When Will Oil Prices Turn Around?

Posted in The Petroleum Truth Report on August 10, 2015

Look for some good news about oil prices this week…maybe.

EIA releases its Short-Term Energy Outlook (STEO) on Tuesday (August 11) and IEA publishes its August Oil Market Report (OMR) on Wednesday (August 12). I hope to see a small increase in world demand and relatively flat supply.  That will bring the market somewhat closer to balance and prices may increase or, at least, stop falling.

Meanwhile, the view among most analysts is grim. On Monday, The Wall Street Journal’s Money & Investing headline read “No Relief in Sight for Crude: Oil’s Malaise could last for years.”  In late September, Bloomberg wrote, “Oil Warning: The Crash Could Be the Worst in More Than 45 Years.” As recently as mid-June, analysts were confident that oil prices were rebounding toward “normal” because both Brent and WTI had risen from low $40- to low-$60 levels.

When many were celebrating a return to higher prices, I warned that prices would fall. Now, when most are proclaiming lower oil prices ahead, I am looking for a bottom to the price slump.

Don’t get me wrong: this is not going to be anything dramatic but, if I’m right, it will add another month of data that suggests flattening production and increasing demand.

I have not changed my view that we have crossed a boundary and things are fundamentally different than before. My colleague Rune Likvern published a post today that details the key reasons why this substantive market shift has occurred.

As I wrote in late June, the world is a fundamentally different place post-the 2008 Financial Collapse and some markets, including oil, no longer respond as they did before. This is a function of even more massive debt than prior to the Collapse and monetary policies that have sustained artificially low interest rates for 6 years. Cheap money has fostered the expansion of oil and other commodity supplies beyond the weakened global economy’s capacity to absorb them. Also, the anticipated de-leveraging of debt has not occurred.

Market Fundamentals

So, where are we today?

Oil prices have fallen about 25% from May and June highs (Figure 1). The exuberance of rising prices in March and April has given way to a view that prices may continue to fall and may remain low for years or decades.

Crude Oil Price Daily Through 3 Aug 2015
Figure 1. Crude oil spot prices, January 1-August 3, 2015. Source:  EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

WTI futures closed at $43.87 on Friday, August 7, almost at the previous low during this price cycle of $43.39 on March 17. Brent futures closed at $48.61 on August 7, still a few dollars above its previous low of $45.13 on January 13.

It seems reasonable that oil prices may have fallen to or at least near some natural bottom.

Traders are looking for hope that tight oil production will decline. IEA data showed that U.S. production fell 50,000 bopd in June (Figure 2). Assuming that OPEC over-production is partly aimed at reducing U.S. tight oil production, that process seems to have finally begun, albeit in a small way so far.

Top Producers Monthly Liquids Production Change June 2015
Figure 2. IEA top producers monthly liquids production change, June 2015. IEA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

The problem continues to be over-supply coming mostly from OPEC whose production increased 340,000 bpd in June (Figure 2).

Although there are positive indicators for demand growth for gasoline in the U.S. and China, production growth has continued to outpace increases in demand. The production surplus (supply minus demand) in the second quarter 2015 grew more than 1 million bpd compared to the first quarter (Figure 3).

Chart_EIA-IEA QUART COMPARE_June 2015
Figure 3. World liquids production surplus or deficit comparison, EIA vs. IEA. Source: EIA, IEA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

That is what must change in order for prices to turn around. The fact that IEA and EIA estimates vary by almost 700,000 bpd shows that there is considerable uncertainty in the data.

We may get better resolution by using EIA monthly data rather than IEA quarterly data. EIA shows that the production surplus in June declined 1.2 million bpd compared to May to 1.9 million bpd (Figure 4).

Chart_Prod Surplus-Deficit_July 2015
Figure 4. World liquids production, consumption and relative production surplus or deficit. Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)


This is because world demand reached a new high of 93.86 million bpd, an increase of 1.3 million bpd over May. Another month of demand growth and slowing production growth might go a long way towards turning prices around.

Second Quarter 2015 Earnings

Pessimism increased about oil prices last week as second quarter earnings for U.S. E&P companies were released. Many tight oil producers including Pioneer, Whiting and Devon announced higher production guidance for 2015. Others, however, like EOG and Southwestern Energy said they would continue to show restraint in production until prices improved.

Despite ongoing macho declarations from tight oil company executives that they are winning the war against Saudi Arabia and OPEC, the truth is that second quarter results were pretty awful, and that is good for oil prices because it may signal falling future production.

For the first half of 2015, the tight oil-weighted E&P companies that I follow spent about $2.20 in capital expenditures for every dollar they earned from operations (Figure 5).

Chart_1H Tight-Oil Companies Spending vs. Earning- 2015-2014 Comparison_Aug 2015
Figure 5. First half 2015 tight-oil companies spending vs. earning: 2015-2014 comparison.
Source: Company 10-Q data, Google Finance and Labyrinth Consulting Services, Inc.
(click image to enlarge)

These companies are outspending what they earn by a dollar more today than they were a year ago during the first half of 2014. Anyone who believes that decreased service costs and drilling efficiency will allow tight oil companies to make a profit at $50-60 oil prices needs to think again.

The debt side of first half earnings looks even worse, if that is possible. Figure 6 shows that debt-to-cash flow ratios for sampled tight oil companies average 3.3. This means that it would take these companies 3.3 years to pay down their total debt using all cash from operating activities.

Chart_Oil_Weighted Debt-CFO_9 Aug 2015
Figure 6. First half 2015 debt-to-cash flow For tight oil companies.
Source: Company 10-Q data, Google Finance and Labyrinth Consulting Services, Inc.
(click image to enlarge)

This is a standard measure used by banks to determine credit risk and to set loan agreement requirements (covenants). The average of 3.3 for the first half of 2015 (annualized) is more than twice the mean for the E&P industry from 1992-2012 (Table 1).

Debt-to-Cash Flow Table from Ending over-lending- Assessing systemic risk with debt to cash flow_November 2014
Table 1. S&P industry group total debt/cash flow and total liabilities/cash flow means (1992-2012).
Source: Bank of Finland Research Discussion Papers 11-2014.
(click image to enlarge)

This has profound implications for debt re-determinations that will happen during the third quarter of this year. It means that most of the companies shown in Figure 6 with debt-to-cash flow ratios above 2.0 may have considerably less access to revolving credit lines going forward. That equals more limited capability to drill and complete wells.

At the same time, favorable hedge positions, that allow companies to realize prices higher than current spot markets pay, will begin to expire in coming months. The drop in value for long-dated futures contracts since oil prices slumped in July means that tight oil companies are unable to hedge much above current low prices.

My colleague Euan Mearns recently did a forecast for U.S. tight oil plays and concluded that production from the Eagle Ford, Bakken and Permian would decline by about 830,000 bopd by the end of 2015. His estimate assumed that rig counts had stabilized but tight oil horizontal rig counts have increased 20 during the last 4 weeks.

The EIA forecasts approximately 390,000 bopd of production decline by year-end (Figure 7).

Chart_Oil Forecast 9 Aug 2015
Figure 7. EIA U.S. crude oil production and forecast, 2015-2016. Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

What It Means

The significance of these production forecasts and the second quarter earnings reports is that U.S. tight oil production will decline. The fact that production has remained strong despite a 60% decrease in the tight oil rig count has incorrectly lead some analysts to conclude that production will not fall because of the ingenuity and efficiency of U.S. producers.

It takes time for production to decline because there are months of lag between the beginning of drilling and first production, and more months of lag before production data is released. Also, many of the rigs that were released were drilling marginal locations that didn’t contribute much to overall production–the 80-20 rule. And, there is the inventory of uncompleted wells that are unaffected by rig count.

Will a decline of 400,000 to 800,000 bopd in U.S. tight oil production make a difference in the global market balance? Obviously, it depends on what other producers do but it is certainly important to OPEC’s strategy of gaining market share from unconventional producers.

OPEC is producing more than half of the world production surplus and has the capacity to cut production by the entire amount of the surplus. This will not happen until its goals are achieved but Saudi Foreign Minister al-Jubeir will meet with Russian Foreign Minister Sergei Lavrov August 11 in Moscow to discuss global energy markets and other topics. EIA will release its STEO on the same day and IEA will release its OMR the next day.

I am hopeful that something positive will emerge that will at least help to stop the decline in oil prices.

 


17 comments on this entry


  1. Art,

    A hat-tip for the very interesting blog post, as always. As you rightly observe, it is hard to tell when oil prices may recover in earnest, as it depends so much on what may happen to production in the U.S.

    You cited various projections of the decline in U.S. oil production by the end of 2015, varying from the EIA’s 390K/bopd decline to your colleague’s, Euan Mearns, 830K decline. Would you like to hazard a projection of your own? Presumably you do not still think that “U.S. tight oil production may fall 600,000 barrels per day by June 2015”, as you did in your February 17, 2015 blog post at http://www.artberman.com/tight-oil-production-will-fall-600000-barrels-per-day-by-june/

    Thanks in advance for your response, and for your insights.

    Paul


  2. Paul,

    My earlier estimate did not anticipate two things: 1) the extraordinary amount of capital that flowed to U.S. E&P in 2015, and 2) the sentiment-based price increase from low $40- to low $60-levels in May and June. Secondarily, I did not consider the effect of deferred completions not because I was unaware of them but because I could not quantify them.

    To not answer your question, it depends. Euan’s estimate assumed that rig counts had stabilized–that is not a confirmed assumption just a few weeks after he published his forecast. I have no idea how EIA does its estimates but they have been as consistently wrong as I was once.

    To answer your question, I will stay with my original estimate of 536/582/665 kbpd as Low/Base/High cases but with time as end-of-2015. I choose this estimate because it’s the only one that I have done. Clearly, many of its underlying assumptions were incorrect as I explained above. Nonetheless, it still seems notionally correct and lies in-between Euan’s and EIA’s.

    Thanks for your comment,

    Art


  3. Art

    I looked at the forecast from Euan Mearns. He has Bakken production going from 1,200,000 bpd to 871,000 bpd in 6 months with a 5.2% monthly decline rate. That is true – as long as no new production is brought on over the next 6 months. If drilling ceased completely the Bakken would decline about 330,000 bpd as he indicated over 6 months. It is going to take longer than 6 months.

    I appreciate your work and I have followed you for several years. Keep it up.

    Bill


  4. I am hopeful that something positive will emerge that will at least help to stop the decline in oil prices.

    Art, I note that you view higher energy prices as a positive thing;-) This is the view from the O&G investor / producer side of the fence. But from the consumer side of the fence low prices are much better.


  5. Euan,

    I view a stabilization of energy prices as a positive thing, not high oil prices. While I agree that lower oil prices should be good for consumers theoretically, I am not sure that those benefits translate as clearly in our post-Financial Collapse world and economy.

    In the U.S., the reduction in domestic oil spending has had negative effects across the economy and has been disastrous for energy-producing states like North Dakota, Texas and Pennsylvania. Lower oil prices have not resulted in increased consumer spending so far except, perhaps, on gasoline and that story is still unclear to me. Also, the U.S. housing market has had mixed results from lower oil prices.

    Lower prices have had negative effects on countries that are highly dependent on oil for revenue like Russia, Venezuela, Nigeria, Angola, Mexico and Iraq. The reduction or elimination of fuel subsidies in countries like Indonesia, Oman and India have a preferential regressive effect on those who earn less money.

    The amount of money that U.S. E&P companies have borrowed through corporate bonds, secondary stock offerings and direct debt is staggering and low oil prices threaten the stability of the stock and bond market as a result. This could be very negative for the world economy. These companies and their capital providers deserve what may happen to them but the collateral effects on consumers could be severe.

    Thanks for your comments,

    Art


  6. […] To get straight to the point. Brent will need to fall below $30 to match the lows seen in 1986 and to below $20 to match the lows seen in 1998. WTI in particular is trading close to its support level of $43.39 marked on 17 March 2015. If traders push the price below that level then the price could fall a lot lower for a brief period. At the fundamental level, supply and demand need to be rebalanced and the main problem is over-supply of LTO from the USA and of OPEC crude depending upon which way one views the problem. The recent price action since September 2014 has been brutal on producers but not yet brutal enough to remove the 3 million bpd over supply from the system. I do not believe that the white knight of increased demand is about to gallop over the hill and therefore see a risk of substantially lower price in the months ahead. Colleague Arthur Berman has a somewhat more upbeat perspective. […]


  7. Euan,

    We are witnessing “drowning man” behavior from U.S. tight oil producers (borrowing a phrase from my friend Jim Halloran). They are so desperate to save themselves that they are unaware that they are bringing down the guy who is trying to rescue them. This resolves itself when both men drown. Their talk about ingenuity and resilience don’t change the circumstances out there in the water for the two men.

    All the best,

    Art


  8. Picking up on the “Are low oil prices good or bad for the U.S. economy independent of the oil business” theme, I think the answer is all about credit contagion.

    The subprime housing debacle wasn’t nearly big enough (in total credit risk terms) to materially affect the global economy. But it WAS big enough to start a credit contagion that had devastating effects. The notional size of junk bond issuance by shale drillers is bigger than subprime mortages were. It could be the snowflake that starts the next global credit contagion.

    That’s not a prediction, but I do think it an entirely plausible outcome. We’ll soon see.

    Erik Townsend


  9. Erik,

    Is the magnitude of the junk bonds really greater than the subprime mortgage?

    Thanks,

    Art


  10. Market is figuring out an equilibrium. Initial expectations for a massive drop in US LTO (including on this blog) were not borne out. Plus the growth from OPEC. Now we are down to less than $45 and US LTO production is starting to go lower. The US crazies actually started picking up rigs at $60+ WTI and the market had a cow. They notice US indicators and react to them. It’s not just that the immediate price went back down, but medium term expectations went down too.

    http://www.wsj.com/articles/oil-futures-signal-weak-prices-could-last-years-1439159387

    But US LTO doesn’t have the strength to take prices down to the 30s. Doesn’t even have the strength to keep it in the 40s for more than a year. But then again it does have the strength to keep prices well below the 100s (Hamilton JUL14) or 85ish (Hamilton 30NOV14).

    Takes time to work off the glut in supply and to get demand up. We should expect gradually increasing prices but within a general are of 45-65 for a long time.


  11. Art,

    I should disclose that I don’t have first-hand access to hard data on this. I have read at least two separate analysts’ pieces on the subject, and both said total shale debt now outstanding is larger than 2007 subprime MBS. They quoted the notional figures, but I don’t remember them.

    It’s key to understand, however, that subprime per se was not very big. It was the next fiew tiers (Alt-A, etc.) after subprime where all the big problems occurred. And there was also the fact that most institutional investors in CDOs really had no clue how the things worked.

    My own view is that the junk bond market in general is way overvalued. Yes, the SPREADS to treasuries are within historical norms, but treasuries are artificially depressed in yield by CB easy money policies. The governments involved can print more currency to avoid defaulting, but the junk bond issuers can’t print more money to service their debt.

    So to my thinking, a credit contagion that starts with shale-issued junk bonds then spreads to the broader junk bond market is entirely plausible. Full disclosure: I’m short both JNK and HYG in both my fund and my personal accounts for this reason.

    But the key to all this will be shale decline rates. We all know that US production is certain to fall off a cliff at some point. The question is when. If the mal-investment in the shale patch keeps US production high enough long enough to force a storage crisis later this year (and WTI prices all the way down to the $20s), I think the ingredients are there for shale junk bonds to be the new subprime MBS.

    But if US production falls off a cliff, this thing could already be over, as you have alluded in this post. You’re better qualified than I am to know the liklihood of US production staying flat for another 6 months. If that happens, I think it’s gonna be fireworks.

    My approach is very different than yours. I look at this in terms of how much KSA has already “spent” on this campaign, how high the stakes are for them, and the fact that fall maintenance and Oct. credit review season are huge vulnerabilities to the U.S. shale industry. I reason that the incentive has never been higher for KSA to turn up the pressure, and this last OPEC production report seems to confirm that. Furthermore, the Obama administration’s agenda with Mr. Putin seems to make it clear that the U.S. gov’t is not likely to intervene to protect U.S. shale operators. To the contrary, Mr. Kerry’s outspoken defense of the Iran deal seems to evidence that their inclination is to do whatever is going to keep prices low for the purpose of kicking Putin’s teeth in.

    I have quate a bit more perspective in my Q3 Peak Oil Investor newsletter, which I e-mailed you under separate cover. If anyone else wants a copy, you can find it (free) at http://www.eriktownsend.com.

    Best,
    Erik


  12. From a technical analysis perspective, today was HUGE.

    When I predicted in my last newsletter (penned Aug. 5th) that we’d soon take out the Mar. 17 “bottom” in favor of new lower lows, even I didn’t think it would happen until we saw a big inventory build surprise. The fact that it happened this week after a modest draw on inventory volumes to me about the structural weakness of this market.

    An hour into the GLOBEX session we’re at $41.80 WTI. If we got a 41 handle from a smaller than expected DRAW, what’s going to happen when we get a series of BUILDS? I think they’re coming, and it won’t be pretty.

    Im still convinced that Sept. – Oct. is going to be the big price vulnerability time. If we’re trading below $42 in the first half of August, what’s October going to bring? I predict much lower prices. $30s if not high $20s.

    Erik


  13. Erik,

    There was an inventory build of 1.4 mmb of liquids but a withdrawal of 1.7 mmb of crude oil. That says to me that consumers aren’t buying all the refined products that are being produced (end of driving season, etc.) and that there is no incentive to store crude oil based on futures.

    All the best,

    Art


  14. > draw on inventory volumes to me about…

    Should have read “draw on inventory SPOKE volumes to me about…”

    Erik


  15. > That says to me that consumers aren’t buying all the refined products that are being
    > produced (end of driving season, etc.) and that there is no incentive to store crude oil
    > based on futures.

    Fascinating that we see it differently. I would have said that the build on finished products clearly shows that supply (in general) is starting to pile up, and that what will COME NEXT will probably be crude inventory builds. It’s still early august, and if you look at the historical data on builds and draws, July is usually a big draw month (summer driving season), August is hit or miss, and Sept., is a big build month (fall maint.).

    What all this says to me is that inventory builds (on crude, not finished product) are likely to begin in the next few weeks. I thought they’d take the price below $42 when they started, but it already tested a $41 handle BEFORE any crude builds occurred. I think they will, and I think the price is headed lower. When it does move lower, contango will expand and thus the storage incentive you describe will be apparent in the WTI term structure.

    Erik


  16. > What all this says to me is that inventory builds (on crude, not finished product) are
    > likely to begin in the next few weeks… I think they will, and I think the price is
    > headed lower.

    DING DING DING DING!

    I’m still predicting low $30s by October. This was just the first inventory build. Summer driving season is over for all intents and purposes. Unless U.S. production declines very steeply, I think we’re headed for a series of >5mm bbl inventory builds, much lower oil prices, and a junk bond massacre.

    Erik


  17. […] oil company’s credit risk. The E&P industry’s average ratio from 1992 to 2012 was 1.58. A ratio of more than 2.0 is a red flag that a company may become a credit risk, probably has […]