from inventory reflecting increased demand.

The International Energy Agency (IEA) reported last week that global liquids markets would move to a supply deficit by the first quarter of 2017 if OPEC production cuts take place as announced (Figure 1).

Figure 1. IEA Demand/Supply Balance until 2Q17. Source: IEA February 2017 Oil Market Report.

Yet the OECD inventories on which IEA’s forecast is based have increased and are now more than 400 million barrels above the 5-year average (Figure 2). In order for a supply deficit to develop in the first quarter of 2017, those stocks would have to be drastically reduced over the next 6 weeks. Comparative inventory analysis provides some context for the necessary magnitude of that reduction.

Figure 2. OECD Incremental Inventories Are At Record High Levels Although Absolute Inventories Have Flattened in Recent Months. Source: EIA and Labyrinth Consulting Services, Inc.

Comparative inventories index current storage levels against a moving average of values for the same calendar date over the previous 5 years. This provides the most reliable way of understanding oil-price trends by normalizing stock changes for seasonal variations and comparing them with 5-year average values.

Figure 3 shows that current OECD comparative inventories (C.I.) are at an all-time high level of more than 300 million barrels (absolute inventories are 3.1 billion barrels).

C.I. values around zero (+/- about 50 mmb) correspond to periods of high oil prices (>$80 per barrel) over the past decade. That suggests that comparative inventories need to fall approximately 200 to 300 million barrels to support $70 to $80 per barrel oil prices.

Figure 3. OECD Comparative Inventories Are At An All-Time High & Need to Fall 200-300 mmb To Support $70-$80 Per Barrel Oil Prices. Source: EIA STEO and Labyrinth Consulting Services, Inc.

What IEA is apparently showing in Figure 1 as a “demand/supply balance” is really a demand/production balance. If OPEC cuts move forward as announced, consumption will exceed production in the first two quarters of 2017 and withdrawals from storage will occur. That is a legitimate demand increase.

The billions of barrels of working capacity remaining in inventory are not considered supply in this calculation of balance. That distorts the supply-demand relationship.* At the very least, it does not treat that the ~550 million barrels of incremental inventory that has accumulated since December 2013 in Figure 2 as supply.

Inventory is like a savings account for oil. It may be in a separate account from checking but it is part of total available supply. This sort of confusion over definitions of supply and demand is easily avoided by considering comparative inventories.

Figure 4 is a cross-plot of OECD comparative inventories and Brent prices. It shows that current prices of ~$55 per barrel are approximately $10 per barrel over-valued compared to the trend line. It further shows that comparative inventory levels must fall ~200 million barrels to support ~$70 per barrel oil prices.

Figure 4. OECD Comparative Inventories At Record Highs–Comparative Inventory Suggests That Current Prices Are ~$10/Barrel Over-Valued. Source: EIA and Labyrinth Consulting Services, Inc.

Movement toward market balance cannot help but accelerate as a result of OPEC production cuts. Still, the massive stock reductions necessary to support higher oil prices will only occur over a much longer period.

It will take at least a year to reduce OECD inventories 400 mmb down to the 5-year average. This assumes that all OPEC cuts take place as announced and continue beyond the 6-month term of those agreements. It also assumes that non-OPEC production declines or at least remains static.

U.S. Production Will Not Remain Static

It is worth recalling that over-production by the U.S. and Canada was the trigger for the global oil-price collapse in 2014 (Figure 5). These two countries accounted for almost half (44%) of the incremental increase in crude oil and lease condensate production in the world as of March 2015 peak production levels.

Figure 5. U.S. + Canada Incremental Ouput: The Major Contributor to Low Oil Prices. Source: EIA and Labyrinth Consulting Services, Inc.

U.S. production fell more than 1 million barrels per day (mmb/d) from April 2015 through September 2016 but is now recovering because of higher oil prices (Figure 6). EIA forecasts that field production will increase to 9.28 mmb/d by the end of 2017 and will reach almost 10 mmb/d by December 2018.

Figure 6. U.S. Crude Oil Production Has Increased 290 kb/d in The Last 4 Months After Falling 1.06 mmb/d From Apr 2015 to Sept 2016. Source: EIA February 2017 STEO and Labyrinth Consulting Services, Inc.

EIA does not predict that WTI oil prices will exceed $60 per barrel throughout this 2-year period. It is interesting to note that EIA shows prices falling below $50 per barrel in February 2017 and remaining at that level through mid-year.

After OPEC announced that a production cut agreement was evolving in September 2016, the U.S. horizontal tight oil rig count accelerated. Since then, 130 rigs have been added and 67% have been in the Permian basin tight oil play (Figure 7). In recent weeks, the Eagle Ford play rig count has made impressive gains and the Bakken rig count has steadily increased also.

Figure 7. 130 Tight Oil Rigs Added Since Mid-Sept 2016: 67% Are In The Permian Basin. Source: Baker Hughes, EIA, Bloomberg and Labyrinth Consulting Services, Inc.

This reflects a massive flow of capital into these plays that will certainly result in production increases. Approximately $10 billion was spent in 2016 on Permian basin drilling and completion costs for horizontal tight oil wells. An additional $28 billion was spent on Permian land acquisitions.

Don’t Hold Your Breath for $70 Oil Prices

Traders, analysts and the press have consistently looked for every possible reason to anticipate higher prices since the collapse in 2014. Expectation of an OPEC production cut or freeze has provided an artificial lift to oil prices for at least a year and now, probably accounts for at least $6 per barrel of current $53 per barrel NYMEX futures prices.

A recent Wall Street Journal article noted a new record in long crude oil futures positions during the last week in January. It went on to speculate that this meant a possible end to the over-supply of oil and that prices should increase.

That observation is not supported by history. In fact, record long positions are commonly followed by a drop in oil prices. Notable examples shown in Figure 8 include price declines around the 2008 Financial Collapse, the 2014 world oil-price collapse, and the brief rally to $60 prices in the Spring of 2015.

Figure 8. Record Long Positions on Crude Oil Futures Suggests That Prices Will Fall. Source: CFTC, EIA and Labyrinth Consulting Services, Inc.

Inventory data provides compelling evidence that present oil prices are over-valued.  Last week, 13.8 million barrels (mmb) were added to U.S. crude oil storage. That’s the second highest weekly addition ever–the highest was 14.2 mmb on October 28, 2016 when WTI prices were about $5 per barrel lower.

Current crude oil inventories are at record high levels of 509 mmb (Figure 9). That’s 37 mmb more than at this time in 2016 and 140 mmb above the 5-year average level.

Figure 9. Crude Oil Inventories Are At Record Levels 140 mmb Above the 5-Year Average. Source: EIA and Labyrinth Consulting Services, Inc.

Comparative inventories are also near record highs (Figure 10). When C.I. was at this level in March 2016, WTI prices were around $39 per barrel. When C.I. was slightly lower in August 2016, prices were about $47 per barrel. The trend line in Figure 10 shows that oil prices are probably about $6 or $7 per barrel over-valued.

Figure 10. Comparative Inventories Near Record High Levels–Comparative Inventories Suggest Current Prices Are ~$7 Per Barrel Over-Valued. Source: EIA and Labyrinth Consulting Services, Inc.

Oil prices do not always reflect underlying fundamentals but markets eventually adjust because of them. Comparative inventory analysis suggests that current oil prices are over-valued. It is possible that markets have already priced in anticipated uplift from OPEC production cuts. If so, prices may not increase much beyond present levels and expectations of $70 prices any time soon are improbable.

OPEC cuts have almost certainly put a floor under oil prices but volatility will continue to characterize markets as it has for the past 2 years. U.S. production is a wild card that will almost certainly be a drag on upward price movement. My guess is that WTI prices are likely to move below $50 per barrel until effects of OPEC production cuts are reflected in falling global inventories.

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*To its credit, IEA shows 2016 inventory declines reaching the maximum levels of the 2011-2015 average. That doesn’t change the fact that current stock levels are 400 mmb above the 2012-2016 5-year average. That’s why comparative inventories are essential.

The Keystone XL Pipeline: A Risky Bet on Higher Oil Prices and Tight Oil

The Keystone XL Pipeline (KXL) is a bet on much higher oil prices several years from now.  It will take at least $85 oil prices to develop the new oil sand projects needed to fill the pipeline.

It is also a bet that U.S. tight oil output will continue to grow and will need heavy oil to blend for refining. Both bets are risky.

A Bet On Higher Oil Prices

KXL would add about 830,000 barrels per day (b/d) to the 1.3 million b/d already moving through the base Keystone Pipeline system completed in 3 phases between 2010 and 2014 (Figure 1) when oil prices were more than $90 per barrel.

Keystone & Keystone XL Map 29 Jan 2017

Figure 1. Location map of Keystone XL and Base Keystone pipeline systems. Source: TransCanada and Labyrinth Consulting Services, Inc.

It was not until prices exceeded $70 per barrel in 2005 (December 2016 dollars) that oil sands expansion began to accelerate (Figure 2). Since then, production has almost doubled from 1.3 to 2.4 mmb/d and cumulative production has increased from 5.4 to 10 billion barrels.

Oil Sands Production Accelerated at $30 and $70 per Barrel

Figure 2. Oil Sands Production Nearly Doubled After Oil Prices Exceeded $70 Per Barrel. Source: Statistics Canada and Labyrinth Consulting Services, Inc.

By comparison, the Bakken and Eagle Ford tight oil plays have each produced 2.4 billion barrels. The Permian horizontal tight oil plays–Spraberry, Wolfcamp and Bone Spring–have produced less than 1 billion barrels.*

Oil Sands-Tight Oil Cumulative Comparison Table FEB 2017

Table 1. Comparison of Oil Sands and U.S. tight oil plays. Source: Statistics Canada, EIA, Drilling Info and Labyrinth Consulting Services, Inc.

In 2015, oil prices averaged only $43 per barrel. No new oil sand projects have been sanctioned since oil prices collapsed in 2014 although 3 pilot projects have been approved since prices moved into the $50 per barrel range. Approval is not the same as sanctioning and these 3 projects together would add only 35,000 b/d.

It seems unlikely that new greenfield projects will be sanctioned until oil prices move much higher (Canadian heavy oil (WCS) trades at a 25% discount to WTI). Assuming that prices stabilize in the $50 to $60 range, it is reasonable that pilots may evolve into brownfield expansion projects over the next year or two.

The Canadian Association of Petroleum Producers estimates that annual oil sand production will grow 128,000 b/d until 2021 and then, grow more slowly at 59,000 b/d. If all of that new oil were going to KXL, it would not reach capacity for about 10 years. But other pipelines are already approved for expansion and will probably get much of the oil before KXL is completed.

TransCanada’s bet, therefore, is that oil prices will move much higher and more quickly than most forecasts anticipate and that the volumes will be there by the time that the pipeline is built.

Light Oil and Heavy Oil

U.S. tight oil plays produce ultra-light oil. Almost all of it is too light for refinery specifications. That means that it must be blended with heavy oil in order to be refined and that is why there is demand for Canadian heavy oil.

The Keystone XL Pipeline is, therefore, a bet that tight oil plays will continue for several decades.

Similarly, Canadian viscous, heavy oil must be diluted with ultra-light oil to move through pipelines. Because of that, Canada is the biggest importer of U.S. light oil.

The U.S. imports almost 3 times more oil from Canada than from Saudi Arabia (Figure 3). Imports from Canada are roughly equal to the amount from Saudi Arabia, Venezuela, Mexico, Colombia and Iraq combined.

The U.S. Imports Almost 3 Times More Oil From Canada Than From Saudi Arabia

Figure 3. The U.S. imports almost 3 times more oil from Canada than from Saudi Arabia. Source: EIA and Labyrinth Consulting Services, Inc.

The average U.S. refinery is designed for 31° API gravity oil but 80% of domestic crude oil is more than 30° and 70% is more than 35° API gravity so it must be blended with heavier oil before it can be refined (Figure 4). The Keystone Pipeline carries oil that is approximately 22° API so the fit with lighter U.S. oil is perfect.

80% of U.S. Crude Oil > 30 API and 70% > 35 API

Figure 4. 80% of U.S. Crude Oil is greater than 30° API and 70% is greater than 35° API. Source: Drilling Info, EIA, Labyrinth Consulting Services, Inc. and Crude Oil Peak.

The increasing percentage of ultra-light oil (>40° API) after 2011 shown in Figure 4 is because of the growth of tight oil plays. More than 95% of tight oil is greater than 30° API and these plays now account for more than half (52%) of U.S. output.

It is, therefore, no surprise that 98% of the oil imported by the U.S. is heavy that is, less than 35° API gravity (Figure 5). The biggest sources of heavy oil other than Canada are Saudi Arabia, Venezuela and Mexico.

98% of U.S. Imports Less Than 35° API Gravity

Figure 5. 98% of U.S. Imports Less Than 35° API Gravity. Source: Drilling Info, Labyrinth Consulting Services, Inc. and Crude Oil Peak.

Production from Venezuela and Mexico is declining (Figure 6). Canada, Iraq and Saudi Arabia have strong production histories and are, therefore, more reliable long-term providers of heavy oil to the U.S. Canada has many advantages over other providers because of geographic proximity, supply security and price.

Mexico, Venezuela, Nigeria and Angola Have Declining Production

Figure 6. Mexico, Venezuela, Nigeria and Angola Have Declining Incremental Production. Source: EIA and Labyrinth Consulting Services, Inc.

Venezuela has enormous reserves of heavy oil and declining production is mostly because of political and social instability. This could change but it is more likely that Venezuela’s problems will continue. Mexico’s production decline is more systemic because the country has not made a significant new discovery since 1980.

A Bet on Tight Oil

So far, so good for the Keystone XL Pipeline but what about the longevity of the tight oil plays?

Production from the Bakken and Eagle Ford plays is in marked decline and Permian tight oil production growth has slowed (Figure 7). This is despite record high numbers of producing wells in all 3 plays.

Eagle Ford-Bakken-Permian PROD by API 1 FEB 2017

Figure 7. Bakken and Eagle Ford production are declining and Permian basin tight oil production growth has slowed. Source: Drilling Info, Labyrinth Consulting Services, Inc. and Crude Oil Peak.

The Bakken and Eagle Ford plays have probably peaked based on remaining core area locations, generally poorer performance from recently drilled wells compared to older wells, and current rig activity. Assuming that oil prices recover to the $70 range in coming years, production should increase as more marginal locations become economically viable–just not to peak levels reached in 2015.

The Permian basin, on the other hand, should continue to grow for several years for all of the reasons that the Bakken and Eagle Ford will not. There are substantial areas in the Permian core that have not been fully developed. Well performance continues to improve and the horizontal rig count has increased 70% since mid-August to 243.

Most forecasts are optimistic about tight oil output. The EIA Annual Energy Outlook 2017 anticipates that tight oil production will decline in 2017 but recover to 2015 peak levels by 2019 (Figure 8). WTI oil prices are expected to be $64 per barrel then and slowly increase to $80 by 2025. Tight oil production will rise to 6 mmb/d by 2026.

EIA Forecast- Tight Oil Will Not Recover to 2015 Levels Until 2019

Figure 8. EIA Forecast: Tight Oil Will Not Recover to 2015 Levels Until 2019 and Then Increase to 6 mmb/d by 2026. Source: EIA AEO 2017 and Labyrinth Consulting Services, Inc.

Although the forecast seems reasonable, it assumes that 2016 was the oil-price floor and that prices will continue to increase. It also suggests that prices will not reach the $70 threshold for new oil sand projects for 5 years. Other forecasts like HSBC are more aggressive and anticipate mid-$70 WTI prices as early as 2018.

The Big Long

If the last few years since the oil-price collapse have taught us anything it is that prices are unlikely to move in one direction. Nor are they likely to conform to mainstream analyst views.

Markets have been driven partly by an expectation that prices must inevitably return to levels of at least $70 to $80 per barrel sooner than later. This belief has endured despite a persistent global supply surplus and outsized inventories. The long-anticipated OPEC deus ex machina was lowered onto the stage in late 2016 and markets responded enthusiastically. Yet WTI prices have not crossed $55 per barrel so far.

It is difficult to find supply-demand fundamentals support even for the limited price rally that began with the OPEC announcement.  There may already be an expectation premium of $10-12 per barrel built into current prices. Yet markets don’t always follow fundamentals in the short term although they return to them eventually.

U.S. ultra-light oil production is a central component of the global supply dilemma. Permian basin companies are adding rigs like the boom days of 2011 to 2014 have already returned. When tight oil output is high, some fraction can neither be refined nor exported and simply adds to inventories. This occurs despite the best efforts of Canadian oil sand producers to bring as much heavy oil to the party as they can.

Oil consumption remains relatively weak in the U.S. This is disturbing against the backdrop of surging tight oil rig counts.

Consumption increased with very low oil prices in 2015 and early 2016 but not to the levels before the Financial Collapse of 2007-2008 (Figure 9). Most of the increase was from greater gasoline use and more refined products exports. Modestly increasing prices in 2016 dampened consumption suggesting that demand is highly price-sensitive.

Consumption Fell >2 mmb-d After 2005 But Recovered

Figure 9. Consumption fell >2 mmb/d after 2005 but recovered 1 mmb/d with increased refined product exports, lower oil prices & increased gasoline use. Source: EIA and Labyrinth Consulting Services, Inc.

This does not represent peak demand.  All credible forecast anticipate oil-demand growth over the next decade or so, albeit at a slower rate. Instead, it reflects an economy weakened by excessive debt and changes in Federal Reserve Bank monetary policy after mid-2014.

These rather gloomy observations may explain TransCanada’s motivation to complete the Keystone XL Pipeline now. I’m talking about a long bet on oil prices.

Future supply constraints will become greater the longer new E&P project investments are deferred. At the same time, the decline of production from developed fields will be more pronounced. Improved production efficiency will further accelerate reserve depletion. Meanwhile, new field discoveries are at the lowest level in decades and the average reserve size of those discoveries has gotten smaller.

Oil prices will increase dramatically at some time in the next several years. That should lead to the next oil boom and the Keystone XL Pipeline will be there to provide heavy oil to U.S. tight oil plays.

There is little doubt that a supply crunch lurks in the future. The risk for the Keystone XL is that much higher prices will collapse the global economy before new projects can fill the pipeline and pay out the investment.

___________________________________________________________________________________

*EIA’s Drilling Productivity Report estimate of 4.8 billion barrels includes all conventional production in the counties in which the tight oil plays are located.

Matt Mushalik contributed to the research on light oil.

The Days of Cheap Natural Gas Are Over

Natural gas prices averaged a little more than $2.50 per mmBtu (million British Thermal Units) in 2016. Those days are over. Prices will average at least $3.50 to $4.00 in 2017.

Prices have more than doubled since March 2016 but gas is still under-valued. Supply is tight because demand and exports have grown and shale gas production has declined.

In April of last year, I wrote that natural gas prices should double and they did. Henry Hub spot prices increased 2 1/2 times from $1.49 to $3.70 per mmBtu and NYMEX futures prices doubled from $1.64 to $3.30 per (Figure 1).

Natural Gas Prices Have More Than Doubled Since March 2016 The Days of $2.50 Gas Are Gone

Figure 1. Natural Gas Prices Have More Than Doubled Since March 2016: The Days of $250 Gas Are Gone. Source: EIA and Labyrinth Consulting Services, Inc.

Nevertheless, gas prices are still too low. Storage was at record high levels throughout 2016 reaching 4.1 Tcf (trillion cubic feet) and 84% of working capacity in mid-December. Storage has fallen 1.1 Tcf in the last month to 61% of capacity. That is below the 5-year average (pink, dashed line in Figure 2).

Gas Storage Levels Have Fallen 1.1 Tcf To Below the 5-Year Average

Figure 2. Gas storage levels have fallen 1.1 Tcf in the last month to below the 5-year average. Source: EIA and Labyrinth Consulting Services, Inc.

Comparative inventory (C.I.) trends are the best indicators of gas price. These compare current storage to a moving average of levels for the same date over that last 5 years and correlate negatively with spot prices (Figure 3). C.I. fell 120% from May to December 2016 and gas prices doubled.

Comparative Inventories Have Fallen Sharply Since May

Figure 3. Comparative Inventories Have Fallen Sharply Since May. Source: EIA and Labyrinth Consulting Services, Inc.

There are occasional short-lived excursions from the correlation. These typically occur when the market believes there is sufficient supply for the winter heating season in September or October. The market over-shoots with lower prices that are later corrected upward.

The November 2016 price drop shown in Figure 3 is an example of this phenomenon that occurred outside of the normal September-October pattern. A similar price drop began in January 2017.

Figure 4 shows the November and January price drops as departures from comparative inventory vs. spot price trend lines.* The current trend line (May 2016 – January 2017 in red) closely resembles trends for periods when gas prices were $4.00 per mmBtu or higher (August 2011 – March 2013 in orange and March 2013 – March 2014 in purple).

Natural Gas Is Undervalued By $0.50 - $1.00-mmBtu

Figure 4. Natural Gas Is Undervalued By $0.50 – $1.00/mmBtu. Yield curves show relevant trend lines for current natural gas prices. Source: EIA and Labyrinth Consulting Services, Inc.

Recent price drops partly reflect market expectation of increased gas production in the Marcellus Shale play because of new 2017 pipeline capacity. They also suggest that the market anticipates greater tight oil and associated gas production following OPEC production cuts.

Figure 4 suggests that current gas prices are under-valued and should be at least $3.75 and probably closer to $4.00 instead of $3.27/mmBtu, last week’s average spot price.

Supply and demand fundamentals also support higher prices. Gas production has been declining since February 2016. At the same time, net imports are decreasing as pipeline and LNG exports increase.

Shale gas production is declining and conventional gas has been in terminal decline for the past 15 years. As a result, the supply surplus that has existed since December 2014 has disappeared and a supply deficit began in January (Figure 5).

Natural Gas Supply Deficit In January 2017

Figure 5. Natural Gas Supply Deficit in January 2017. Source: EIA January 2017 STEO and Labyrinth Consulting Services, Inc.

During the last supply deficit from December 2012 to November 2014, Henry Hub spot prices averaged $4.05 per mmBtu. NYMEX futures prices reached $3.93 in late December 2016 before closing at $3.20 last week. Both spot and futures prices should return to $3.75 or higher once the market recognizes the reality of tighter gas supply.

Shale gas production has declined almost 1 Bcf per day since August 2016 and all shale gas plays are in decline (Figure 6).

Shale gas production has declined 1 Bcfd since August 2016

Figure 6. Shale gas production has declined 1 Bcfd since August 2016. Source: EIA and Labyrinth Consulting Services, Inc.

Only the Marcellus and core Utica plays break even at $4 gas prices. The Marcellus has stopped growing and more pipeline capacity to better-priced markets won’t happen as quickly as some analysts believe. Although the Utica play has growth potential, it will be spread over several years and will be largely cancelled by increased exports.

Shale gas magical thinking remains strong but the paradigm of infinite, cheap supply is no longer working. There is now too much demand between power consumption and exports to keep up with declining production.

Once decline begins, it is almost impossible to turn around short of a massive drilling campaign. The requisite capital and public support are simply not there.

That means that prices will increase. Enough additional drilling will become marginally profitable to keep natural gas affordable but it is unlikely the U.S. will return to a supply surplus any time soon. The exuberant days of cheap, abundant natural gas are over.

*Developed by my colleague J. M. Bodell who has taught me everything that I know about comparative inventories.

Despite OPEC Production Cut, Another Year Of Low Oil Prices Is Likely

An OPEC production cut offers oil producers hope for higher prices in 2017. But there is a dark cloud hanging over that expectation. Global storage inventories must be substantially reduced before higher oil prices can be sustained. Some of U.S. tight oil has nowhere to go but into storage because it can neither be refined nor exported.

If all OPEC cuts take place as announced, it will be at least a year before sufficient inventory reductions allow prices to move much higher than current levels. If not, lower oil prices will last even longer.

The OPEC Production Cut and Spare Capacity

OPEC agreed to cut production in November partly because it was incapable of sustaining output at 2016 levels. Announcing a cut is a good way to cover the reality that commercial reserve limits have been reached.

Analyst narratives have created the unfounded but widely accepted belief that OPEC has a strategy, and that strategy involves a price war with U.S. tight oil producers. The cartel’s inaction since 2014 more probably reflected an unwillingness to repeat the mistake of cutting output between 1980 and 1985: those cuts had little effect on world over-supply and damaged OPEC market share and revenue.

The possibility of a production freeze  was suggested in February 2016 when oil prices were less than $30 per barrel. Expectation of OPEC action and improving fundamentals lifted prices to an average of $43 per barrel in 2016.

Failure to act in November probably would have sent prices into the mid-$30 range. As my colleague Allen Brooks remarked just after the cut was announced, this is more about setting an oil-price floor than about raising prices.

By July 2016, OPEC surplus production capacity had fallen to only 0.92 mmb/d  (million barrels per day).  The all-time low was 0.71 mmb/d in late 2004 (Figure 1).

low-spare-capacity-was-a-key-factor-in-the-opec-output-cut

Figure 1. Low surplus production capacity was a key factor in the OPEC output cut. Incremental spare capacity volumes are shown relative to the minimum levels in the time series; in this case, December 2004. Source: EIA and Labyrinth Consulting Services, Inc. Source: EIA and Labyrinth Consulting Services, Inc.

The negative correlation between oil price and OPEC spare capacity is obvious. Low OPEC surplus after 2004 along with increased demand from China corresponded to rising oil prices that reached $146 per barrel in June 2008. The exception to the correlation in late 2006 resulted from demand destruction when real oil prices (2016 dollars) exceeded $85 per barrel for the first time since 1982.

A production cut may bring higher short-term prices but it should also result in higher OPEC spare capacity, a negative factor for higher prices.

Massive Oil Inventories Are The Problem

After the 2008 Financial Collapse, declining OPEC spare capacity, falling OECD inventories, low interest rates, and record-high oil prices produced a classic oil-production bubble.

The bubble burst in 2014 as over-production resulted in swelling inventories (Figure 2).

oil-prices-collapsed-because-of-inventory-imbalance-will-not-recover-until-balance-is-restored

Figure 2. Oil prices collapsed because of inventory imbalance and will not recover until balance is restored. Incremental inventory volumes are shown relative to the minimum levels in the time series; in this case, November 2013. Source: EIA and Labyrinth Consulting Services, Inc.

There is little chance that oil prices will return to the $70-80 range that many analysts predict until OECD storage falls approximately 400 million barrels to its 5-year average. If all the announced output cuts take place and extend beyond the 6-month term of the agreement, that will take at least a year.

The idea that there was a price war between OPEC and tight oil producers arose largely from a story line that analysts promoted. It was accepted and maintained largely by American hubris.

An over-supply of oil was the enemy if there was one and it negatively affected OPEC as much as other world producers. It resulted from the longest period of high oil prices in history. Brent was more than $90 per barrel from October 2010 through October 2014.

It is true that tight oil over-production was the biggest single offender in the supply glut and price collapse but all global producers contributed their share. It is likely that OPEC would have cut production in late 2014 if Russia had agreed to participate.

Ali Al-Naimi, the Saudi oil minister at that time said, “We met with non-OPEC producers, we asked ‘what are you going to do?’ They said nothing. We said the meeting is over.”

Tight Oil Is Not A Threat To OPEC

Tight oil has never been a long-term threat to OPEC because the reserves are relatively low. EIA year-end 2015 data indicates that U.S. tight oil proven reserves are less than 12 billion barrels.

Canada’s and Venezuela’s combined oil sands reserves exceed 350 billion barrels. Oil sands are Saudi Arabia’s and OPEC’s chief reserve competition, not U.S. tight oil (Figure 3).

oil-sands-are-saudi-arabias-chief-reserve-competition-not-u-s-tight-oil

Figure 3. Oil Sands Are Saudi Arabia’s Chief Reserve Competition, Not U.S. Tight Oil. Source: EIA, Hyperdynamics and Labyrinth Consulting Services, Inc.

In fact, tight oil production is a plus for OPEC. The U.S. must import increasing amounts of OPEC heavier oil for blending in order to refine the ultra-light oil produced from tight oil plays.

OPEC’S share of U.S. imports has increased 9% since January 2015. Total U.S. crude oil imports have increased about 1 million barrels per day and most of the increase has come from OPEC countries (Figure 4).

us-crude-oil-imports-opec-dec-2016

Figure 4. U.S. Total Imports of Crude Oil and Imports From OPEC Countries Have Increased 1 Million Barrels Per Day Since Early 2015. Trend lines represent polynomial fits. Source: EIA, Labyrinth Consulting Services, Inc. and Crude Oil Peak.

Canada could provide almost unlimited amounts of heavy oil to the U.S. but the Obama Administration’s decision to block the Keystone XL Pipeline means increasing reliance on OPEC.

Another Year of Lower Oil Prices

OPEC members leaked the possibility of a production freeze in early 2016 when oil prices were $26 per barrel. Fears of further price collapse began to fade reinforced by improving fundamentals.

The U.S. horizontal rig count fell almost 250 rigs (44%) between the end of 2015 and late May 2016. The world production surplus peaked in January 2016 and moved unevenly toward market balance throughout 2016 (Figure 5).

the-world-production-surplus-peaked-in-january-2016-has-since-moved-unevenly-closer-to-market-balance

Figure 5. The World Production Surplus Peaked in January 2016 and Has Since Moved Unevenly Closer To Market Balance. Source: EIA and Labyrinth Consulting Services, Inc.

Oil prices rose to more than $50 per barrel by June but prices fell below $40 in August when an OPEC meeting in Doha failed to produce a production freeze agreement (Figure 6). Increased global output, slowing demand growth and higher petroleum products inventories also weighed on prices.

at-least-10-of-expectation-premium-is-included-in-current-oil-price

Figure 6. $10-$15 of Expectation Premium is Included in Current Oil Price. Source: EIA, CBOE and Labyrinth Consulting Services, Inc.

In late September, OPEC abandoned its market-based approach begun in 2014 and agreed to cut production. Prices moved up and down as the likelihood of a production cut waxed and waned through October and November. A deal was announced on November 30 and prices have increased from $43 to $54 per barrel mostly on sentiment.Without participation by Russia, there probably would have been no agreement to cut production.

It is clear that like the global economy, the oil-price recovery has been weak and fragile. Hope for some OPEC action has been a significant support for prices throughout 2016. There is probably $10 to $15 of “expectation premium” built into current oil prices.

Some analysts forecast $70 oil prices in 2017. I won’t recite the litany of reasons why OPEC members may cheat or that Libya and Nigeria may increase production. I am focused on the U.S. horizontal tight oil rig count that has increased 34% (85 rigs) since mid-September, 65% of which are in the Permian basin.

If two years of low oil prices have taught us anything it is that shale companies will produce oil at almost any price provided that investors give them money to drill. There does not seem to be any limit to investors’ willingness to believe that tight oil is a good bet.

There never was an over-riding strategy behind OPEC’s unwillingness to cut output over the last 2 years. More probably, it was based on a pragmatic recognition that cutting production without participation by Russia would not meet the cartel’s needs. Now that surplus capacity is exhausted and Russia has agreed to participate, a production cut makes sense.

U.S. output will rise but imports of heavier oil will be needed for blending. Excess tight oil will go into storage keeping U.S. inventories high and U.S. crude prices at a discount to Brent.  OPEC will sell heavier oil to the U.S. at higher international prices. OPEC knows this but those who are celebrating what they believe is OPEC’s surrender in a make-believe price war, apparently do not.