Remember the shale gale and Saudi America? The scale of those outlandish delusions has now dwindled to plays in a few counties in West Texas and southeastern New Mexico. Saudi Permian.
It’s a race to the bottom as investors double down on the tight oil companies that can still tell a growth story. Permian-weighted E&P companies are the temporary darlings of Wall Street as other tight oil plays have lost their luster.
A Silly Price Rally: Catch-22
We are in the middle of a truly silly price rally. Other rallies of 2015 and 2016 took place despite substantial production surpluses and too much inventory. Then, there was some hope that higher prices might result if over-production could be brought under control. Now, the world’s production and consumption are near balance but oil prices remain mired in the $40 to $50 per barrel range.
This current rally will end badly because there is something more fundamental keeping prices low. Despite repeated assurances from IEA and EIA that demand growth is strong, it is not strong enough to draw down outsized global inventories.
Hope for an OPEC production freeze at next month’s meeting in Algiers is the main factor driving this rally. The problem is that the world liquids market is as close to balance as it ever gets—over-supply has been less than 0.5 million barrels per day for the last two months (Figure 1). Oil prices were more than $100 per barrel at similar or greater production surpluses in 2013 and 2014.
Figure 1. World liquids production minus consumption shows that the present market is as close to balance as it ever gets. Source: EIA and Labyrinth Consulting Services, Inc.In 2015, when the average production surplus was 2 million barrels per day, it was a different story. Over-production is not the problem now as it was then. If OPEC freezes production, it won’t make any difference.
Inventories exceed all historical levels. The world remains over-supplied because there is too much oil in inventory.
As long as oil prices are are range-bound between about $40 and $50 per barrel, it makes more sense to store oil than to sell it. The carrying cost of storage is less than what can be made by rolling futures contracts over each month. Inventories will stay high until prices break out of their current range but outsized inventories make that impossible. Catch-22.
Four Oil-Price Cycles in 2015 and 2016
There have been four oil-price cycles in 2015 and 2016-the first three each lasted approximately 6 months (Figure 2). Each new cycle began with high price volatility that fell as price peaked. We are currently in the upward arc of Cycle 4.
Figure 2. Oil-price and oil-price volatility cycles since 2014. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.
The oil-price volatility index has fallen to levels similar to when prices peaked during the last cycle suggesting that current WTI futures prices just above $48 per barrel may already be near the peak for this cycle. Prices may increase into the low-$50 per barrel range as they did in June before falling again.
The latest cycle began when NYMEX futures prices fell below $40 per barrel in early August. In the succeeding two weeks, they have climbed to more than $48 (Figure 3). A factor beyond a possible OPEC freeze is the weakened U.S. dollar because of expectations that the Federal Reserve Bank will not raise interest rates at least until December. The value of the dollar against other major currencies has fallen 3% over the last month (36% annualized). WTI futures prices have increased 22% since August 1.
Figure 3. 2016 U.S. dollar index and WTI NYMEX futures prices. Source: EIA, Wall Street Journal and Labyrinth Consulting Services, Inc.
A third factor driving the current price rally is long-term concern about supply because of under-investment in oil development projects and exploration since the oil-price collapse. Recent statements by the International Energy Agency that demand may outpace supply in the next few years underscored that anxiety.
Figure 3 shows that oil prices appear to be range-bound between about $40 support and $51 per barrel resistance levels. The upper boundary is largely controlled by record-breaking volumes of U.S. and world crude oil inventories and the fact that producers add rigs and production with each upward swing in oil prices.
The 200-day moving average of NYMEX futures prices suggests similar range boundaries of about $38 and $52 per barrel (Figure 4).
Figure 4. Two-hundred day moving average of WTI NYMEX futures prices. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.
This market looks for any excuse to raise prices. Every price upswing is seen by some as the beginning of a return to oil prices above $70 per barrel. We seem to selectively forget that the staggering inventory levels of crude oil make this impossible until those volumes are drawn down substantially. Oops.
U.S. crude oil inventories fell 2.5 million barrels this week but have increased a net 1.6 million barrels over the last month during what is supposed to be de-stocking season (Figure 5).
Figure 5. U.S. crude oil inventories and comparison with 2015 levels and the four years preceding. Source: EIA and Labyrinth Consulting Services, Inc.
Storage volumes are 57 million barrels more than at this time in 2015 and are 143 million barrels higher than the 5-year average. This is definitely not a basis for a sustainable oil-price rally. Until inventories are drawn down by at least another 125 million barrels, a recovery to somewhere approaching mid-cycle 2014 levels of about $80 per barrel is technically impossible.
The Permian Basin Dominates Rig Count Increases
Five new horizontal rigs were added last week to drill tight oil objectives in the Permian basin and 12 rigs were added the previous week. Only 1 rig was added in the Bakken play after losing 2 rigs a week ago. No rigs were added in the Eagle Ford after losing 1 rig the previous week. More capital is being spent in the Permian basin than in all the other plays put together.
Overall, 67 tight oil rigs have been added since early June. Forty eight of those are in the Permian basin, 5 in the Bakken and 6 in the Eagle Ford play (Figure 6). Four rigs were added in the Niobrara, 3 in the Granite Wash and 1 in Other. Rig count increases began as oil prices peaked above $50 per barrel in early June and continued through the slump toward $40 prices before the latest upward swing to $48 per barrel.
Figure 6. Permian basin, Bakken and Eagle Ford tight oil horizontal rig count, NYMEX WTI prices and oil-price volatility index. Source: Baker Hughes, EIA, Bloomberg and Labyrinth Consulting Services, Inc.
Weekly changes in the Permian basin rig count are the leading indicator of capital flows and expenditures. Permian rig count is more responsive to capital flows than the other tight oil plays because there is more money available for Permian-weighted companies.
In late July, I wrote, ‘When prices fall and oil-price volatility increases, the floodgates of capital open. Every genius-investor wants to buy low and sell high. Rig count rises with fresh capital, production increases and oil prices fall.’
In fact, the Permian basin accounts for 64% of the total U.S. horizontal tight oil rig count (Figure 7).
Figure 7. The Permian basin rig count represents more than 60 percent of the U.S. horizontal tight oil rig count. Source: Baker Hughes and Labyrinth Consulting Services, Inc.
This is curious because Permian production from the Bone Spring, Wolfcamp and Trend-Spraberry horizontal plays represents only 21% of total tight oil production (Figure 8).
Figure 8. Permian basin daily production from the Bone Spring, Wolfcamp and Trend Area-Spraberry plays is only 21% of total U.S. horizontal oil production. Source: EIA, Drilling Info, North Dakota Department of Natural Resources and Labyrinth Consulting Services, Inc.
It is even more curious because Permian basin tight oil proven reserves rank 42nd in the world just behind Denmark and Trinidad and Tobago based on the latest EIA data (Figure 9).
Figure 9. Permian basin tight oil proven reserves compared with world crude oil reserves. Source: EIA and Labyrinth Consulting Services, Inc.
Some will argue about potential and possible Permian resources and reserves preferring Pioneer CEO Scott Sheffield’s view of things to reality. I won’t debate them but the point is that Saudi Permian is a stretch based on any reality-based interpretation of existing data.
This article is for information and discussion purposes only and does not form a recommendation
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