- February 14, 2017
- Posted by: Art Berman
- Category: The Petroleum Truth Report
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 When consumption exceeds production, oil is withdrawn from inventory reflecting increased demand.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).
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Thank you for another insightful article. Do you have an estimate for how many rigs are needed to offset tight oil decline and keep toght oil production flat? Thanks.
Joe,
That is a really good question that is not easy to answer with much confidence.
Just considering the 3 main tight oil plays (Bakken, Eagle Ford and Permian), a reasonable but rough estimate is about 120 rigs. There are currently 115 rigs in those plays and the minimum monthly rig count was about 60 in July 2016.
There are many complexities and uncertainties involved in that estimate that I won’t burden you with except to say that I am probably wrong but not ridiculously wrong.
All the best,
Art
Mr. Berman…just wanted to say thank you for your analysis of the oil market. I look forward to receiving your email updates. They are the most objective & unbiased I have run across. I also enjoy your appearances on Macro Voices.
Thanks again! Doug M – Boca Raton, FL
Thanks, Doug.
Art
I cannot understand why anyone is drilling other than using other people’s money and hoping for a better price in the future. And I don’t understand the bean counting. SandRidge went belly up but still running and in a meeting I was told that an ex-employee had set in on, some kind of consultant told them that they could cash flow even if they had to pay $100,000 per acre for mineral leases….really?
That is insane on the face of it. With drilling commitments, increasing rig and service costs, and continued low prices almost a given, like the old lady said years ago, “Where’s the Beef?”
I generally recommend to mineral owners to never sell, but if they offer to buy minerals at $100,000/acre…go for it. That is way too insane a price.
Terrel,
It’s become a race to the bottom.
There are only a few plays left with any running room and everyone is trying to get a seat before the music stops. Money spent on leases disappears from the balance sheet in a few quarters as a sunk cost and investors don’t care about standard financial measures like capex-to-cash flow. Meanwhile, They are eager to provide capital lacking other investments with any kind of reasonable margin.
There is a day of reckoning out there somewhere but it’s not obvious when so why worry?
All the best,
Art
As it relates to the shale basins, I was wondering if you have revised your break even EUR number on wells by the different shale basins. I now that’s a pretty general question. So I guess what I’m asking is with the decline in drilling and completion cost, and the price increase, do you find the increase in drilling of new wells justifiable at today prices?
Tim,
It’s a major effort to re-evaluate a play so no, I haven’t updated any of the plays recently. I don’t think the costs have decreased as much as the hype suggests and in fact, the costs are now increasing again with all the renewed operations. I will get around to the re-evaluations that you suggest some time sooner than later.
Thanks for asking,
Art
Art,
I agree with the points you make in your article. In my opinion there is clearly a speculation component to the current price but I’m also gathering a sense that people are comparing the 508 million barrels in inventory reported last week to last year’s high of 541 million barrels without taking into account that the EIA stopped including “lease stocks” in their numbers back in July. Comparing last weeks number of 508 vs. the adjusted numbers excluding lease stock, we are 4 million barrels away from a record.
One thought which may support the price above $50 is that producers are selling oil now and are reducing lease inventory but I can see no way to know for sure. Clearly, US supply has increased but how much is from new production and how much is simply a flood from lease inventory?
Lastly, I don’t think we can compare rig count to production just yet. Obviously an increase in rigs should translate to an increase in production but we both know rigs do not produce oil. The barrier between rig count and production is frac crews. The current wait for fracing is about 4 months; in other words, a well drilled today won’t see production hit the market until summer.
The only plausible scenario I see to sustain prices above $50 is the idea that production is stabilizing – not increasing – due to limited frac crews and the swell in inventory is due to unloading lease stock (and obviously imports). I suspect, however, that production is ramping up and when the EIA reports that inventory is at levels not seen in 80 years, a reality gut-check will hit the headlines, the market will over-react, and oil will fall to the low $40s or $30 yet again.
Todd,
Many thanks for your thoughtful comments. It is difficult and frustrating trying to decipher the relationship between inputs and outputs–none more so that rig count and production. The main point I am trying to make in this post is that the time for the reality gut-check that you mention is now.
IEA has taken a much rosier position in the last several months because they seem fixated on demand and the short-term demand outlook is better. As I pointed out in this post, I don’t think they want to acknowledge that crushing burden of supply that resides in inventory.
All the best,
Art
Art, You always provide us with top notch information and analysis on the current status of world oil and prices as usual. Thank you for your articles.
I saw this comment from ‘Eric’ on the Forbes site and was wondering if you could answer Eric’s comments here on your site? Regards, Daniel.
“In your Keystone XL column a couple of weeks ago, you said (i) oil prices will increase dramatically in the next several years and that (ii) there is no doubt a supply crunch (to be distinguished from a production crunch) lurks in the future. This column says “don’t hold your breath for $70 oil”. Has your outlook changed recently, or are you simply saying we’ll no doubt see $70 oil but not see it until 2019 (for instance)?”
Daniel,
Here is what I wrote to Eric on Forbes:
Eric,
I stated in this post:
“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.”
and “It will take at least a year to reduce OECD inventories 400 mmb down to the 5-year average.”
My guess is that over the next year, there will be enough inventory reduction that oil prices may begin a real recovery based on fundamentals. Until now, all that we have seen is price volatility around superficial indicators of fundamentals starting to move in the right or wrong direction.
Once inventories get lower, we will see if there is sufficient “quick-hit” supply from the tight oil and other unconventional plays to meet demand (as Rex Tillerson said there would be a few months ago). If not, we will move quickly toward the supply crunch that I described in the previous post on the Keystone XL pipeline because other sources of supply are not “quick-hit” and will take investment and time to develop.
I expect a year (plus or minus a few months) for fundamentals to stabilize barring a war, very bad behavior by a big producer like Russia or Iran, or something exogenous. The ensuing lead-up to a supply crunch will take another 1-3 years depending on whether the shale plays can deliver or not.
I hope that helps.
Art
Art, Thanks for another great article. You, Tad Ptazek and others have argued that because of the limited production history of horizontal tight wells, forecasts of future production is less certain than many have assumed. Perhaps, these formations have much less recoverable resources than generally predicted.
The North Dakota Directors Cut released today shows a 92,029 bopd decline from November 16 to December 16. Could this decline be a harbinger of things to come in other basins, and how would this impact your above analysis.
John,
There was considerable uncertainty in the early days because there was no production history but that has changed. The Bakken production decline in December was accompanied by a decrease of 183 in the number of producing wells–November was the record for number of producing wells. I assume the decrease was because the wells had reached their economic limit since wellhead prices were the highest in a year or so at $42.50 per barrel.
There is evidence that water production is the real problem with the Bakken. The water cuts have always been quite high but, as the pressure drops around the wellbore as depletion proceeds, there are all sorts of problems with cement failures and fracturing in the reservoir because of differential pressure. This allows water to move into the production tubing from other formations either through rock fractures or failed cement.
My colleague Rune Likvern believes that the Bakken has peaked and I agree. The Eagle Ford has also probably peaked. Production will increase again if prices and capital availability permit but the new production highs will be less than the late 2014-early 2015 peaks. I imagine that the Eagle Ford has similar water-production problems as the Bakken. This will ultimately be the limit of field production.
The Permian basin has not yet peaked and probably has a few more years at current activity levels before that occurs. Water cuts there are also quite high so I expect a similar water-production problem and fate.
All the best,
Art
Hi Art,
Do you any data on global oil inventories not just U.S and OECD? Are global inventories rising along with U.S. and OECD?
Thanks,
Don
Don,
No, global inventories beyond OECD are largely speculative. We know that China has been stockpiling oil and there are groups that guess at those volumes. I assume that global inventories parallel OECD because low oil prices favor storing oil and selling it forward on rolling futures contracts. The forward curve has, however, flattened considerably in recent weeks and is even backward-dated a few years out. I believe this is probably a temporary signal based on hedging but I honestly don’t know what to make of it.
All the best,
Art
Hi Art,
Here is a presentation from Amrita Sen at Energy Aspects. It is a few months old now so I don’t know if her projections would be different now but she spends a fair amount of time on global inventories. Starting around the 5:00 minute mark. Also… the guys at Core Labs have also been claiming global inventories have been declining for a few months now. Not sure what to make of it.
https://www.energyaspects.com/company/events/amrita-sen-ons-2016-conference-appearance?utm_medium=banner
Thanks
Don
Don,
Sen may be right about $70 oil prices later in 2017…or not. Almost half of the world’s demand is from OECD.I understand that the rest of the world matters but I don’t have data for those stocks and no one does.
The correlation between OECD inventories and Brent price is excellent. When I see reductions in OECD stocks, we can talk about higher oil prices on the horizon and that may come sooner than later.
The point of my post is simply that there are as many reasons for lower oil prices as higher oil prices in the near term.
All the best,
Thanks Art!! I really appreciate your work.
You combine oil business knowledge and research like no one else. Do you have an update on the eia inventory data that does not add up but upon which wti price is largely determined?
George,
Thanks for your comments. I had a call from the now-Acting Administrator of the EIA in mid-October and we exchanged a series of documents in which he posed specific questions and I provided specific responses.
In the end, he concluded that we misunderstood almost everything about how inventories are determined and dismissed our concerns. He contends that stocks represent measurements and, therefore, all attempts to reconcile inputs and outputs to supply balance are irrelevant. I know that this is incorrect and that stock levels are estimated from surveys and algorithms.
I suppose it is just another case of alternative facts.
All the best,
Art
Hi Art
Please help me understand on where you get the data for OCED comparative inventory or how to formulate it in order to build the graph in Figure 3. I can get the Brent price but not CI.
I have been trying to understand the same for the data source for natural gas comparative inventory.
Thanks.
Sorry for asking the question above. I had not checked for your reply on the natural gas article you had posted a month ago. I thought that it might not be monitored as it’s older.
Thank you so much for your kind reply. I am a big fan of yours. I read all your articles since i came across your blog. It has helped me understand natural gas very well.
Tan
Tan,
The comparative inventory approach for natural gas is somewhat more straight-forward than for oil because there is only one storage number for gas vs. the various PADDs and differing components if you go beyond crude oil to things like gasoline and diesel.
All the best,
Art
Art, I’m posted this comment on Oilprice.com and your website as I really hope you will comment on the following:
I’m hearing from an operations contact in the Permian Basin that crude oil purchasers have, since November- December 2016, become very strict (or choosey) about production meeting VERY STRICT LTO pipeline specifications.
As I understand it, the engineers refer to this “Reid Vapor Pressure” where the volatility of the NGL’s in solution with LTO create an unmarketable product. To meet buyer specifications the volatile NGLs dissolved in solution must be removed either by chemical treatment or Processing through a heater treater before the production will be accepted by the buyer.
I’ve been told that this is the first time in 35 years that a crude oil buyer has ever invoked this pipeline market condition.
My contact said that if this Reid Vapor Pressure is a weather related anomaly simply brought on by cooler temperatures then the issue should disappear with warmer weather.
But since my source is an old friend then he asks what if this is not weather related and after looking at storage levels at Cushing and elsewhere wonders it it is an attempt by the crude oil traders to encourage Permian operators to CURTAIL production at the lease.
It kinda of makes you go hmmmmm……, doesn’t it?
[…] https://www.artberman.com/oil-prices-are-at-least-7-per-barrel-too-high/ […]
If “energy is the economy” then why isn’t the global economy booming ? What is wrong with this oil since the economy doesn’t want it ? The inventory build up is unprecedented. The economies around the world are in depression or recession despite an oil glut.
Although most emerging markets currencies collapsed against the petrodollar with the collapse of the oil price and at $50 the oil price is $100 in their currencies, which might cause demand destruction and inventory build ups.
The inventory build up has still been taken place when we have had low oil prices.
Something seems to be broken.
Yoshua,
It takes time for the effect of lower oil prices to translate into economic growth especially when debt consumes much potential investment capital. Even at today’s depressed oil prices, the cost of oil in constant 2016 dollars is still 40% higher than it was in the 1990s and early 2000s. That is why the economy cannot grow.
I suggest that you look at my Slide Presentation–Low Oil Prices in a Failing Global Economy: Nowhere to Go for Tight Oil
The economy is weakened by massive debt and over-supplied with commodities because low interest rates have led investors to push production of un-needed products for the sake of yield. This is a classic bubble and it has been deflating for 2 years–not just oil but most commodities.
We are in new territory outside of conventional business cycles because of the growth-through-debt strategies and monetary policies of the last 25 years. I believe it is unlikely that a return to the growth levels of the 1990s is feasible.
The limits to growth were recognized long ago but largely unheeded. Debt steroids made it seem like those limits were illusory. For at least the last 8 years, we are seeing the effects of exhaustion from that injection of artificial growth.
All the best,
Art
Art- thanks for the article. I am trying to understand better the CI numbers you have plotted. For figure 3, is the plot of comparative inventory actually the difference between the weekly inventory and the 5 year inventory average for the same week? So for any given data point in FIg 3 on the RHS for CI, one would take the current week inventory in 2017 and then subtract from that the simple average of the same week inventory # for 2017, 2016, 2015, 2014 and 2013 to get the data point? Does the zero line then represent the 5 year average of the inventory for a given week?
In figure 10, the is no data plotted with negative CI values. Is this a function of the time frame used in the graph where no price data is plotted for a CI below the 5 year average?
thank you
Jeff,
U.S. crude oil C.I. indexes the present inventory level with a 4-week moving average of those levels for the same date over the last 5 years. There are variations for different storage sites and mixes of crude oil and petroleum products. For OECD stocks, the data is only available monthly, so the C.I. moving average scheme is a bit different. U.S. natural gas is just like crude oil.
The mid-cycle price is where the trend crosses the y-axis and represents the median price the market determines for balanced supply during that cycle of prices.
All the best,
Art
The credit/debt expansion, the QE program and ZIRP after the financial crash have of course led to extreme debt levels around the world which now are a burden and that money has been invested in energy and commodity production which has created a bubble in regards to what is sustainable in regard to economically viable recourses.
With limits to growth the financial and economic system should have adopted a new model. In the end they will be forced to do so.
Thx
expansion de deuda
https://i2.wp.com/www.gurusblog.com/jordi/wp/wp-content/uploads/2017/02/ml_debt-and-opportunity_exhibit1-1.jpg?ssl=1
Art- Do you have a link to show how CI is calculated? Would like to understand better. thank you
Jeff,
No, I don’t have a tutorial on comparative inventory on my website.
All the best,
Art
Hello Art,
I followed the steps you had mentioned in the “The days of cheap natural gas are over” article to build figure 3 graph for CI and price.
I tried building the storage line in CI graph for Natural Gas with the below steps:
1. Got the lower 48 states weekly working gas in underground storage data
2. Calculated 5 year moving average for each week from year 2010 to 2017 ( Data was only available from 2010, so 2013 could only had a 4 year average, 2012 had a 3 year average and so on)
3. Plotted it on a graph to see if I get anything close to yours from the Natural gas article on Jan 23rd, 2017, graph screenshot link : http://imgur.com/42kMDAo
I don’t get anything like yours. It is more like the storage graph for NGas on EIA’s website.
I saw that your graph (Figure 3) from that article has data points like 900 and -300 BCF.
Am I looking at the wrong data or is my computation incorrect for creating the storage line for the graph?
Thanks,
Tan
Art
I found this article about Saudi Aramco, it is alternative redactor of economy, I think you and the other people may be interest in it, sorry by my english
http://wolfstreet.com/2017/02/28/most-hyped-ipo-ever-saudi-aramco-overvalued/