How a Meeting in Paris Just Changed My Oil Outlook
I just left a closed-door meeting in Paris. Assembled here were some high-powered oil practitioners, the traders selling their productions, and the bankers financing all of it.
As often happens, the pundits and talking heads have been discussing matters quite similar to what was on our agenda. And as usual, their perspectives are very different from those of us “behind the scenes.”
As a matter of fact, what I heard this week has led me to believe that I may even have made a misjudgment.
For some time I have been talking in Oil & Energy Investor about a confluence of factors leading to a rise in oil prices. It was heartening to see I was right according to those assembled in my meeting… except for in the case of one interesting factor…
Here’s my take on what’s really going on in the oil markets, despite all the noise…
Have OPEC and American Shale Destroyed the Supply/Demand Balance?
First, let’s discuss what the pundits in the media have been getting wrong.
In the last two days, no fewer than four separate opinion pieces have appeared, all focusing our attention on the same point. About a year ago, each of these missives begins, a crude oil pricing collapse began. By the time it was over, prices had slid almost 60%.
The apparent culprit, according to this view, then and now, is a surplus of crude on the market. Each of these pieces then concludes that the problem is continuing.
Why? Because OPEC production is up, U.S. unconventional oil (read: shale and tight) remains too high, and there is a declining drain-off from refinery runs despite the reported rise in gasoline demand as we move into the primary driving season.
The translation being advanced is simple enough. The expected rebalancing of the crude oil market, in which supply and demand are equivalent and pricing changes are narrow, has not taken place because there remains too much supply on the market. In support of the argument, the pundits then turn to their two primary culprits.
The first is the decision by OPEC to initially keep production levels high and then to raise them even more in an almost frantic attempt to maintain market share. The second is the resilience of the American shale patch to continue extraction levels in the face of subdued prices for the product being lifted.
“It’s the supply side, stupid,” the commentators seem to be saying in unison.
However, the truly remarkable thing to recognize is that these same writers were touting that the rebalancing was in fact forming. And they had even proclaimed it had actually arrived early this week!
We Don’t Need a Shortage to Rebalance the Market
So what happened?
Initially, they had to contend with the uncertainty of a Greek collapse in Europe and then with the uncertainty of what the Fed would say yesterday afternoon. Pundits, you see, hate uncertainty.
Then the weekly figures came in from the EIA (the Energy Information Administration, a division of the U.S. Department of Energy). They continued to show a drawdown and an absolute decline of almost 2 million barrels a day in American crude oil inventory. But not as large a decline in gasoline as anticipated.
That combined with a report earlier in the week that OPEC had produced 31.1 million barrels a day in May, a level higher than for any month since October 2012. This puts the cartel’s production some 1.1 million barrels a day above its own monthly member quotas and 1.8 million barrels a day over its own estimates of the demand for its own oil.
Suddenly, the opinions were looking back a year to the beginning of a pricing decline and proclaiming the same supply problem existed this time around.
Now, what the “short-sightseers” want is an absolute contraction in American production totals, not simply a reduction in forward production rates. That is both unnecessary and a terrible way to calculate the actual base for prices. Nobody is expecting a shortage. We don’t need one for the balance in the oil market.
Why My Estimates Were Wrong
This leads me back to yesterday’s meeting here in Paris.
Behind the closed doors, the consensus was quite different. While nobody considers a constriction of supply likely (there is currently too much short-term available oil from both the conventional OPEC providers and the new U.S. oil fields), the balance is already here.
Hence my misjudgment: It seems I may be too conservative in my price readings of $73-78 a barrel for the West Texas Intermediate (WTI) in New York and $82-85 a barrel for Dated Brent in London by the end of the year. These came in at the very low end of the figures being proposed.
While the pundits are still in search of their illusive “balance,” the combination of OPEC member financial difficulties – all of them, including Saudi Arabia, are drawing heavily on hard currency reserves as credit become more expensive, making the present overproduction unsustainable. With a range of other considerations, this has established a pricing floor.
These other considerations have been the subjects of my briefings here for months. U.S. shale and tight oil production has been buttressed by expanding volume from the most recent wave of wells. That flow will begin to taper off next month (July) as the wells exhibit the production peak at about 18 months from opening common to fracked drilling.
Much of the secondary and enhanced oil recovery normally used to temper the decline will be too expensive for use without cutting into profit margins. Companies will cream frontend production and move to additional wells drilled but not completed. These are primarily replacement wells and will not provide any overall increase in aggregate production rates.
The other major consideration is on the financial side. The availability of credit on both sides of the Atlantic is becoming more expensive. Here in Europe, the concern over a “Grexit” (a Greek exit from the euro zone) and the attendant drain on interbank credit mean there will be a spike in interest requirements on new drilling loans. Much of that is orchestrated from London. I was certainly picking up signals of this while I was there last week.
The Balance Is Already Here
In the U.S., the quality and expense of the high-yield (read: junk) bonds used to finance new drilling have resulted in companies scrambling to pay an increasing debt load and remain the single major reason for major cuts in future capital expenditures for horizontal, fracked, deeper, and more expensive shale drilling.
That means the prospects for significant new drilling remain problematic. That is another decided cause of lower new production trends moving forward.
There will not be any sudden shortage of oil. But the price will also not be retreating back to the mess of late last year. The European movers and shakers have concluded the balance is here.
And what of all that noise the pundits were making yesterday afternoon? Oil did close down in New York – by a whole five cents a barrel. It was up nine cents in London.
Someday maybe these guys will understand the market they are commenting upon. But I haven’t seen any indication of that yet.