Crude Prices Lower for Longer

Jim Brown
 
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Investors betting on a rebound in the price of oil better have a very long time horizon. Companies are still reporting increases in production despite slashing drilling expenses and laying off thousands of workers.

Noted oil bulls have had their horns clipped in 2015 and the outlook is not that much better for 2016. T. Boone Pickens is a regular on CNBC and he has repeatedly predicted a return to $70 per barrel by the end of the year. That prediction is not working out well for him and he recently admitted he misjudged Saudi Arabia's determination to raise production at any price.

Harold Hamm, the CEO of Continental Resources was so sure oil prices had bottomed that he closed all the hedges the company held for 2015 and 2016. That generated about $350 million in cash at the time but he is regretting it now. Oil was $83 at the time and had he kept his hedges they would have been worth roughly $1 billion more today. Now Continental is being forced to slash drilling expenses in an effort to halt the cash burn until prices recover.


So why is production still rising? Most production companies hedge their production for several years into the future. Most did not make the mistake Harold Hamm made and they are still selling their oil at higher prices because of their hedges. Those will eventually expire and producers will be forced to face reality.

Producers are also forced to drill on new leases in order to keep them from expiring. The normal lease is for a certain period of time and should the producer not drill any wells the leases expire and the landholder can release it to someone else. Producers must drill wells on any undrilled leases in order to "hold" them with production. They do not have to drill every location on the property but enough to keep the leases from expiring.

Lastly, producers need to pay the bills. They need to generate enough new production to offset the decline from existing wells in order to keep the cash flow moving. While they may not want to drill a well at $50 a barrel to sell the oil for $40 they still need that $40 cash flow to pay the bills. Yes, they are losing a little on every barrel but they are still generating a lot of new cash. A well flowing at 3,000 bpd at $40 per barrel generates $120,000 bpd in cash flow that they did not have last month. That pays for employees, rig leases, debt service, etc as everyone waits for oil prices to rebound.

There are some major offshore projects coming online in 2016 and those will slow the decline in U.S. production. Producers have spent billions developing these projects and even if they have to sell the oil for less than it costs them to produce it they need to recover that cash flow they spent over the last several years in that development.

OPEC produced 31.72 mbpd in September and near a record high. The U.S. produced about 9.15 mbpd, down -450,000 bpd from the peak in April. The EIA said there was 1.8 mbpd in excess production in September. The EIA expects U.S. production to decline -400,000 bpd in 2016. With oil demand expected to rise 1.2 to 1.4 mbpd in 2016 that would put supply and demand nearly in balance by the end of 2016. However, Iran expects to put 500,000 bpd on the market in early 2016 and another 500,000 bpd by July. That will keep a strong surplus of oil on the market throughout 2016.

Saudi Arabia has another 1.5 mbpd of production they could bring online if they could find somebody to buy it. They are currently negotiating with Iran's customers and Russia's customers in an effort to steak market share from them. That will lower the price those countries get for their oil and reduce the cash they will have available to advance their military ambitions against Saudi Arabia and its neighbors.

In theory, oil prices should be weak until 2017 unless something happens to supplies in the Middle East. With war in progress in four oil producing countries anything is possible. We could wake up any day to a major attack on an oil facility and the supply/demand balance could be completely reversed.

I would not expect oil prices to rally significantly on the fundamentals until 2017. That means energy investors are going to be sitting on a lot of stagnant stocks for a long time. However, as fighting accelerates in the Middle East there is an increasing chance for a major incident that clouds the production picture and sends prices higher. The U.S. announcement of Special Forces troops going to Syria last week was an example. Major oil pipelines crisscross Syria and any of them could be severed at any time. Saudi Arabia has multiple large scale oil processing and exporting facilities that process millions of barrels per day. With Saudi fighting in Yemen and as a part of the coalition against ISIS in Iraq and Syria that makes them a terrorist target and one such attack was thwarted in September.

I would not be buying energy stocks today on expectations for oil prices to rise based on supply and demand fundamentals. If you want to speculate on a rocket landing on a Saudi facility that would be your choice. You might have better luck at the craps table in Vegas but at least you can get paid a dividend while holding oil stocks for the 2017 rally.


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Active Rigs

Active drilling rigs declined -12 to 775 for the week ended on Friday and that is still a 10 year low. Oil rigs fell -16 for the week to 578. Active gas rigs rose +4 to 197. Active rigs have now declined -1,156 since the high of 1,931 in September 2014. That is a -64% drop. Active offshore rigs declined -2 to 33.


Oil Inventories

Crude inventories rose +3.4 million barrels to 480.0 million. That is only 10.9 million below an 80-year high.

Refinery utilization rose slightly from 86.4% to 87.6%. That is down from the high of 96.1% on August 7th.

U.S. production rose slightly from 9.096 to 9.112 mbpd, down from the 9.61 mbpd and 40-year high in June.

Cushing inventories declined slightly to 53.3 million.

Gasoline inventories fell -1.1 million barrels to 218.6 million.

Distillate inventories fell -3.0 million barrels to 142.1 million.

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


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