CRUDE OIL PRODUCTION in the United States is finally starting to drop, and that's a good sign for rising oil prices. Output has fallen below nine million barrels per day, which is about 700,000 barrels a day below the peak rate in April 2015, and the decline seems to be accelerating.
The current oil industry downturn, which began in mid-2014, is now well into its second year, so it has taken producers a while to respond to the price collapse. In fact, oil production continued to grow for the better part of a year even as prices plummeted. If producers wanted higher prices, it seems they were hoping someone else would cut back on output.
The petroleum industry is facing some difficult issues, including just how far to cut back on production, how much oil prices will need to rise before we start to reverse those declines, and what impact labor shortages will have on producers as the industry begins to recover.
In his latest "Musing from the Oil Patch," Allen Brooks, managing director at PPHB, reminds us that we still have an estimated two million barrel per day oversupply situation in global oil markets. "While the supply surge has helped create an oil market supply/demand imbalance, the absence of robust demand growth is often overlooked."
In today's world, that means China. Industry forecasters are looking to the world's most populous country to see how long the contraction in China's economy will last. And when it does start to bounce back, how robust will growth be?
Brooks said the availability of cheap capital further contributed to the oil industry collapse. The combination of an oversupply of oil, declining markets, and easily available capital created the "perfect oil market storm," he added.
In its recently released report on "Oil Markets in 2016," Wood Mackenzie compares the current oil price collapse to the downturn in the mid-1980s and says the percentage drop in price in 1986 and 2015 was virtually the same. In both instances, amid growing oil demand, non-OPEC supply growth exceeded the gain in demand. And in yet another similarity, OPEC, largely influenced by Saudi Arabia, changed its behavior to compete for market share.
A comparison of the crude oil price (as an index) in each period shows a similar trajectory for the oil market in the year immediately following the peak price, says Wood Mac. However, there are key differences as well:
- Current high level of stocks: In 1987, the year after the collapse, oil prices rose. By contrast, in 2016, the year after the market collapse started, prices are still declining. [NOTE: Prices have risen just a bit since the release of the Wood Mac report.] The present high levels of stocks have resulted in a weaker crude oil outlook than the previous history would suggest.
- Responsiveness of US tight oil: Despite the brief recovery in 1987, prices then fell. This time, it should be different because by 2017, the projected decline in non-OPEC supplies will occur more quickly than in the 1980s. This is largely due to the responsiveness of US tight oil, which supports a faster recovery in prices than history suggests.
The Wood Mackenzie report is more optimistic about global demand growth than some other forecasters. Some might call it "bullish." The research firm's outlook for 2016 and 2017 shows demand growth outpacing supply growth, which did not occur in 1987 and 1988, thus prolonging that recession. With the non-OPEC oil sector responding faster due to further deep cuts in upstream investment, Wood Mac says, "This re-adjustment of the fundamentals should result in a stronger price environment."
On the heels of its annual investor conference, Raymond James' latest equity research report says the industry is in a "rough, albeit improving, commodity landscape."
Here are a few of RJ's observations:
- Oil prices will bounce further by year-end, and the US rig count will begin to recover.
- The consensus among attendees at the investor conference was for WTI to exit 2016 at $40 to $50 per barrel, less optimistic than RJ's forecast for recovery to $65 by year-end (and a 2017 average of $75).
- Global inventories will peak by year-end 2016. However, this depends in part of the rise in Middle East supply and Chinese demand. The bulls think cheap fuel will energize the Chinese economy.
- Labor constraints will hamper drilling recovery. Energy executives spoke to the difficulty of recruiting people who were laid off and left for other industries.
- E&Ps plan to rebuild balance sheets before adding rigs. Although credit constraints are tight, they expect loosening as soon as activity starts to recover.
- Finally, there is still bearishness on US natural gas. Close to 80% of respondents forecasted a 2016 average below $2.50/Mcf with the remainder below $2.00. RJ forecasts $2.00 and says there is slim visibility as to when meaningful demand improvement will materialize.
We are seeing glimmers of hope for an industry recovery this year. With luck, the recent uptick in oil prices isn't another false start like the one in the spring of last year. However, most industry executives and capital providers seem to be looking toward a recovery in 2017. There seems to be a broad consensus on that. To hasten a recovery, the US oil and gas industry should continue to strive to reduce both production and storage volumes. Only then can we expect to see any meaningful improvement in market conditions.