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

Posted in The Petroleum Truth Report on January 9, 2017

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.


35 comments on this entry


  1. “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.”

    Could you please enlighten us on this? What is the blending ratio between what comes out of tight & imported heavy oil, in order to produce a refined barrel?

    As for, “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.”

    If US tight is already at 70$/b on average, then how can adding another 25-30$ for a barrel of Canadian heavy oil is profitable? Or is the 70$ per US tight barrel already accouting for the heavy oil mix?

    Many thanks!
    Alex.


  2. Alex,

    My colleague Matt Mushalik and I have been working on a major post about the ultra-light oil story that should be out in another week or so.

    No oil is $70/barrel right now. WTI is $52 and wellhead prices vary from $42 to $47. The tight oil plays produce oil that is mostly >40 API gravity and the average U.S. refinery takes 31 API gravity oil so much of the light must be blended with heavier oil in order to be refined. The blending ratio depends on the gravity of the oils available for mixing.

    The take-away is that there is some volume of light oil that can neither be blended or exported because of limited light oil refining capacity and/or demand. That amount always goes to storage keeping inventories fairly high. The light oil, therefore, sells at a discount to grades that can be readily refined or exported. As more light oil is produced, the discount will increase making light oil increasingly less profitable than it is now.

    This is the secret part of the light, tight oil story. Most people think all oil is the same. It is not. Even though light oil is technically higher quality i.e., it can be more easily refined into gasoline and other light products, refineries moved away from that kind of oil in the 1980s when U.S. production was in serious decline and refineries were re-designed for the heavier grades that dominated world supply (and still do).

    I hope this answers your questions for now. Stay tuned for the more detailed post.

    All the best,

    Art


  3. Art, thanks for another great article. I always enjoy when I am notified of your articles in my inbox. Two questions. Is US or Mexico Gulf of Mexico oil considered to be light or heavy crude or is it comparable to on-shore tight oil. Second question, with Pemex conducting a recent auction of oil acreage in the Gulf of Mexico, will this just not exacerbate the future oversupply problem beyond 2018 or is the exploration timeline to bring these potential reserves to market too far out. Thank you.


  4. Jerry,

    I wouldn’t hold my breath for large, new volumes of oil from Mexico.

    U.S. oil runs the spectrum of heavy to light but, on average, it is lighter than the average grade of oil in the world. Conventional U.S. plays are heavier than tight oil plays.

    All the best,

    Art


  5. Jerry,

    Here is a diagram that shows the API composition of U.S. tight oil plays vs. U.S. conventional oil plays.

    Here is a chart that shows the API composition of the Gulf of Mexico Shelf vs Deep Water oil:

    This suggests that the Gulf of Mexico shelf oil is similar to the composition of overall U.S. conventional plays whereas the Deep Water GOM is heavier.

    All the best,

    Art


  6. During the oil price collapse the price, strangely, always remained in contango. This means the purchasers could always buy at the wellhead, put it in storage, and sell into the future at a profit. If the price would have ever gone into backwardation, which seems like it should have, there would be no reason to purchase at the wellhead and put into storage. This certainly would have precluded a storage glut.


  7. Ken,

    For oil to be worth more today than in the future, demand must be higher today than in the future and that suggests a shortage of near-term oil. The profitability of storing and selling forward depends on the cost of storage and the volume as well as the price someone will offer you in the future. If you look at the volume of trades more than a few months into that contango, they are very small.

    All the best,

    Art


  8. Art- intersting article. If the Keystone pipeline goes through under the Trump administration, would you expect the OPEC imports to decrease? If so what effect would you expect this to have on oil prices?


  9. Jeff,

    Timing is everything and the time to have approved the Keystone XL has long passed for it to make a difference in the relatively near- to medium term. Obama delayed a decision in late 2011 and finally killed the project a year ago. If Trump gives this priority (it is probably not high on his list) and can somehow sort through the regulatory obstacles, I see no way that oil can flow for several years. So, the simple answer to your question is No, OPEC imports will not decrease any time soon.

    Thanks for your question,

    Art


  10. You stress that prices cannot rise whilst inventories remain high. However if there was a price rise due to an unexpected event and afterwards suppose expectations were that prices would continue to rise. I am supposing some fairly extreme scenario ie. disruption from a major oil producing country.

    Might this mean that oil in storage remains in storage due to the expectation of realising much higher prices in future?


  11. Nigel,

    Prices will increase if there is some geo-political disruption that threatens oil supply regardless of inventory levels. Prices will adjust if the crisis does not result in disruption or does not seem to threaten supply after awhile.

    Governments may decide to keep oil in storage for strategic reasons but markets are all about maximizing profits so contracts will be bought and sold based on money that can be made today. It is hard for me to imagine a situation of deferred gratification in oil markets.

    At the same time, things have changed since the price collapse. When Saudi Arabia and Iran closed their embassies in early 2016, there was no oil-price response whereas this would have caused a serious price spike any time before late 2014.

    One of the most interesting aspects of the last 2+ years in the oil markets is that the rules have clearly changed and it everyone who is honest admits that he doesn’t know how prices will adjust to changed conditions.

    Thanks for your comments,

    Art


  12. Hi Art,

    Thanks for yet another good post. Have made a couple of statements that may or may not contrast your view – I’d appreciate your thoughts on them!

    Price setting mechanisms.

    Oil prices don’t move on S/D fundamentals here and now, but rather on expectations of future market conditions. Thus, prices are already pricing in draw in inventories and are likely to move higher if it happens as I see it. I’m not saying USD70-80/bbl, but defenetily above USD60/bbl if we start to see consistent draws.

    In my view, people are missing the point if they point the finger at current fundamentals.

    I mean, look at stocks and how they move way before S/D fundamentals actually change. There is absolutely no reason for offshore seismic players to be priced at current levels.
    Now that might be a clear short-opportunity in my view, but that’s a different topic. Thus, trying to assess oil prices by looking at current S/D fundamentals is next-to-useless if it doesn’t imply a different long term thesis.

    My base case scenario includes SA defending prices throughout 2017. The biggest uncertainty in my view is whether the market points its attention to the S/D deficit in 2019/20/21, or if they look at 2018 and the potential surplus there if US shale returns. If we assume a conservative 1mmbpd growth in demand for the next 5 years, we need US shale and OPEC to ramp up from keeping prices below USD100/bbl.

    Whats your view on the price setting thesis? And what is your take on the base case I presented in the section above.

    All the best,
    Erik


  13. Erik,

    Saudi Arabia may well defend price now that is has crossed the Rubicon but its willingness to persevere beyond mid-year will depend on the level of support it gets from its colleagues. It will not make the same mistake as in the early 1980s and carry the weight alone with disastrous consequences again. It will also closely watch U.S. production because it knows it is giving it a gift for free. December production is back to 8.9 mmb/d according to the just-released STEO.

    We agree that markets anticipate changes before supply-demand fundamentals necessarily support pricing changes. This gets to the heart of which fundamentals are evaluated. Classic supply-demand models assume that markets are equilibrium systems but oil and gas markets are clearly characterized by disequilibrium. Comparative inventories describe that disequilibrium.

    I don’t see sustained $60/barrel prices until U.S. stocks are drawn down another 100 mmbo. The false price recovery in May-June 2015 is a perfect example to consider. Prices reached $60 but could not sustain that level for long because comparative inventories were too high although inventory draws were strong. This is a case where the market got the right signal but was premature in its pricing because it was grounded in assumptions from the recent past when the norm was $100 oil.

    The market is, after all, people and not the silent hand of God. Capital flow is the ultimate market force.

    Thanks for your comments,

    Art


  14. Art, one additional piece of bearish news is that Libya has reported production of 708,000 bpd. If that rises to target of 1 Mbpd and sticks, it undoes a lot of the feeble deal. I divided OPEC into weak and strong. As you point out, the weak will reach their new reduced targets without government intervention. But I think its a mistake to downplay the production ability of the strong. You just need to look at Iraq and how quickly Iran came in from the cold.

    My wag on the OPEC deal is here:

    http://euanmearns.com/opec-production-data-and-the-feeble-deal/

    And my wag on oil price this year is here:

    http://euanmearns.com/oil-price-scenario-for-2017/

    I think the price will continue to recover for the first half if the OPEC + Russia deal sticks. But then the return of the frackers and doubts about the OPEC deal being renewed will send the price down again come year end. Absolutely impossible in current circumstances to make anything I would call a forecast.

    Finally, latest Vital Statistics where I am developing the delivery format.

    http://euanmearns.com/oil-production-vital-statistics-december-2016/


  15. Euan,

    Thanks for the comments. I follow your “wags” and like the OPEC strong vs weak approach you have taken. I have also been following the activity of General Haftar in Libya who has been effectively returning oil facilities to service over that past 6 months.

    I think that oil price recovery may follow separate paths for WTI vs Brent. Brent may well “recover” as you suggest to $60 or so until Wile E. Coyote realizes that he is suspended in thin air as far as fundamentals go. WTI, on the other hand, may not recover much beyond the $54-$55 price threshold because there is nowhere for light, tight oil to go except to sell at a huge discount or to go into storage. It is interesting to note that the Brent-WTI spread has opened since the OPEC announcement.

    All the best,

    Art

    All the best,

    Art


  16. But what is the price of oil that our globalized structure can support?

    We are far from the 20 dollars / barrel of the golden decades, adjusted for inflation.
    What happens to our great complex dissipative global system?

    What happens to the big shipping companies and the big oil tanker and container shipbuilders? From what I can see things are not right in them.

    Can you see what happens with shipping companies? Art you access more information than this “plastic artist” can obtain.

    Could it be that the depression of the non-financial economy is greater than we are being told?

    My best regards for you and your family from Argentina

    Carlos Leiro

    http://www.zc.com.ar


  17. Carlos,

    I don’t know what the right oil price is for global growth but in previous decades when the world had a lot less debt $50-$60/barrel seems to have been the threshold that separated growth from no-growth.

    Oil Price and GDP

    The average price in real 2016 dollars from 1986 to 1998 was $33/barrel and growth was good. Companies and exporting countries can no longer survive at those price levels today. I believe that most people in the world today are struggling to survive economically and that is a factor behind the rise of Trump, Brexit, Le Pen, etc. The higher cost of energy is among the root causes.

    My best to you and your family as well!

    Art


  18. Mr Berman

    Thank you for a very interesting article and the very illuminating presentation on Oil basics-essential reading for any interested amateur like me.

    In view of the fact that we seem to be burning northwards of 30 billion barrels a year do you have any thoughts,opinions on the reserves shown in the in the EIA chart above for individual countries- are any of them out in any meaningful way in either direction.

    Reportedly (and this is from memory) a Saudi sheikh said Saudi would be an importer of oil by 2030. Was this a a joke or if true it makes their reserves seem a bit high. Russia on the other hand seems low to me.

    It is sites like yours and a few others that still reassure me that the internet hasn’t been a waste of precious energy. Thank you

    Mick


  19. Mick,

    I don’t have great faith in the absolute values of the EIA international reserves shown in Figure 3 but I believe that they are notionally reasonable as they are corroborated by IEA and BP data. Most of the largest reserve holders are not audited so there is little independent verification of the estimates. Also, we don’t know the quality of the reserves and I suspect in the case of Saudi Arabia that much of the remaining volumes are sour (H2S) and very heavy.

    As far as the Saudi sheik’s comments that KSA may become a net importer by 2030, remember that the USA has been a net importer of crude oil since the late 1970s but remains the 3rd largest producer of oil in the world. KSA has a growing population that uses increasing amounts of crude oil domestically. Becoming a net importer in no way means that a country is out of oil. It does, however, have profound implications for other net importers of crude oil. Please see Jeffrey Brown’s Export Land Model.

    Russia represents a case intermediate between Saudi Arabia and the United States. 80 billion barrels is a lot of oil although not as much as Saudi Arabia. On the other hand, Russia produces ~10.7 mmb/d of crude oil and condensate, more than Saudi Arabia (10.5 mmb/d) or the U.S. (8.9 mmb/d). BP gives Russia 102 billion barrels of reserves.

    Thanks for your comments and questions,

    Art


  20. Art,
    Great to see another article from you, was starting to get withdrawal symptoms! Would love to see your updated view on Nat Gas. It has been a few months since you last did a big post and things have evolved very much as you foresaw. Would love to see your current view.
    Best
    Alex


  21. Alex,

    Thanks for your comments. I have been pre-occupied with drilling wells, a business trip to Saudi Arabia and holidays and, somehow, posting just didn’t happen.

    My next post will be on natural gas hopefully early next week.

    All the best,

    Art


  22. You are a very informative analyst that I respect very much. But understanding there is a glut in LTO in North America that can’t be refined without a heavier grade ( middle eastern oil and I know SA owns 1 of the biggest refineries in America so they have special interest) but heavier oil like WCS in Canada is trading at a 30% discount. Do u ever see it trading at WTI prices or a premium to counteract excess storage or will LTO continue trading around WTI prices


  23. Josh,

    I believe that the WCS-WTI discount is because of the large component of bituminous oil from the oil sands. This type of oil does not contain the right hydrocarbon compounds necessary for gasoline and diesel production so refiners pay less for it.

    I was unaware of this issue before your question so thanks for asking. It suggests that my comments about the Keystone XL Pipeline may need reconsidering.

    All the best,

    Art


  24. Hi Art,
    as always a very interesting article.
    please could you provide more color about blending of heavier oil with tight oil. for example for the different refined products which mix of heavy oil / tight oil is needed.
    In the last days a lot of conviction is growing that wti price will increase due to tax for imported oil but maybe people forget that tight oil must be blended with heavier oil.
    further in my opinion the tax increase would be a negative catalist for wti price increase because we will see an increase of price of refined product and a decrease of consumpion. if we pair this effect with the increase of tight oil production in US all that would bring an increase of storage of tight oik and a decrease of wti price. thanks in advance for your comments.
    regards marco


  25. Marco,

    Thank you for your comments. I will post more about heavy vs. light oil this week but I agree with your main point that the U.S. needs heavy oil to blend with its ultra-light oil in order meet refinery specifications. Anything that inhibits the import of heavy oil means that more U.S. light oil will go into inventory and depress domestic prices. I sincerely hope that the U.S. does not put tariffs on imported oil (or any other imported items).

    All the best,

    Art


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