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Nasdaq Analyst Warns Of Potential Oil Supply Crunch

Last week I spoke on the phone with Tamar Essner, who is a lead energy analyst at Nasdaq Advisory Services, about the world oil markets. I would say that Tamar and I largely agree on the dynamics in the oil markets.

Robert Rapier: How do you see the oil markets playing out over the next 1-2 years?

Tamar Essner: So much depends on what OPEC does at its May meeting, but I believe oil prices are mostly rangebound between $50 and $60 a barrel (bbl) in 2017, and probably below $70/bbl through 2018. OPEC is in a delicate balancing act. On the one hand, their decision last November pushed oil prices above $50/bbl, but it also spurred additional production from U.S. shale oil producers. But less than $50/bbl doesn’t work for OPEC, particularly with Aramco’s upcoming IPO.

RR: So then I take it you expect OPEC to extend the production cuts at its May meeting?

TE: I think it’s 50-50. They are going to look at several factors, not just the current oil prices. If inventories are close to historical averages, or prices are at or pushing $60, they may not extend the cuts because doing so could trigger too much of a price rally if the market is already near balance. At this point, OPEC appreciates the fast-cycle and growth-oriented nature of shale and understands that anything above $60 triggers incrementally more production and loss of market share for them. OPEC sales are linked to spot prices while shale producers get the price in the forward curve to the extent that most of them hedge a good portion of their production. The flatter the curve, the harder it is for shale producers to hedge prices. But obviously, if spot prices dive lower ahead of the meeting, OPEC has the precedent of the November meeting to show that they can collaborate to defend price.

RR: I don’t see that they have much choice but to extend cuts. Unless inventories are coming down fast, the risk they run if they don’t extend the cuts is that oil prices drop back into the $30’s. They already learned that isn’t low enough to put the shale oil producers out of business, while it hurts OPEC a lot. I characterized their move in 2014 as a “Trillion Dollar Miscalculation.” I still think in hindsight that’s exactly what it was, and they won’t be eager to repeat that experiment – regardless of the risks of propping up the shale oil producers.

TE: I would say right now that OPEC is shale’s best friend because, without the November agreement, we would not have seen enough of a decrease in global supplies to warrant a move to $55, which was enough of a rally to incentivize new rigs in the US and for producers to increase their hedges, locking in future supplies. But shale is a continual thorn in OPEC’s side. I think that OPEC’s goal in November was not simply focused on defending price – again, because too much of rally causes them to lose market share, but particularly on helping to correct the record high inventory levels worldwide, which has slowly been happening.

RR: What are the longer-term trends you see in the oil market?

TE: Over the next 1-2 years we are going to see a lot of production come online from some of the major deepwater and offshore projects. Beyond that, there is a potential slowdown coming due to capital expenditures drying up as oil prices plunged. This dearth of spending is likely to show up as a production shortfall around 2022 – and so we will need the growth in shale supplies to plug these and the other natural declines in aging fields. On the demand side, I am definitely not a believer in peak demand in the next 5-10 years but we do see a structural slowdown in the pace of growth and leveling off in the next 20 years. Largely overlooked is the demand from the petrochemical sector, which will continue to see strong demand growth offsetting declining demand for fuel oil.

RR: Can shale oil producers be cash flow positive at $50/bbl oil?

TE: Some can and some can’t. It will be a struggle for some at that price. The Permian Basin looks profitable at $50/bbl, but if oil prices rise to $70/bbl, it’s “game on” in all the major shale plays. I think about as much has been squeezed from the oil services providers as can be from a cost perspective, but there will continue to be technological improvements to be made to bring down break even costs across all basins. Sand pricing lately has seen the most inflation. Companies that have become more vertically integrated will have a distinct advantage.

RR: That sounds like an argument for a company like EOG Resources (NYSE: EOG), which does control its sand production.

TE: I can’t comment on specific companies.

RR: Understood. Final question. Oil prices dropped back below $50/bbl last month due to a large inventory build in the U.S. I thought that was an overreaction for several reasons, but one thing I noted was that despite the high inventory levels, crude oil imports remain very high. Why are we importing so much crude oil if inventories are so full?

TE: That’s a great question. I think there are a few things going on here. Of course, a lot of U.S. refineries are geared to take heavy, sour crudes that are imported since most of the domestically sourced crude is light and sweet. I think there is a fear of a border adjustment tax, and refiners are hoarding oil ahead of that. Second, since the market has been in contango, there was a strong incentive to store oil in vessels to sell in the future at higher prices. The market is moving toward backwardation, making it less economical to do so. The U.S. has the cheapest storage in the world, so I think you are seeing a lot of that floating storage come to the U.S. Also some of these imports reflect agreements made from before the OPEC cuts and we expect the pace of imports to the US to slow over coming weeks.

RR: Interesting insights. I hadn’t heard anyone make that point before. Thank you very much for your time today.

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