Oil Market Update

The oil market has been volatile since the previous Oil And Gas Market Update in early April. Today I want to review recent events ahead of the 172nd Ordinary OPEC Meeting that will take place next week in Vienna, Austria.

At next week’s meeting, OPEC will decide whether to extend crude oil production cuts that were enacted following the group’s meeting last November. I have argued that they don’t have much choice but to extend the production cuts. More on that below.

But first, let’s review developments since the previous update.

In early April, the price of West Texas Intermediate (WTI) was hovering just above $50. The price rose back to the mid-$50s by the middle of April, but then early May saw a steep sell-off that dropped the price of crude into the mid-$40s.

Continued concern about high crude oil inventory levels that weren’t falling as quickly as expected was the primary reason for the sell-off. The underlying cause was U.S. shale oil production that is bouncing back faster than anticipated — negating the impact of some of OPEC’s cuts. A couple of recent bearish reports added to the downward pressure on prices. 

OPEC’s outlook for non-OPEC supply growth in 2017 has changed dramatically over the past year — but especially since January. In August 2016 OPEC was projecting that non-OPEC supply would decline by more than 100,000 barrels per day (BPD) in 2017. By the time the group announced production cuts in November, it had bumped up the 2017 forecast to non-OPEC growth of just over 200,000 BPD.

But OPEC just put out a new forecast in which they now project non-OPEC growth of 950,000 BPD this year — led by U.S. shale oil producers.

Likewise, the Energy Information Administration’s (EIA) latest Short-Term Energy Outlook has turned more pessimistic about global crude oil inventories. Just a few months ago the EIA expected inventories to start dropping this year. Now, they expect supply and demand to be in balance for the rest of 2017, and for production to again pull ahead of demand in 2018. The change in forecast is primarily due to U.S. oil production that they project will rise ~1 million BPD by next year.  

Many hedge funds and money managers that had made increasingly bullish bets in February and again in early April threw in the towel. Net-long positions in crude oil fell to the lowest levels of 2017 by early May, and as those positions were unwound the price of WTI was driven back into the mid-$40s.

Now, ahead of next week’s meeting comes news that both Saudi Arabia and Russia support extending the cuts until at least March 2018. This caused oil prices to jump about 2%, to the highest levels in more than three weeks. If the report is accurate, then the extension is a foregone conclusion that will be announced at next week’s meeting. While this may not be the catalyst for another move up, it would provide some assurance that the downside is limited from here. 

As I have argued previously, OPEC doesn’t have a lot of options. They tried to defend market share in 2014, and while it did bankrupt some U.S. producers and temporarily halt U.S. production growth, for the most part, it simply caused U.S. producers to become leaner and more efficient. 

OPEC has now tried to defend price, and shale producers responded by ramping up production. Should U.S. production continue to rise, it could nullify OPEC’s production cuts by year-end.

But keep in mind that production is but one of three moving parts here. The second is a global demand that is once more forecast to rise by 1.3 million BPD this year. So if OPEC maintains the production cuts at ~1.5 million BPD, and U.S. production increases by ~1 million BPD by next year, there would still be a shortfall of nearly 2 million BPD.

Further, the third moving part — depletion of existing wells — will keep the pressure on by naturally removing a couple of million BPD of oil from existing wells. That’s a couple of million BPD of oil that has to be replaced just to keep production constant.

As far as U.S. oil producers go, they are mostly signaling that they are going to manage to be profitable even with an extended period of $50/bbl oil. Results for Q1 show that the majority have made significant strides toward improving cash flow and profitability. We believe the companies in the portfolios of The Energy Strategist are well-positioned to profit regardless of OPEC’s decision next week. Consider subscribing for our latest recommendations.

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