Returning To Market Balance: How High Must Prices Be To Save The Oil Industry?

Posted in The Petroleum Truth Report on May 16, 2016

The global oil market is returning to balance based on the latest data from the EIA. That should mean higher oil prices but how high must prices be to save the industry?

Data suggests that oil producers need prices in the $70-80 range to survive. That is unlikely in the next year or so. Without more timely price relief, the future looks grim for an industry on life support.

EIA Revises Consumption Upward

Major EIA revisions to world oil consumption* data provide a new perspective on oil-market balance.

The world was over-supplied by only 570 kbpd of liquids in April compared to EIA’s earlier estimate for March of 1,450 kbpd; that March estimate has now been revised downward to 970 kbpd (Figure 1). February’s over-supply has been revised downward from 1,180 to 240 kbpd.

These revisions indicate that oil markets are much closer to balance than previously thought.

World Market Balance MAY STEO

Figure 1. EIA world liquids market balance (supply minus consumption). Source: EIA and Labyrinth Consulting Services, Inc.

EIA adjusted world consumption growth for 2016 upward to 1.4 mmbpd. Its estimate for 2017 is now a very strong 1.54 mmbpd (Figure 2).

EIA DEMAND GROWTH

Figure 2. EIA annual consumption growth and forecast. Source: EIA and Labyrinth Consulting Services, Inc.

IEA’s demand growth estimate for 2015 is 1.8 mmbpd but the agency maintains its 1.2 mmbpd estimate for 2016 based on concerns about global economic growth.

It is easy to be skeptical about these new revelations but reports by both groups have been pointing toward improving market balance for some time.

Oil Prices and Market Balance

Oil markets are never in balance. Producers always misjudge demand and either over-shoot or under-shoot with supply. Balance is simply a zero-crossing from one state of disequilibrium to the next, from surplus to deficit and back again.

Since 2003, the oil market has only been within 0.25 mmbpd of balance 16% of the time. The average price (2016 dollars) for that near-market balance rate was $82 per barrel (Figure 3).

Market Balance Price

Figure 3. World liquids market balance (supply minus consumption), 2003-2016. Source: EIA and Labyrinth Consulting Services, Inc.

But that was essentially the average oil price of $78 per barrel for the entire period (Figure 4).

CPI-Adjusted WTI Prices, 2000-2016

Figure 4. CPI-adjusted WTI prices, 2003-2016. Source: EIA and Labyrinth Consulting Services, Inc.

In fact, market balance occurred in every monthly average oil-price bin in Figure 5 except $130 per barrel.  Although prices above $90 per barrel represent 37% of near-market balance prices from 2003 to 2016, oil prices also averaged more than $90 per barrel 36% of the time during that 15-year period.

Market Balance Histogram

Figure 5. Brent oil price histogram at plus-or-minus 0.25 million barrels per day of world liquids production. Source: EIA & Labyrinth Consulting Services, Inc.

In other words, market balance merely reflects whatever price the market deems necessary to maintain supply at the time. There is no clear causal relationship between market balance and specific higher or lower oil prices. Balance merely represents the midpoint between prices on either side of the disequilibrium states that it demarcates.

Our recent memory is of $90-100 per barrel prices so we think that was normal. When those prices prevailed in 2007-2008 and in 2010-2014, the disequilibrium state of the market was largely deficit. Moving toward market balance and being on the deficit side of market balance are hardly the same thing.

The Price Producers Need

Lower-cost oil producers of the world (Kuwait through Deepwater in Figure 6) need $50-80 per barrel and an average price of $65 per barrel to break even. Probably $70-80 is a minimum price range for near-term survival of more efficient producers allowing that some will still lose money at those prices.

IMF OPEC and Unconventional Break-Even Prices

Figure 6. Projected 2016 break-even oil prices for OPEC and unconventional plays. Source: IMF, Rystad Energy, Suncor, Cenovus, COS & Labyrinth Consulting Services, Inc.

Existing Canadian oil sands projects, and Bakken and Eagle Ford Shale core areas are among the very lowest-cost major plays in the world. For all of the OPEC rhetoric about the high cost of unconventional oil, few OPEC countries are competitive with unconventional plays when OPEC fiscal budgetary costs are included.

Tight Oil Companies On Life Support

Despite this relatively favorable rating, most unconventional producers are on life support at current oil prices.

All of the tight oil-weighted companies that I follow had negative cash flow in the first quarter of 2016 except EP Energy and Occidental Petroleum (Figure 7). Nine companies increased their capex-to-cash flow ratios compared with full-year 2015 results and six increased that ratio by more than 2.5 times.

Q1 Tight Oil CE-CF

Figure 7. First quarter 2016 and full-year 2015 tight oil E&P company capital expenditure-to-cash flow ratios. Source: Google Finance and Labyrinth Consulting Services, Inc.

On average in 2016, companies spent $1.90 more in capex than they earned while in 2015, they spent $0.60 more than they earned. The percent of negative cash flow has increased more than three-fold so far in 2016 compared with 2015.

The good news is that about half of the companies (Apache, EOG, Laredo, Continental, Statoil, and Diamondback) only increased negative cash flow slightly despite falling revenues. The bad news is that the rest (Marathon, Whiting, Pioneer, Murphy, ConocoPhillips and Newfield) did not.

The debt side of first quarter earnings is far more disturbing. The average debt-to-cash flow ratio for tight oil companies increased more than 3-fold to 10, up from 3 in 2015 (Figure 8).

Q1 Tight Oil D-CF

Figure 8. First quarter 2016 and full-year 2015 tight oil company debt-to-cash flow ratios. Cash flow was annualized based on first quarter data. Source: Google Finance and Labyrinth Consulting Services, Inc.

Debt-to-cash flow is a critical determinant of risk from a bank’s perspective because it measures how many years it would take to pay off debt if 100% of cash from operations were used for this purpose. This means that it would take these companies an average of 10 years to pay down their total debt using all cash from operating activities.

The energy industry average from 1992-2012 was 1.53 and 2.0 was a standard threshold for banks to call loans based on debt-covenant agreements. That threshold increased in recent years to about 4 but 10 years to pay off debt is clearly beyond reasonable bank exposure risk.

 

How High Might Oil Prices Go?

Current prices around $46 per barrel are a big improvement from earlier this year when prices were below $30. Nevertheless, all producers–companies and exporting countries alike–are failing and probably need sustained prices in the $70-80 per barrel range to survive.

That is a stretch from the mid-$40’s resistance level of the past 10 months or so (Figure 9).

NYMEX Futures & OVX Sept 2014-2016

Figure 9. NYMEX WTI futures prices and OVX oil-price volatility index, September 2014-2016. Sourc: EIA, CBOE & Labyrinth Consulting Services, Inc.

In fact, EIA’s forecast data suggest that improving market balance may result in a minor supply deficit by the second half of 2017 (Figure 10). Its forecast for Brent price, however, is to remain below $60 per barrel.

EIA Market Balance-Brent-Forecast

Figure 10. EIA market balance, Brent price and forecast. Source: EIA & Labyrinth Consulting Services, Inc.

Through A Glass Darkly

The price rally that began in late January-early February 2016 seems to have substance even though there are outsized inventories that concern serious observers. Anticipation of future supply deficits are moving prices higher in defiance of present-moment fundamentals to the contrary. Recent consumption data from EIA support improving oil prices going forward.

At the same time, I expect to see high price volatility and price cycling similar to what has characterized oil markets since prices collapsed in late 2014. The current cycle appears to have found resistance at about $46-48 per barrel and will probably move downward in an uneven way over the next few months before beginning the next upward cycle.

Recent outages in Kuwait, Nigeria, Venezuela and Canada have underscored the fragility of supply despite the prevailing production surplus. Under-investment during 2015 and 2016 will undoubtedly lead to much higher oil prices in just a few years especially with strong demand growth.

Prices must eventually reach the $70 to $80 per barrel range to restore balance sheets enough that investment may resume. It is, however, difficult to see that happening in 2016 or 2017 without serious supply disruptions or an OPEC production cut. Otherwise, prices should gradually and irregularly improve over the course of several 4- to 5-month cycles.

The weak global economy will be an important check on price recovery. Demand has improved during the period of lowest real oil prices since the 1990s but I expect demand destruction at prices higher than about $60 per barrel.

The last two years have severely damaged the oil industry and some producers and plays will not survive even with higher prices.

A return to market balance does not necessarily mean that prices will return to the $70-80 range. That is the level necessary to keep enough producers in business to maintain an adequate supply of the world’s primary energy source at a somewhat affordable price.

If a weakened world economy cannot support those prices, we may see supply dwindle in a few years to levels that cause price spikes that cannot be absorbed. That may bring a traumatic end to the Age of Oil. People will have to learn to get by with less in a future based on lower energy-density fuels and lower economic growth potential than oil has provided.

Primary Energy Pie October 2015

*Consumption a measure of oil use. It is often used as a proxy for demand but does not address the supply stream including stocks. It does not measure requirement for oil that may differ from use. 


12 comments on this entry


  1. Great post, as always, Art. I wonder if you’ve spent much time looking at the way crude light futures have taken over the role of driving stock algorithms higher. I just posted a piece this morning that demonstrates pretty clearly how the Dow (true also, for SPX, etc.) has benefited greatly by very timely moves in CL, just as it did with USDJPY in years past. It goes a long ways toward explaining most of the otherwise puzzling timing of CL’s spikes higher.

    http://pebblewriter.com/djia-catapulting-the-propaganda/


  2. Michael,

    Thank for the comment and link to your website. I follow WTI futures and believe that CL is largely determined by traders and will be as long as inventories remain at nosebleed levels. They will bid the price up until there are no takers on the other side and the willingness to buy the other side is part of the propaganda catapult.

    All the best,

    Art


  3. Thanks for posting this Art. I’m just very disappointed every time I have to click at the ”read more at forbes”…. They must have the most obnoxious site in the universe..


  4. Tom,

    True! They wanted an exclusive deal with me for 7 days and I said no. We then negotiated 48 hours where I could post most of it on my site with a link to theirs.

    Come back Wednesday morning and the whole post will be on my site.

    Life is about compromises.

    All the best,

    Art


  5. Thanks Art!! Great to get unbiased information.

    Question. The storage in Oklahoma is still increasing. In your opinion, are we at risk of running out of storage in Cushing? Or is the market right in not worrying about Cushing inventory? It seems very confusing to me.

    Also, if the US has a recession and China goes to deflation, does oil demand go down significantly, or does demand just continually slowly increase over time?


  6. Michael,

    Both Cushing and Gulf Coast (PADD 3) are at 93% of working capacity. Cushing continued to increase last week but Gulf Coast decreased a bit. Comparative inventories everywhere except Cushing are falling. If we can believe the new EIA market-balance data and Goldman Sachs’ pronouncements, storage should not be a problem. If these new revelations are untrue, then the price rally should end and storage could become a problem. We have to wait for storage data tomorrow.

    The weakness of the global economy has been among my major concerns for a crude oil price recovery. I believe that demand is price-sensitive. We have seen a strong demand response to the lowest real oil prices since the 1990s. What happens to demand at $50-60 prices? My guess is that it weakens. There hasn’t been any bad news about the Chinese economy since the current price rally began. China’s problems were a big part of the slump to $27/barrel in October-January. I don’t think China’s problems have gone away. Neither have we heard any bad news about Europe’s economy, but the Greek crisis last year was a factor in last summer’s price slump. Like China, Europe’s problems haven’t gone away.

    I want to be positive about the current price rally but it has resulted from a perfect confluence of no bad news about the global economy, hope for a production freeze and some supply outages that were also strangely absent for much of the last 2 years. So, the answer to your questions is that great uncertainty remains but inventories have been and remain the biggest obstacle to price recovery. Data will uncover the reality of that situation over the coming weeks.

    Thanks for your questions,

    Art


  7. Art, Your comments regarding how the world will deal with oil in the future has touched on some really important issues. These include future crude prices, future demand, future demand destruction, and if the world will be able to even deal with $70-$80 oil prices which is what is needed by producers to stay solvent and in order to supply the world with the amount of oil due to demand growth. Your comments raise significant world issues regarding oils future in a changing world going forward (‘that line which we have crossed’).

    How do you see or think the role of future regulations that will or may be implemented to some degree in order to satisfy climate change issues (i.e. GHG issues)? Could meeting potential or actual GHG regulations wipe out the ‘Age of Oil’ irregardless of the $70-$80/bbl threshold you mentioned that would be required for producers to supply the worlds demand for oil? I realize that the GHG climate change situation is a completely different subject, but I assume it also will be a major driver impacting oil prices, demand, and solvency that oil producers will have to deal with in the future. Thanks for the article and your thoughts on the future to come for oil production.


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  11. Excellent write up Art,
    Well thought out but then at the end you say price spikes will cause an end to the age of oil?
    I think it would pay to be more measured and say that with the declining reserves the cost of producing oil will over the long term continue to increase and make it less and less attractive as an investment relative to renewables. The longer term drain the earth’s resources is a valid argument but not influential to the faceless men in suits who are driving our bus off a cliff.
    The same guys who told us cigarettes, agent orange and Mc Donalds Hamburgers were safe.


  12. Sam,

    I appreciate your perspective and agree that it is a legitimate scenario. At the same time, what I said in my post is what I see as the more likely case. The inevitable spike in oil prices will be catastrophic to a weak global economy and may trigger the energy and debt re-set that the central banks are struggling to push into the future.

    Many thanks for your comments,

    Art