Mixed Signals

We are rapidly approaching the midpoint of the initial term of the OPEC production cut agreed to last November. Initial reports are that the 11 member countries party to the agreement have demonstrated very strong compliance. In fact, a report by the International Energy Agency says that OPEC members collectively have reduced output by 90 percent of the 1.2 million-barrel-per-day cut. Other surveys have supported this extraordinarily high compliance figure. That is significant given that over the past three decades OPEC cuts have only produced a 67 percent compliance rate.

The challenge now for the agreement to succeed in reducing the global oil market’s oversupplied state is the less-than-stellar sup- port from non-OPEC oil exporters who agreed to support OPEC – notably Russia, which reportedly is at only a 50 percent compliance level. Some think Russia may be playing the OPEC producers for suckers in order to boost market share at their expense, especially in the highly competitive Asian oil market.

Regardless of weak support from non-OPEC exporters, global oil inventories are shrinking, but not as fast as many had hoped. According to the latest IEA data, they remain above their five-year average, but the gap is closing. With output limited and healthy demand (albeit slightly below 2016’s rate), oil inventories should continue to decline. Recent estimates suggest the global oil inventory trajectory will bring the market into balance by mid-2017. If that occurs, oil prices should move higher. Just how high is the question.

WHITHER PRICES?

After beginning to rebound last fall, oil prices in 2017 have traded in a fairly tight range around the mid-$50s per barrel. Depending on whether it’s West Texas Intermediate or Brent, oil prices have been stuck in a $50-$55 or $55-$60 per barrel range, respectively. For investors and industry executives alike, the comfort level is somewhere in the mid-to-upper $60s a barrel. They have their fingers crossed that this scenario is only a matter of months away.

Others, however, are not so optimistic and believe the industry should continue to focus on reducing costs and improving drilling and production efficiencies.

The latest concern is the impact on future supplies of two-plus years of reduced oil industry investment. The IEA recently warned that unless industry investment stepped up meaningfully the world is at risk of an oil shortage by 2020, which would result in global economic shock from sharply higher prices.

The “oil shock” scenario is typical of forecasts made at cycle bottoms. Why? Because forecasters are too dependent on “business as usual” assumptions in preparing their outlooks. They fail to understand – maybe because the trends are not clear – how technology improvements will impact both supply and demand going forward. Looking at what has happened in this cycle, we see noticeable shifts underway that make forecasting with “business as usual” assumptions dangerous.

The 2014-2017 oil industry cycle has notched several notable, if dubious, records. The downturn that began in the fall of 2014 saw the sharpest and steepest decline in the history of the U.S. drilling rig count as reported weekly by Baker Hughes since 1949. Most people compare this downturn against the industry collapses of 2008- 2009 and 1986-1987. This one happened faster than either of those past collapses, and this time the rig count fell to a level hundreds of rigs below the lowest rig counts in the depths of those prior declines.

However, since the rig count bottomed in May 2016, the recovery, indexed to the rig count low, has consistently outpaced three of the most recent recoveries – 2002-2003, 2009-2010 and 2013-2014 – along with the mid-1980s recovery. It initially trailed the pace of the 1999-2000 recovery until week 35, at which point it surpassed that cycle’s pace too and continues outpacing it.

This healthy recovery in the U.S. is welcomed by the oil industry but viewed with a skeptical eye by OPEC and non-OPEC producers. The drilling increase is leading to a rapid turnaround in U.S. oil production as companies have substantially reduced their shale well breakeven costs, so at current prices they are able to drill new shale wells in the most prolific basins – the Permian, Eagle Ford and Bakken – at a profit.

Projections suggest that American oil companies may grow domestic output sufficiently over the next six to nine months to offset a substantial portion of the production deferred by OPEC and non- OPEC exporters. This means that reaching a balanced oil market may take longer than anticipated. That possibility has led to calls for OPEC and non-OPEC producers to extend their production cut agreement by three to six months.

If shale producers truly have cut their breakeven prices, then the world may return to a significantly oversupplied oil market by 2018 unless consumption grows faster. Lower prices seem to be the only way to curtail output on a sustained basis while boosting consumption.

TO DRILL OR NOT TO DRILL?

The divergent outlooks for production and prices leave oil companies in a quandary about their corporate strategies. Do they drill like crazy in anticipation of higher prices in the foreseeable future, as it appears many U.S. independents are doing, especially in the Permian Basin? Or do they settle in, betting that oil prices remain in their current range for an extended period?

The former scenario promises a return to the “boom and bust” cycle of activity. The latter means accepting lower returns in exchange for increased price stability. Which will it be? What should it be?

The issue is different for major international oil companies who lack resources in the prolific shale basins. Do they hold back spending until higher prices are evident, or do they ramp up international and offshore projects to be positioned to capitalize on the IEA’s anticipated oil shortage scenario?

The lack of a broad-based oil industry recovery – land drilling in the U.S. continues to do extremely well while offshore and international drilling lags – suggests how precarious the recovery remains. Can it progress with uneven activity just as long as onshore producers retain a profit incentive?

An uneven recovery means oil companies must reassess their near- and intermediate-term strategies. Repairing balance sheets, supporting dividend payments and increasing production remain high priorities for industry executives, but which of these priori- ties will be emphasized? That may depend on how producers see their cash flow growing – from greater output or higher prices?

An important consideration in this equation will be oilfield service costs as more activity forces the reactivation of previously stacked equipment, requiring increased maintenance capital and the hiring of additional workers, which has become more difficult with- out raising overall wages. Potentially offsetting some of these cost pressures will be further gains in oilfield technology, leading to more productive wells and increased reservoir recoveries.

THE GREAT UNKNOWN

The greatest unknown for oil industry executives over the next few years is what happens to global economic activity. The answer is impacted by geopolitical events, including potentially significant energy and environmental regulatory revisions in the U.S. as a result of the new Trump administration. At the same time, mandates to use renewables to power the global energy business are growing. This is especially true for electric vehicles with their dampening impact on gasoline demand. These two forces will challenge oil consumption growth.

At the present time everyone is hoping for an acceleration in global economic activity, but they should prepare for the possibility of continued slow growth and lower oil use. A recent Capital Economics forecast calls for developing economies to grow only four percent a year over the next decade, two-thirds of their historic growth rate.

A continued oversupplied oil market or an impending global shortage? Boom and bust, or steady oil prices? These scenarios con- front oil companies’ business strategies. Since the global economic recovery has now lasted longer than past recoveries, the possibility of a recession in the next several years grows. We are not sure forecasters or oil industry executives have that scenario factored into their oil demand outlooks.

Depending on the severity of a recession, managing the global oil oversupply could become a contentious battle between OPEC and non-OPEC producers with unknown risks for the industry and economy. Where would that send oil prices and what might that do to oil industry cash flows and investment opportunities? We expect this uncertainty will keep oil companies from ramping up investments faster than their cash flows grow.

Given the need to keep bond and equity investors happy, oil industry spending may not rise much more in the foreseeable future, limiting how the current recovery advances from here.

- MarEx