A Production Climax is Approaching

Jim Brown
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Active rigs declined -13 to 744 and the 13th consecutive weekly decline. Active oil rigs declined -9 to 555. Keeping production at the current level is going to become progressively harder as active rigs drop to a 15 year low.

U.S. production declined -17,000 bpd last week but it is only -20,000 bpd off the 10-week high from three weeks ago. Production has plateaued at roughly 9.17 mbpd for the last three months. That is down from the 9.6 mbpd level at the peak back in June but the decline as stalled.

This may be a temporary condition because recent commentary suggests events are building to a climax. I reported several times over the last couple of weeks about the record number of tankers waiting outside Houston to unload their cargo. ClipperData reported last week that many of those cargoes are unsold and there is a similar flotilla outside Singapore. Producers have no place to store their oil so they are loading the oil on tankers and sending it to ports where they hope to find a buyer.

With oil inventories approaching an 80-year high there is little available storage and so the cargoes remain unsold. The longer they wait outside Houston the cheaper the oil will become. It costs $35,000 to $40,000 a day for tanker rental. A couple weeks of waiting will cost half a million dollars for each tanker. At some point, the owners of the oil will lower the price to a point where onshore buyers will decide it is worthwhile to offload into their already cramped storage facilities. That point may be $35 or even $30 because the alternative for the owners is that daily tanker rental.

This is going to depress the price of WTI as buyers negotiate ever-lower prices for those unsold cargoes.

Storage at the futures delivery point at Cushing is also starting to become a challenge. Inventory levels there rose nearly 2.0 million barrels last week to 58.6 million. Cushing only has about 70 million barrels of capacity. They need to keep about 10% of that open to allow for the inflow of new oil and their blending business where they take ultra light and heavy oil and blend it into a mixture that refiners want. If they have no empty tanks, there is no capacity for blending. Oil does flow in and out of Cushing every day but for the last four weeks more oil remained there as inventories rose. Also, with no available storage capacity speculators cannot buy oil and store it in hopes of reselling for a higher price later.

I said this was approaching a climax. OPEC has a semiannual production meeting next week. They are not likely to reduce production quotas. In reality they may increase the quotas to accommodate the return of Indonesia as an OPEC member. Indonesia only produces about 852,000 bpd and currently consumes more than that but demand is declining. They expect to be an exporter in the years ahead.

Iran is planning on boosting exports by 500,000 bpd in Q1 and by 1.0 mbpd by July. Iraq is expected to increase production by 500,000 bpd at some point in 2016. OPEC members are currently ignoring the 30.0 mbpd production quota and with the additions above they will be producing more than 32.0 mbpd. In October they produced just over 31.0 mbpd. Some analysts believe OPEC will raise the quota to account for these increases but it is just a symbolic move since nobody is sticking to quota anyway.

With oil stacking up outside ports around the world and new supply coming online in early 2016 we are reaching a crisis point. The IEA claims global inventories are at record highs at 3.0 billion barrels and rising 1.6 mbpd. If production from Iraq, Iran and Libya rises another 1.0 mbpd we are rapidly going to run out of tankers and onshore storage locations. Once there is no place to put new oil, the prices could decline significantly.

This means U.S. producers are going to have to stop producing more than can be consumed internally. With U.S. imports at roughly 7.5 mbpd and demand roughly 16.5 mbpd that means any U.S. production over 9.0 mbpd will have to be shut in. There will be no place to put it. Refiners will not halt the imports because they depend on the heavy oil from overseas to produce heating oil, diesel and jet fuel. The ultra light oil from the shale fields produces mostly gasoline and gaseous byproducts.

Once producers are forced to shut in production there will be a major drop in crude prices. This will be the climax that pushes some drillers over the edge into defaults as cash flows shrink.

Moody's said there have been 79 defaults in the energy sector in 2015. Prior to 2015 companies increased their borrowing to between $250-$300 billion compared to only $100 billion at the start of 2015. Even the Federal Reserve warned they were seeing increased weakness in credits related to oil and gas exploration. Wells Fargo, Bank of America and JP Morgan Chase have all warned of rising delinquencies in loans to the energy sector. Some 31 companies have renegotiated loan agreements and 10 firms saw their loan limits reduced.

Asset sales are normally the method used to raise quick cash to handle looming debt payments. However, that has not worked this time around because most companies have reserves on the books at much higher prices than today's buyers are willing to pay.

Once production volumes reach the climax point, the potential defaults will push those companies to discount their assets and a new wave of acquisitions will appear. Whether that will keep companies out of default or even bankruptcy remains to be seen. What we do know is that global production cannot continue to climb indefinitely. There is simply no place to store it and excess supplies will force prices lower and increase the pain for everyone concerned.

Active Rigs

Active drilling rigs declined -13 to 744 for the week ended on Friday and that is another 10 year low. Oil rigs fell -9 for the week to 555. Active gas rigs fell -4 to 189. Active rigs have now declined -1,187 since the high of 1,931 in September 2014. Active offshore rigs were unchanged at 30.

Oil Inventories

Crude inventories rose +1.0 million barrels to 488.2 million. That is only 2.9 million below an 80-year high.

Refinery utilization rose from 90.3% to 92.0% as the fall maintenance season ends. That is down from the high of 96.1% on August 7th.

U.S. production fell -17,000 from 9.182 to 9.165 mbpd.

Cushing inventories rose from 56.9 million to 58.6 million.

Gasoline inventories rose +2.5 million barrels to 216.7 million as refiners rushed to replenish depleted inventories with winter blended fuels.

Distillate inventories rose 1.0 million barrels to 141.4 million.

In the graphic below green represents a recent high and yellow a recent low. The blue-green represents a record high.

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