Join our community of smart investors

Crude markets in equilibrium - and under pressure

Though oil markets are moving into equilibrium, high inventory levels and improved incentives for swing producers could weigh on prices
May 18, 2017

As this magazine heads to press, official US storage data will be released by the Energy Information Administration (EIA), which is expected to show an increase in US crude inventories, raising fears that markets remain oversupplied, despite efforts by Saudi Arabia and Russia to rebalance the market. Members of the Organization of the Petroleum Exporting Countries (Opec) and 11 other exporting nations meet next week with the aim of extending the production cuts agreed last year to take 1.8m barrels a day off the market. But even if agreement is reached to extend output cuts into the second half of 2017, it is far from certain whether this will have a substantive effect on inventories - at least in the short term.

Global stockpiles hit a new all-time high at the end of the first quarter, largely due to a marked step-up in US imports and increased maintenance outage at northern hemisphere refineries. Inventory drawdown is set to accelerate during the next six months, as refineries consume more crude oil to meet peak demand for fuel in the summer. However, stocks are forecast to remain well in excess of the five-year average.

Brent crude futures, the international benchmark for oil prices, have been marked down recently due to slower than anticipated growth in global demand. However, we needn't read too much into that, according to Bjarne Schieldrop, chief commodities analyst at Nordic bank SEB. "Worries over the rest of 2017 are probably exaggerated" as "overall demand remains reasonably steady", he said. It could mirror the market situation in 2014 when similar anxieties were unfounded, eventually giving way to a demand increase of 1.3m barrels of oil a day, he added. Indeed, both the EIA and the Paris-based International Energy Agency (IEA) believe supply and demand are moving into equilibrium, but the balance of risks remain negative for crude pricing.

This poses a particular problem for those cartel members struggling to fund expanding budget deficits, which could conceivably exacerbate the security issues that bedevil many member states. The EIA estimates that Opec members earned about $433bn in net oil export revenues in 2016, a 15 per cent decline from the previous year, representing the lowest earnings for Opec since 2004.

 

 

The supply cuts have boosted prices back above $50 a barrel for much of the past six months, but that naturally acts as an incentive for US shale drillers, although the dollar viability of unconventional fields across North America varies widely. Nevertheless, they've effectively become the new global swing producers due to their ability to ramp up output much faster than conventional producers. The incentives for US shale producers could increase dramatically if the Trump administration convinces Congress (and perhaps even the US Supreme Court) that the implementation of the proposed border adjustment tax (consumption-based tax) is a good idea.

Ironically, though, seven years on from the Deepwater Horizon disaster, US output is surging due to new production streams from the Gulf of Mexico, moving Uncle Sam within touching distance of top producers Russia and Saudi Arabia.

The strengthening US market is reflected in the Baker Hughes Rotary Rig Count, which just recorded its 17th consecutive weekly rise, although investors shouldn't get too carried away. The US can't be viewed in isolation, but recent progress across the pond belies wider industry trends. Any of our readers looking to the oil services sector as a bellwether of increased industry activity are likely to be disappointed. We're seeing some signs of improvement, but the latest upstream industry survey from Wood Mackenzie indicates that the preferred routes to growth are lower-risk options: M&A, near-field exploration, and exploitation of confirmed discoveries. Higher-risk investments, including deepwater projects, are now being screened at higher hurdle rates - risk is most certainly still off. The good news for investors is that this increased prudence should improve prices over the long haul, while shoring up industry balance sheets. Protecting the dividend has become a higher priority than growth, as we pointed out in our recent analysis of Royal Dutch Shell (RDSB) and BP (BP.), but it's obviously a situation that isn't tenable indefinitely.