Tyler Durden: The recent rally in crude prices looks more like a head-fake than a sustainable turning point, suggests Citigroup Inc’s (NYSE:C) Ed Morse, noting that short-term market factors are more bearish, pointing to more price pressure for the next couple of months and beyond. While the shape of the oil price recovery is unlikely to be ‘L’-shaped in their view (more likely ‘U’, ‘V’, or ‘W’-shaped recovery), Citi warns the oil market should bottom sometime between the end of Q1 and beginning of Q2 at a significantly lower price level in the $40 range (perhaps as low as the $20 range for a while) – after which markets should start to balance, first with an end to inventory builds and later on with a period of sustained inventory draws.
The recent rally in crude prices looks more like a head-fake than a sustainable turning point — The drop in US rig count, continuing cuts in upstream capex, the reading of technical charts, and investor short position-covering sustained the end-January 8.1% jump in Brent and 5.8% jump in WTI into the first week of February.
Short-term market factors are more bearish, pointing to more price pressure for the next couple of months and beyond — Not only is the market oversupplied, but the consequent inventory build looks likely to continue toward storage tank tops. As on-land storage fills and covers the carry of the monthly spreads at ~$0.75/bbl, the forward curve has to steepen to accommodate a monthly carry closer to $1.20, putting downward pressure on prompt prices. As floating storage reaches its limits, there should be downward price pressure to shut in production.
The oil market should bottom sometime between the end of Q1 and beginning of Q2 at a significantly lower price level in the $40 range — after which markets should start to balance, first with an end to inventory builds and later on with a period of sustained inventory draws. It’s impossible to call a bottom point, which could, as a result of oversupply and the economics of storage, fall well below $40 a barrel for WTI, perhaps as low as the $20 range for a while.
Is a ‘new oil order’ replacing the old order?
Markets have, in Citi’s view, correctly depicted the heart of the lower price oil environment as a result of a conflict between markets and marketing influence, or more directly between the impacts of the shale revolution on OPEC’s ability to drive a significant “permanent” wedge well above production costs to maximize revenues for OPEC and other oil producing countries. No matter what the ultimate outcome, it looks exceedingly unlikely for OPEC to return to its old way of doing business. While many analysts have seen in past market crises “the end of OPEC”, this time around might well be different.
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There are three critical factors in the future: supply, demand and inventories.
How rapidly is supply likely to adjust to low prices?
From a supply perspective, $50-or-even-60/bbl is unsustainable in the medium-term as not enough future oil supply is generated to meet future oil consumption:
1) up to half the world’s future projects are uneconomical at oil prices below $50/bbl;
2) corporate cash flow generated at $50/bbl is not enough to meet debt, shareholder and capex requirements and pullbacks on brownfield spending should accelerate existing decline rates; and
3) $50/bbl cuts government revenue budgets, up to half in some cases, and with domestic spending hard to cut meaningfully, hence NOC investment has to be revised down sharply. This means supply cuts are on the way, and the lower and longer oil prices stay, the more deferred supply will be curtailed, especially given the myriad implications this has for geopolitics. Lower prices, in short, create greater political risk of supply disruption in distressed economies, including among other Nigeria and Venezuela. By 2016, we expect non-OPEC supply to be declining y/y, by ~0.2-m b/d, from a combination of US shale curtailment and accelerated current field depletion.
For now however, crude supply has significant momentum as prices above operating costs mean there is little reason to pull back output. US production is still growing at 1.1-m b/d y/y, Atlantic Basin waterborne loadings are up 665-k b/d y/y to 9.6-m b/d in January-February, and Brazil and Russian output reached record levels in December, of 2.5-m b/d and 10.7-m b/d respectively, with Russia maintaining this level for January. Saudi Arabia, Iraq and Iran continue to cut their Official Selling Prices (OSPs) to Asia in a bid to retain market share meaning supplies out of the Persian Gulf aren’t expected to decline (by choice) soon. Iraq exported a record 2.7-m b/d in December from Basrah, and Federal and Kurdish exports are growing in the North, reaching 300-k b/d in January. This wave of supplies has been depressing prompt prices and a pullback isn’t expected until 3Q’15, or 2Q’15 in our “V” scenario where oil may need to price down to $30/bbl to shut-in current production.
The biggest revision to oil supply growth is coming out of the US, with recent growth rates of over 1-m b/d y/y for crude output overwhelming global oil markets. While there could be a range of responses, we expect that shale producers may end up cutting rigs by around 50%, while some 0.2-m b/d of marginal oil wells could see shut-ins. (By itself, this could mean US crude production growth could slow to ~0.6-m b/d y/y in 2015, or ~0.8-m b/d y/y for crude and NGLs together, and down to 0.25-m b/d y/y in 2016 for crude output growth, or ~0.45-m b/d for crude plus NGLs.) But given prices might drop significantly in 2Q’15 as US storage tanks near critical levels, US shale producers may also drill but not completing wells in 2Q, building an inventory of drilled-but-not-completed wells. These could be brought back in 2016, or when futures prices recover and could be hedged out.
Falling oil prices have led to parallel processes of supply adjustment. First, US shale producers were cashflow negative on aggregate, with capex higher than cashflows, with high-yield debt bridging much of this gap. As production volumes grow quickly, the industry was set to move to a cashflow neutral position in 2014, and was expecting to go increasingly cashflow positive in 2015 and onwards. The oil price drop scuppered that outlook. Capex has therefore been cut back to defend balance sheets. Second, as the oil price fell, less productive shale acreage became uneconomic. Taken together, company announcements to reduce drilling activity in 2015 and onwards, and focusing remaining activity in the most productive core areas of the major shale plays makes sense. See “Is the falling US oil rig count really driving an oil price turnaround?”, where the rig cuts seen so far in 2015 are meaningful, but not so much as to bring US production growth to anywhere near zero, let alone negative, particularly if productivity gains are substantial.
In our report, “Catching the Knife – call on shale is a new balancer for oil markets”, we explored the level of capex/rig cuts to get the US oil and gas industry as a whole to cashflow neutral. We found that with only modest productivity gains, a ~50% rig cut could bring the industry to cashflow neutral in 2015, moving to cashflow positive in 2016 as production volumes continued to grow, and prices could recover. With such a 50% rig cut, US oil production growth could still be +0.6-m b/d y/y in 2015, flat y/y in 2016, and growing again in 2017. So far, company-announced capex cuts look in the 20-40% range, and so far, total active US oil rigs are down 30% from the peak, though most of the falls have been in vertical and directional rigs.