OPEC Analysis

Jim Brown
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The OPEC production meeting is next Friday and there is a lot hanging on the outcome even if they do nothing. Their decision will impact oil prices and investment decisions by oil companies for the next six months.

At the November meeting OPEC members could not agree on a production cut because of the vast differences in production potential between the various countries. For example Venezuelan production has been declining for years as a result of bad political decisions and they could not produce up to their quota for the last several years. Libya is in a civil war and has only been able to produce at 30% of their capability for the last two years. There is no chance of reaching a quota there. Iran, the arch enemy of Saudi Arabia, is under severe sanctions and only producing at about 40% of quota. Because of the war in Iraq they have not had a quota for the last decade and they are increasing production at a rapid rate. Even if a quota was assigned to them they would not honor it. Saudi Arabia is the only OPEC nation that can produce significantly over their quota. That means if OPEC is going to cut production it will be up to Saudi Arabia to make the cuts.

For obvious reasons that really aggravates Saudi Arabia. Why should they cut two million barrels per day of production just so everyone else can enjoy higher prices? Saudi's patience with the rest of OPEC finally ran out. The same thing happened back in 1998 and Saudi Arabia opened all the valves and flooded the market with oil to punish the other OPEC members that were not honoring their quotas. Prices fell to $10 per barrel before everyone capitulated and OPEC production slowed.

OPEC or more appropriately Saudi Arabia is not going to agree to a cut in production at this meeting for two reasons. The first is Russia, which produces about 9.0 mbpd and just slightly less than Saudi Arabia's 10.3 mbpd. Saudi is not going to agree to a cut in OPEC production unless Russia, not an OPEC member, agrees to cut as well. Saudi does not want to be the only country cutting. Other OPEC countries can't cut since about half can't make their quotas on a constant basis anyway. If there is any meaningful reduction it would have to come from Saudi Arabia and they are not going to do it just to make everyone else happy if there is not an equal cut by Russia. Of course policing a cut from Russia would be impossible. Putin would just say he cut and then produce whatever he wants.

The second reason OPEC is not likely to cut production is the U.S. shale production. So far there has not been a material decrease in production despite nearly a year of falling prices and more than a 50% decline in active rigs. Producers are currently drilling their best locations that will give them the strongest initial production. Even though only about 30% of the wells drilled are being completed the production continues in the 9.4 mbpd range. If Saudi Arabia and OPEC cut production before U.S. production declines significantly they will have wasted the last 8 months of pain in prices. They need to wait until U.S. production actually declines before OPEC changes their plan.

With more than 5,000 wells drilled and not completed there is roughly 375,000 bpd of new production ready to come online when those wells are completed. If OPEC were to announce a cut and prices rebound to $75 the U.S. producers would trigger a massive completion wave that could boost U.S. production by 500,000 bpd within 6-9 months. They would put rigs back to work and begin completing every well they drilled.

The Saudi plan only works if they can create lasting pain for high cost producers. So far the pain has only been temporary. RBC Capital Markets believes at the current activity level Brent prices will rise to $70 by the end of December and $79 in 2016. They expect WTI to be $5 less than Brent.

If that comes true that would be enough to put most of the U.S. drillers back to work. They might not be running full speed but we could see 25% of the rigs go back to work. Saudi and OPEC know this and that makes their decision even tougher next week. Do they continue to endure the pain of $60 oil or have they given up on trying to push the high cost producers out of business? Saudi burned through $36 billion in foreign currency reserves in March/April. The new king may be looking at the cash drain and changing his mind on how to fight this battle. There is also a new oil minister in Saudi Arabia since the November production meeting. We don't know how the king and minister are viewing this problem and what internal problems they are facing at home from a lack of oil revenue.

The OPEC meeting next Friday is going to be very interesting and it will have a market impact regardless of which way they go.

Recently Saudi Arabia has stopped talking down prices. In prior months they kept saying they will produce all the oil they can sell at whatever price it will bring. In theory they were going for market share rather than market prices. Over the last month or so they quit talking up their excess production capability and the potential for pushing prices lower. I am sure they were getting a lot of hate mail from other OPEC members. Whatever Saudi Arabia decides in the meeting will be the official position. The country with the most oil makes all the rules.

If OPEC says they are going to continue flooding the market with oil then U.S. producers are going to continue to cut active rigs and conserve cash. If OPEC says something about returning prices to a fair level we will see those producers begin to put rigs back to work. The OPEC outcome will impact U.S. producer decisions for the next six months.

While active rigs declined again last week the Eagle Ford saw its third week of gains with a gain of 1 rig following a gain of 2 rigs the prior week and 1 rig the week before that. The breakeven cost per barrel in the Eagle Ford are among the lowest in the nation. Wells in the Karnes Trough section of the Eagle Ford are still profitable at $40 oil while wells in other less desirable sections could see a breakeven has high as $50-$60. Companies are spending their capex dollars in the best locations where they can still make a profit. Eventually those well locations will all be drilled and production will slow unless prices rise.

Active Rigs

Active drilling rigs declined -10 to 875 for the week ended on Friday. This was the 26th consecutive week of declines. Oil rigs declined -13 for the week to 646. Active gas rigs rose +3 to 225. Active rigs have now declined -1,056 since the high of 1,931 in September. That is a -59% drop. Active offshore rigs were flat at 29 and well off their January high of 60.

Oil Inventories

Crude inventories declined -2.8 million barrels to 479.4 million and the fourth decline in the last 24 weeks.

Refinery utilization rose to 93.6% last week from 92.4%. Imports declined -503,000 bpd. U.S. production spiked +304,000 barrels to 9.566 mbpd. This was an anomaly after a strong decline of -112,000 bpd the prior week. This was related to an outage in the pipeline system that halted production in one area. When the outage was cured the backlogged production was released into the system. The 9.566 mbpd number will not likely be repeated and production should return to the 9.37 mbpd level from before the outage.

Cushing inventories declined slightly to 60.0 million. Oil in storage at Cushing will not begin to decline until the next futures cycle. Speculators that bought oil and stored it at Cushing while selling into a longer dated futures contract will "deliver" that oil when their contract expires. That could be next month or several months from now. Meanwhile Cushing has no available storage for future speculation.

EIA Crude Inventory Chart

Gasoline inventories declined -3.3 million barrels to 220.6 million. Gasoline demand rose +473,000 bpd and imports rose -233,000 bpd.

Distillate inventories rose +1.1 million barrels to 128.8 million. Demand fell -206,000 bpd. Imports increased +21,000 bpd.

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

Jim Brown

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