$60 Oil – A Ceiling or a Floor?
Currently accepted wisdom suggests that a price for West Texas Intermediate (WTI) crude oil above $55-$60 a barrel will provoke a flood of new shale supply, driving pricing right back down. Count us among the skeptics of that theory.
In July, WTI traded below $45; in November, WTI broke $55/bbl; and today, WTI trades near $65. While we aren’t necessarily calling for further gains, we don’t expect much of a retracement, and we doubt we will see $50 oil for quite a long while.
What’s Driving the Market?
A weak dollar is undoubtedly a contributing factor, but inventory rebalancing is the dominant force. Strong global economic activity is driving consumption higher, with usage rising at an annual rate of more than a million barrels a day. At the same time, supply is short. The production cut agreement between Russia and OPEC took considerable supply off-line, allowing the global inventory glut to clear, even as U.S. production has risen to a level not seen since the early ‘70s (Figure 1). Those supply cuts will likely be unwound later this year, but inventory levels may remain under strain for years.
Figure 1: U.S. Oil Production Hits Historical High
DOE U.S. Crude Oil Production
Source: Bloomberg, as of 1/29/18.
The Lag Effect
The steep decline in crude oil pricing in 2014 and 2015 led to massive capital expenditure cuts by exploration and production companies around the globe. As such, many large conventional projects were deferred or canceled. These decisions, made a couple of years ago, are only now beginning to impact the supply outlook, due to the multi-year lag between the decision to invest and the extraction of the first barrel of oil. So even as OPEC/Russia restore their production and the shale supply in the U.S. expands, supply growth may be inadequate to keep pace with demand, due to waning production from non-U.S., non-OPEC (NOPEC) sources.
The futures curve doesn’t seem to agree with us. In steep backwardation, the price of a barrel of oil to be delivered a few years from now is significantly lower than the cost of delivering a barrel of oil today, implying little risk of future scarcity (Figure 2). We disagree, and anticipate that the curve will gradually rise toward current pricing as the impact of past CapEx reductions becomes more visible.
Figure 2: Oil Futures in Backwardation – Not a Problem
WTI Crude Oil Futures
Source: Bloomberg, 1/29/18. The WTI Futures Curve is a contractual agreement for the price of oil at a specific date in the future. A futures contract is a contractual agreement typically made on the trading floor of a futures exchange. It enables the purchase or sale of commodities at a predetermined price in the future.
The Shift to Greater U.S. Production Looks Permanent
Improvements in shale-drilling technology allow for more productive wells to be completed in less time, using fewer workers. The sum of each means breakeven costs have fallen sharply, and investment in any large-scale deep water, arctic, or tar sands project is less economical than it used to be. Our suspicion is that shale supply will gradually displace these more conventional sources of oil and gas, as the U.S. becomes the world’s largest producer. That shift is underway, as evident in rising levels of petroleum exports (Figure 3). We expect that exports will grow substantially in the years ahead.
Figure 3: U.S. Crude Oil Exports on the Rise
DOE Total U.S. Cruide Oil Exports
Source: Bloomberg, as of 1/29/18.
Why Does It Matter?
There are two significant (if obvious) implications of steady or rising crude oil prices amidst sustained growth in U.S. production.
The first is that higher energy costs are inflationary, adding to upward pressure on bond yields and pushing the Fed toward tighter monetary policy.
The second is that earnings’ prospects for both midstream and upstream energy producers in the continental U.S. are bright. Lower extraction costs, combined with higher sales prices, translate into rich profit margins for drillers, while volume increases bode very well with energy infrastructure. The market has been slow to embrace improving earnings’ prospects, so we believe substantial gains still lie ahead.
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Capital expenditures (CapEx) are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings, or equipment. It is often used to undertake new projects or investments by the firm.
MLPs and other natural resources sector companies are subject to certain risks, including, but not limited to, fluctuations in the prices of commodities; the highly cyclical nature of the natural resources sector may adversely affect the earnings or operating cash flows of the issuers; and a significant decrease in the production of energy commodities would reduce the revenue, operating income, and operating cash flows of MLPs and other natural resources sector companies and, therefore, their ability to make distributions or pay dividends.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a domestic benchmark in oil pricing.
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