Rigs Down -32%, Oil Production Up

Jim Brown
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The active rig count declined by -48 rigs last week to 1,310 and a -32.2% decline from the 1,931 high back in September. Oil production rose to a new post 1972 record at 9.28 mbpd. What is wrong with this picture?

Rigs are contracted months or even years in advance and that means it will take additional months for the rig decline to hit bottom. However, recent reports by E&P companies project continued rising production in the U.S. even though the new well count will be slower.

U.S. inventories hit 425.6 million barrels and that is an 80 year high. The same situation is happening around the world. China has been aggressively buying oil at cheap prices since October. Unfortunately it appears China has completed filling their strategic oil reserves and the number of Very Large Crude Carriers (VLCC) either unloading in China or headed for China fell to 62 last week and the lowest since September 19th. Each tanker carries 2 million barrels. China began filling its reserves in early October when a record 89 tankers were making trips to China with a daily average of 76. The country imports an average of 6 mbpd in normal times. If China has finished its four month stocking binge then the biggest surplus buyer in the market may no longer be in the market. This would mean that the surplus oil being produced every day has to find someplace else to go.

The U.S. Strategic Petroleum Reserve (SPR) has a capacity of 727 million barrels and currently holds 691 million. It has theoretical room for 36 million additional barrels but I don't expect the president to suddenly become oil friendly and start buying oil to fill it to capacity. The average cost of the oil currently in storage is $28.42 per barrel or roughly $20.1 billion. The last time oil was purchased for the reserve was in 2009 when the DOE used revenues from the 2005 Hurricane Katrina emergency sale to begin refilling the SPR. The DOE purchased just under 11 million barrels to replace what was sold in 2005.

The problem facing us is not storage and not excess production. Those are just symptoms of a larger problem. The biggest problem we are facing is a slowing demand for oil. OPEC did not suddenly begin producing more oil in July and cause the current crude crash. They had been producing at roughly 30.0 mbpd for a couple years. The increase in U.S. production of roughly 700,000 bpd per year roughly offset declines in Venezuela and Mexico so the U.S. did not cause the oversupply problem. Iraq increased production by the most in OPEC but they were offset by declines in Libya as a result of the civil war. Production did not increase so much that suddenly there was a huge surplus of oil. Demand declined as production increased and the OPEC decision was the final tipping point.

Investopedia.com definition: Deflation, or negative inflation, happens when prices fall because the supply of goods is higher than the demand for those goods.

The following chart came from the Washington Post and an article by Matt O'Brien last week. This shows that global inflation is dead and we are reaching the point where deflation will soon be the global enemy if economic conditions don't change soon. Commodity prices are crashing and it is not just oil. Global demand is shrinking for multiple reasons and the global economy is weakening. This is the main reason for the drop in oil demand.

Historically whenever oil prices crash an economic surge follows. Since the first major discovery of oil in the U.S. on August 28th, 1859 in Titusville Pennsylvania, oil has alternately caused economic surges and economic crashes. Little did George Bissell and Edwin Drake understand that their gusher was going to revolutionize the global economy for the next 150+ years. Oil had been around for hundreds of years but it was not until the Drake well that it was available in commercial quantities sufficient to manufacture an almost unlimited supply of kerosene. The success of the Drake well immediately prompted a surge of investment in drilling and the oil industry was born.

Since then whenever oil prices rise to high that it shuts off demand for gasoline and diesel the global economy declines. Soon thereafter oil prices decline and cheap gasoline and diesel eventually fuel a new economic surge. These events don't happen overnight and while it takes 12-24 months for the economic cycle to reinflate it takes far less time for the economic crashes to occur. The record high of $147 a barrel in 2008 was a contributing cause of the subprime crash. Gasoline prices that were $1.50 a gallon rose to more than $4.00 and the sudden increase in fuel costs choked the budgets of paycheck to paycheck workers that were barely making their house payments.

Fast forward to 2014 and Europe was headed for a recession. Demand for oil was declining week by week but was not in the headlines. China's 20 years of spectacular growth was slowing despite multiple stimulus programs. China's economic cycle today has declined to the same point it was at the bottom of the financial crisis and could soon be as weak as the 1998 Asian Crisis. Oil consumption in China is still rising but at a much slower pace than in years past. China has been the major driving force in rising oil demand since the financial crisis. Their consumption increases have accounted for nearly all of the annual production increases around the world. Suddenly their demand was barely growing and at the same time Europe's demand was slowing as well.

Our current challenge is the decline in demand in Europe, China, India, Latin America and even in the USA. Our demand growth based on refinery inputs grew about 300,000 bpd in 2014. In 2013 demand increased about 900,000 bpd. If the U.S. economy was growing 3% as everyone claims our demand for crude oil should be growing as well. Also, since oil prices began to fall sharply in July the second half of 2014 should have actually seen additional demand thanks to cheap fuel prices. That additional demand actually occurred and that is what lifted us to that 300,000 bpd number. Without the cheap oil it would have been much lower.

Oil prices are not likely to rise in the next several months because of a surplus of supply. Because oil prices crashed every global producer including Russia, OPEC, etc, are pumping as much oil as possible to make up for the last revenue. By doing this they are adding to the oil glut. Once available storage capacity is filled the price of oil could drop much lower.

This will force gasoline prices lower and we should see the beginning of an economic recovery. Unfortunately this is a long term process of 12-24 months. The QE in Europe should help economic sentiment. China is expected to launch another stimulus program in March. The Bank of Japan is giving away money faster than any other country. The seeds of economic revival are being sown but don't expect it next week.

The odds are very good we are going to see lower oil prices in the months ahead even though prices normally rise in May as the summer driving season begins. Every time you fill up with cheap gas there are millions of other consumers the world over doing the same thing and thinking how lucky they are. This is what changes buying habits and fuels the economic rebound.

Active Rigs

Active drilling rigs declined -48 to 1,310 for the week ended on Friday. Oil rigs declined -37 for the week to 1,019. Active gas rigs fell -11 to 289 and a new 18 year low. Active rigs have now declined -621 since the high of 1,931 in September. That is a -32.2% drop.

Other than during the financial crisis the number of active rigs has been above 1,700 since the beginning of 2006. We are poised for a significant decline, possibly to the 1,000 level.

Baker Hughes warned that in those previous oil declines of 50% or more the active rig counts declined by 40% to 60%. So far we are only down -32% so we still have a ways to go. A 50% decline in oil rigs would be -805 from the 1,609 peak on October 10th. So far we have declined -590 oil rigs so we could lose another 200 before it is over.

Oil Inventories

Crude inventories rose another 7.7 million barrels to 425.6 million and the highest level for February since 1930. Crude inventories have risen +43 million barrels over just the last six weeks. Refinery utilization fell to 89.7% last week from 90%. Imports declined -200,000 bpd. U.S. production rose +54,000 barrels to 9.28 mbpd and the highest level since 1972.

Cushing inventories rose +3.7 million barrels to 46.3 million and a 6-year high.

Gasoline inventories rose +0.5 million barrels to 243.1 million. Gasoline demand rose +527,000 bpd and imports rose +173,000 bpd.

Distillate inventories declined -3.8 million barrels to 127.4 million. Demand declined -50,000 bpd. Imports decreased -53,000 bpd. Inventories should rise in the coming weeks with tens of thousands of airline flights cancelled due to winter weather.

In the graphic below green represents a recent high and yellow a recent low.

Propane inventories declined by -3.49 million barrels to 61.47 million. Demand rose slightly to 1.71 mbpd. With the cold weather continuing this week we should see higher demand over the next several weeks as late winter refills continue.

Natural gas inventories declined -111 Bcf to 2,157 bcf. Inventories are now +2.8% above the five year average of 2,099 Bcf and +45.8% above year ago levels at 1,479 Bcf. With only 4 weeks left in winter there will be no gas shortage like we had in early 2014.

The blue line in the chart below shows the current inventory relative to the five year average.


The market ended at new highs on Friday and assuming Janet Yellen does not say something unexpected on Tuesday when she gives testimony to Congress I expect the gains to continue. While the fundamentals don't support a further rise in the markets it appears investors are unconcerned. Markets can remain over valued far longer than anyone ever expects.

Jim Brown

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