- September 8, 2017
- Posted by: Art Berman
- Category: The Petroleum Truth Report
The most likely case is that WTI will remain stuck in the upper $40 to lower or mid- $50 range through December 2017.
Comparative inventories have fallen dramatically since mid-February yet oil prices languish in the mid-to-upper $40 range. What will it take for oil prices to break out of the $45 to $55 range boundaries since OPEC production cuts were announced in late 2016?
WTI prices increased from below $45 to almost $55 per barrel based on expectation that OPEC cuts would quickly balance international oil markets and result in near-term higher oil prices. While that expectation lasted, prices remained near $55 from late November 2016 until early March 2017 (Figure 1).
Prices adjusted downward four times between March and August as it became clear that output cuts were not enough to produce a meaningful price recovery. Since mid-August, markets have rallied back to the ~$49 per barrel price average since November.
Tight Oil Rig Counts
Rising rig counts in U.S. tight oil plays have been the most important factor constraining oil prices. Investors fear that resulting increased output will prevent the market from reaching balance.
Rig counts in the Permian basin, Bakken and Eagle Ford plays began increasing after WTI fell below $30 per barrel in early 2016. Since OPEC first suggested the possibility for a production cut in August 2016, tight oil rig counts have more than doubled (Figure 2).
While the increase in the number rigs is impressive, the most revealing aspect of Figure 2 is the decline of the Eagle Ford, and the flattening of Permian basin and Bakken rig counts since June. This suggests that the appetite for tight oil plays among equity investors may be moderating.
Despite claims of sub-$40 per barrel break-even prices by Permian basin producers, rig count data indicates that overall play economics require higher prices. The weekly change in Permian rig count suggests that break-even WTI prices may be closer to $55 or $60 per barrel (Figure 3). Break-even prices for some producers are certainly lower but higher prices are required for the average company.
Above all, rig count reflects capital flows and the availability of other peoples’ money to fund the tight oil plays—this is critical to production maintenance and growth. Figure 3 shows that capital availability is dependent on expectation of $55 to $60 oil prices. Capital flows have apparently faded with those expectations or else producers are using available capital for other purposes in addition to drilling.
Comparative inventory (C.I.) fell 117 million barrels (mmb) from mid-February through the end of August (Figure 4).* This is the most significant oil market development since oil prices collapsed in 2014 but it has had little affect on oil prices so far.
Lower net imports of petroleum products is the main reason for this reduction in C.I. Refinery intakes are at record levels as refiners produce and sell refined products in the U.S. and abroad. As I pointed out last month, this trend is only sustainable if demand for U.S. refined products persists.
While exporting products helps reduce U.S. stocks, it aggravates the global over-supply of liquids. Higher net imports in recent months suggest that this trend may be weakening or ending.
Figure 5 shows the magnitude of inventory reductions from mid-February to late August as a “yield curve” of WTI price vs. C.I.
I estimated a range of probable year-end C.I. values to be between 40 and 75 mmb using EIA August STEO inventory forecasts and 2017 inventory decline trends. This range of C.I. translates to December WTI prices between $50 and $56 per barrel.
Continued demand for refined products is the key. I stated in a previous post that I doubted that ongoing U.S. inventory reductions were sustainable because of over-supply in international refined product markets. That would result in lower reductions in C.I. and most-likely December prices in the upper $40 to lower $50 range.
On the other hand, if refined product demand remains strong and inventory reductions follow a trend similar to that of the last several months, it is more likely that year-end WTI prices will be in the $50 to $56 per barrel range.
Large reductions in C.I. so far have not resulted in meaningful increases in oil prices because the yield curve is fairly flat. That is typical of outsized storage levels.
Oil prices collapsed in 2014 because of excess supply from over-production. Low prices and the contango term structure of forward curves encouraged putting large volumes of crude oil and refined products into storage.
Record U.S. inventory levels were reached in February 2017. Inventory reductions since then leave comparative inventories down only somewhat from record levels (Figure 6).
Progressively higher absolute inventory levels push the 5-year average continually higher. Since C.I. is the difference between inventories and the 5-year average, falling C.I. relative to climbing 5-year averages results in a fairly flat yield curve (Figure 5).
A greater rate of curvature will result in higher oil prices from incremental C.I. reductions as the yield curve approaches the y-axis and mid-cycle price. That, however, is not likely to happen in 2017.
Barring unforeseen supply outages and ongoing rates of C.I. reduction, December 2017 WTI prices should be only slightly higher than current prices namely, in the lower or mid-$50 range at best.
* C.I. increased 5 mmb for the week ending September 1 and net imports of petroleum products increased 1.7 mmb because of Hurricane Harvey. Latest data is included in Figure 5 but not Figure 4 because it skews net imports based on a weather-related anomaly.