Recent headlines featuring the epic battle between OPEC and shale are the stuff of great movies. With the conclusion of the latest OPEC meeting and Memorial Day summer driving season kickoff, it is time to take the pulse of the crude oil market.
Now that the U.S. has assumed the role of marginal producer for the world, the arcane subjects of rig efficiency, frac sand pricing and the like have become hot topics among oil experts. Granted, OPEC still matters greatly – witness the market tantrum in the aftermath of the much-expected decision to extend the production cut for (only) another nine months. But the interplay between American shales and other producers holds the real key to the new paradigm in the coming years.
The Productivity Curse
The CME Group recently published a study on the new relationship between rig count and production in this shale recovery. It estimates from current data that each rig equates to about 3,500 to 4,500 bbl/d with a four to five-month lag. At the center of action is the Permian Basin, whose surging production has effectively negated the OPEC-Russia deal. Given $30s-$40s breakeven cost, a healthy hedge book, and easy access to capital, shale producers are rushing to put new rigs to work. Couple that with the relentless gains in rig productivity, the swollen inventory continues to linger and suppress price recovery.
To make matters worse, new productions from the last investment cycle (Canadian oil sands, Gulf of Mexico, Brazilian offshore) are trickling in to replace the declining production from elsewhere. Rising Nigerian and Libyan output could also trigger new tension among OPEC members. If prices fail to stabilize, the cooperative spirit displayed at the meeting last week may evaporate and rampant quota cheating could ensue. If the deal unravels, a precipitous drop in price is almost a certainty.
The Great Rebalancing Act
Analysts have been calling 2017 the year of rebalancing. Despite all the gloomy headlines, it is indeed happening. Initial OPEC cuts from January are still making their way through the system and it will be evident when 2Q17 numbers are tallied. The rebalance is still on track, but the push-pull between OPEC and shale producers are delaying the day of reckoning from 2H17 to possibly 2018. In the meantime, flat forward price structure, mildly profitable prices, and a deep hedging market are discouraging further stock build and producing a self-fulfilling prophesy.
On the demand side, worldwide growth is robust but slightly underwhelming so far. There is no reason to expect a upside surprise other than the seasonal lift from summer gasoline demand. Current refinery runs are much higher than average, providing a superficial boost to near term demand, but it only cannibalizes demand on the back end. If demand softens down the road the momentum could prove very fragile.
Another tailwind for crude is the US dollar. Although the near term correlation has broken down, the Unraveling of Trump Trade could continue to weaken the dollar and support all commodities.
Putting It Together
The oil market has always been a complicated chess game with many moving parts. Basic supply and demand sometimes take a backseat to old fashion geopolitical events. The electoral victory of moderates in Iran has helped keep its oil flowing. For better or worse, Trump’s transactional mercantilism translates to pragmatism when dealing with the Middle East. With a big IPO coming up, the Saudis are effectively giving the market a “Saudi put” by promising to do “whatever it takes” and jawboning the market.
Taken together, the market appears to be balanced at the moment with a bias for downside risk. It is perceivable that in the absence of shocks, the compressed volatility in the crude oil market will trend lower and stay low for the foreseeable future. The advent of short cycle production, i.e. shale drilling, has created a more efficient market where both physical and financial players have to respond to compressed commodity cycles and decreasing structural alpha. Despite the exciting headlines, the shale vs sheik battle is turning into a trench warfare with volatility its latest victim. Oil has become another boring commodity.
Kronos Management, LLC
May 30, 2017
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