Crack in the Foundation?

Jim Brown
 
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The markets sold off again on Wednesday and the Tuesday short squeeze was erased. Crude prices and commodities fell on worries over weak demand from China.

The weak flash manufacturing PMI from China is still weighing on commodities and the government numbers are not due out until Thursday. The government numbers are normally a little more "optimistic" to characterize them nicely.

The IMF announced it had cut the growth expectations for China to +7.75% from +8.0%. They kept that 7.75% rate for 2014 as well. In April they were predicting +8.2% for 2014. Over the weekend Chinese officials said they were targeting 7% growth for the rest of the decade. This set the tone for the market and the tone was negative.

Precious metals were higher as fear began to creep back into equities. Gold was holding just under $1400 and silver at $22.50. Neither gain was material considering the sell off over the last three months.

The EIA inventory report is not until Thursday as a result of the holiday on Monday. The API inventories showed a gain of 4.4 million barrels to 395.1 million and the highest level since July 1981. The API report is less reliable but in the absence of EIA data the numbers weighed on the market.

OPEC meets this weekend but the various rational oil ministers have already said there will be no change in the quota at the current target of 30 mbpd. Output in April was 30.9 mbpd. In a survey of 20 analysts by Bloomberg all but one expected OPEC to make no change.

However, SocGen said the necessary reduction in output could be substantial if they want to put a floor under prices. With production increasing in the U.S. and Brazil the demand for OPEC oil is going to decline slightly. The market today appears over supplied and the failure to lower the official quota could cause priced to decline according to Citigroup.

The offsetting voice here is the IEA, which claims the call on OPEC for the second half of the year will be closer to 31 mbpd. Saudi Arabia burns up to one-million barrels of crude per day during the summer months to generate electricity and desalinate drinking water. This seasonal surge in demand reduces the amount of oil available for export.

Bank of America cut their forecast for prices to $105 from $112 for 2014 on the outlook for lower demand and higher supply. However, the OECD said today they are projecting a rebound in the global economy in early 2014. That would increase demand and support prices.

The current price of $102.50 for Brent and $92.50 for WTI is a fair price according to multiple OPEC ministers. Saudi oil minister Ali al-Naimi said current conditions are "the best environment for the market" and that "demand is great" when he arrived in Vienna for the OPEC meeting yesterday. He also said, "All new supplies are welcome" when he was in Istanbul a week ago.

Saudi Arabia said this week that production for all of 2012 rose to a record of 9.51 mbpd. Reserves are still claimed to be 260 billion barrels as they have for the last 20 years. Apparently they can produce more than 3.5 billion barrels a year and not have their reserves decline. It is the bottomless oil reserve. They exported more than 2.5 billion barrels. They also claimed 284 Tcf of gas reserves.

Aramco, the Saudi oil company, began pumping from Manifa on April 10th. This is the world's fifth largest oil field. Saudi is opening new production to offset declines at existing fields in order to maintain their stated capacity of 12 mbpd. Manifa is expected to produce 500,000 bpd of Arabian heavy crude by July and increase that to 900,000 bpd by the end of 2014. The output from Manifa will go to the Satorp refinery and two other refineries currently under construction. Because it is heavy crude it is not desirable in the global market. Saudi planned for this by investing heavily in refineries to process this oil. The refined products of gasoline, diesel, fuel oil and jet fuel are easily sold on the global markets.

There are not expected to be any fireworks at this OPEC meeting but future meetings are going to become hostile. Iraq is currently producing about 3.0 mbpd and has no quota since it is in a rebuilding stage. However, they are hoping to expand production to 9.0 mbpd by 2020. Iraq has said it will leave OPEC if they do not agree to establish a fair quota to accommodate the increase in output.

Obviously if demand for OPEC oil is 30 mbpd or 33 mbpd if you count Iraq today and they want to increase production by 6.0 mbpd it could be a problem. In order to avoid flooding the market OPEC members would have to cut production by 20% to accommodate the increase from Iraq. This would be very traumatic since OPEC countries count on oil revenues for the majority of their budget.

They can't just ignore Iraq because either way the new Iraqi production is going to be a problem. If they accommodate the new production then quotas would have to be slashed. If they don't agree with a high quota for Iraq and Iraq drops out of OPEC they will produce at the high rate with no controls. That will flood the market and OPEC countries will have to cut production sharply or see prices decline dramatically. There is no easy answer.

Fortunately for OPEC the increase in Iraqi production is still problematic. U.S. oil companies are leaving Iraq because of overly restrictive contract terms and the ongoing security problem. China is taking over contracts that others are leaving. China has oil knowledge and unlimited manpower but their technology is not as good as American companies. Production will increase but not at the rate Iraq was expecting.

Iraq is also falling into a civil war. This will slow production growth for a long time as security issues impede new development. There are other estimates suggesting Iraq will be lucky to boost production from 3.0 to 5.5 mbpd by 2020. Others are a little more optimistic at 7.0 mbpd but there are a lot of qualifications on those estimates. Iraqi oil is not hard to produce. They are conventional wells and they are relatively shallow. The challenge is outdated infrastructure, damage from the war and little to no maintenance for the last 20 years. Everything has deteriorated including the wells. They need a lot of remedial work plus a lot of new wells drilled.

Over the next seven years the production in the U.S. is expected to grow by 1.5 mbpd. Petrobras is expected to also increase production by that amount. Add in Iraq at a conservative 3.0 mbpd and no corresponding quota cut by OPEC and we have roughly 6.0 mbpd of new production coming online. With demand increasing at the current 800,000 bpd per year that would be +5.6 mbpd by 2020. If the global economy ever recovers that demand growth would be back at +1.5 mbpd per year. Assuming that happened in 4 of the 7 years that increases demand by 8.4 mbpd by 2020. So even at the current lackluster pace of demand growth the increase in supply will not be enough to cover demand by 2020. I did not even discuss the current depletion rate of existing fields. Peak oil has not gone away but thanks to the reduced demand of the last four years it has been pushed deeper into the current decade.

The U.S. may not be increasing production as much as expected. Recent presentations by companies drilling in the Bakken show that production "growth" is slowing. In a Continental (CLR) presentation they contrasted their Bakken production growth with the other majors in the area. Continental was increasing production but EOG, STO and WLL were declining. Hess was growing marginally.

Continental Slide Showing Production by Majors

Analyst Devon Shire tracked the production growth in the Bakken over the last five years. In 2007 North Dakota production rose +21,000 barrels per day. In 2008 +66,000, 2009 +40,000, 2010 +102,000, 2011 +191,000 and 2012 +235,000. Shire correctly deduced the reason for the rapid increase in production over the last two years as the influx of rigs from around the country that were previously drilling for gas. Since that rotation is now over with active gas rigs at 354 and an 18 year low there are very few left to move from gas to liquids production.

Now that active oil rigs have leveled off at 1,760 the rate of production growth should level off. Secondly, when a company acquires new leases and commits rigs they always drill the low hanging fruit first. They go for the sweet spots that produce the most with the least amount of effort. With a Bakken well running $8-$10 million each they need the high initial production numbers to offset well costs. Producers live on initial production. A well that comes on at 2,000 bpd may only be producing 500 bpd a year later. That means they need to keep punching those new holes in order to keep growing production.

Once the sweet spots are drilled the initial production from the marginal wells will be hard pressed to offset the production declines in the good wells. Some Bakken wells are only coming in at 500 bpd so it would take three of those to offset the depletion from one well in the sweet spot depleting over a year.

As the drilling in the Bakken continues the explorers are going to be branching out with completions in the other zones in the play such as the Three Forks. There will be oil flowing from the Williston Basin for a very long time. It is just a numerical fact that the pace of production growth is going to slow.

The pace of rigs moving into North Dakota has slowed and rigs have actually been moving out to move to more prolific areas like the Eagle Ford.

Bakken Rig Counts Leveled Off

EOG is the largest horizontal driller in the U.S. with twice as many active rigs as their closest competitor. CEO Mark Papa said the Eagle Ford was going to surpass the Bakken growth rate in 2013. Eagle Ford wells are easier to drill and cheaper. That is attracting the surplus rigs that don't have a permanent home.

Production in the Eagle Ford rose +77% in March compared to March 2012. The nine fields that make up the "Eagle Ford" produced 529,874 bpd in March. This helped raise Texas production to 2.3 mbpd in February and the most since April 1986 according to the EIA.

EOG is the largest leaseholder with 639,000 net acres in the Eagle Ford followed by CHK, APA and BP in that order.

Production of NGLs was 89,345 bpd in March. That was down from 123,871 in March 2012. Natural gas was 1.89 Bcf down from 2.03 Bcf in 2012. This shows the move away from gas drilling and towards oil.

Market

The U.S. markets may finally be in correction mode. The markets opened lower this morning and although they closed off their lows the Dow still lost -106, Nasdaq -21 and S&P -11. This puts them near the bottom of the dip from last week and a break below that level would be technically bearish. Futures are negative -2 at 7:30 ET but that is nothing this early in the session. The European and Asian markets tonight will greatly influence our markets on Thursday.

U.S. economics include the GDP revision, pending home sales and Chinese PMI.

We may be seeing some cracks in the foundation of the market and seven month rally. The Dow has not had a three-day losing streak in 2013 so we are way overdue for a decent bout of profit taking.

We are going to be heading into the summer doldrums where traders are absent from the market and spending time with their families. Even the most bullish of analysts are still predicting a weakening of the market the summer. Be patient because we will use any declines as a buying opportunity.

Jim Brown

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