Analys
QT is good for OPEC
It is quite clear that the strong rebound in US shale oil production since early 2016 has been fuelled by access to cheap and easy money derived from the world’s central banks QE programs. It is not to say that US shale oil is not viable at the right price. US shale oil business has however been running at negative cash flow year after year with growth being bankrolled by investors. Not even in Q3-18 this year when Brent averaged $75.8/bl and WTI averaged $69.5/bl did they in total have positive cash flow. Since the start of 2017 the three main US shale oil producers (EOG, Continental Resources and Pioneer Natural Resources) have had an average negative equity return of -13% while Equinor has yielded +21% and S&P 500 has yielded +16% to end of Friday last week.
Bjarne Schieldrop, Chief analyst commodities
Quantitative tightening is now blowing out credit spreads. US high yield junk rated credit spreads have jumped to 5.5% over investment grade in Q4-18. Not a single company in the US has been able to borrow money in the $1.2trn high yield market so far in December which is the worst since November 2008 according to FT today. So easy money is rapidly drying up for US shale oil players which means that they will likely have to run disciplined according to cash flow. That implies much softer US shale oil production growth in a market where the high yield US junk bond energy credit market is closed and Brent and WTI prices are $60/bl and $51/bl respectively.
What matters for US shale oil production growth is US shale oil well completions per month and how much new production they bring that month versus losses in existing production that month. As production has moved higher and higher the running losses in existing production has moved comparably higher as well. At the moment losses are running at a rate of 530 k bl/d/mth. So US shale oil production is losing half a million barrels per day each month. So more and more wells needs to be completed each month to counter this. The net of new production from well completions and losses in existing production is what brings either growth or decline in US shale oil production.
In October US shale oil producers completed 1308 wells. In real, productivity adjusted terms this is the highest level ever and it is 57% higher than the real, average level in the peak year of 2014. But losses in existing production have increased strongly as well.
We have calculated the “steady state US shale oil well completion rate (SSCR)” meaning the number of well completions needed in order for US shale oil production to move sideways. US shale oil production is growing when the monthly completion rate is above the SSCR and it is contracting when it is below the SSCR. In October completions were running at 231 wells (18%) above the SSCR. Completions were however running at a rate of 35% above the SSCR level in September 2017. As a result the marginal, annualized production growth in the US was much stronger in late 2017 than what it is right now. In late 2017 the 6mth average, marginal annualized US shale oil production growth was running at a stunning 1.9 m bl/d/yr. It is still running at a very strong 1.5 m bl/d/yr rate, but the last monthly data point for October (marginal, annualized) was down to 1.3 m bl/d. And that was despite the fact that real well completions were at an all-time-high of 1308 wells.
So more and more wells needs to be completed in order to keep growth going. At current crude oil price levels the US shale oil business is running a negative cash flow and equity owners have lost money since the start of 2017 and the US high yield energy market now seems to have closed. US shale oil well completions are in our calculations running at an 18% completion rate above the SSCR level. So US shale oil players only need to reduce completions by 231 wells ( or 18%) per month to bring the marginal US shale oil production growth rate to zero.
If crude oil prices continue at these levels this is probably exactly what we’ll see: well completions will be brought down to the SSCR level and we’ll have zero marginal production growth in US shale oil production. So far OPEC+ has put a floor under crude oil prices with Brent crude at $60/bl. If we stay at this price the well completion rate will probably be brought down towards the SSCR level and US shale oil production will stop growing for a while. Lower oil prices and lack of credit (due to QT) will now most likely give OPEC+ a helping hand in the market balancing.
Today we’ll have the latest US EIA Drilling Productivity report showing the well completions in November. It will be extremely interesting to see if prices already have started to bite so and the completion rate has started to tick lower from October to November. Losses in existing production have definitely ticked one notch higher since October and the marginal, annualized production growth has probably ticked lower.
Market is starting to take US/Iran headlines with a pinch of salt. Brent crude rose $2.8/b yesterday to an official close of $112.1/b. But after that it traded as low as $108.05/b before ending late night at around $109.7/b. Through the day it traded in a range of $106.87 – 112.72/b amid a flurry of news or rumors from Iran and the US. ”US temporary sanctions during negotiations” (falls alarm). ”We will bomb Iran” (not anyhow),… etc. While the market is still fluctuating to this kind of news flow, it is starting to take such headlines with a pinch of salt.
We’ll see. Maybe, maybe not. The Brent M1 contract is trading at $110.2/b this morning which very close to the average ticks through yesterday of $110.4/b.
Trump with bearish, verbal intervention whenever Brent trades above $110/b it seems. What seems to be a pattern is that Trump states something like ”very good negotiations going on with Iran”, ”New leaders in Iran are great,..”, ”Great progress in negotiations,…”, ”Deal in sight,..” etc whenever the Brent M1 contract trades above $110/b. An effort to cool the market. These hot air verbal interventions from Trump used to have a heavy bearish impact on prices, but they now seems to have less and less effect unless they are backed by reality.
As far as we can see there has been no real progress in the negotiations between the US and Iran with both sides still standing by their previous demands.
Iran is getting stronger while the cease fire lasts making a return to war for Trump yet harder. Iran is naturally in constant preparation for a return to war given Trump’s steady threats of bombing Iran again. Iran is naturally doing what ever is possible to prepare for a return to war. And every day the cease fire lasts it is better prepared. This naturally makes it more and more difficult and dangerous for the US to return to warring activity versus Iran as the consequences for energy infrastructure in the Persian Gulf will be more and more severe the longer the cease fire lasts. Israel seems to see it this way as well. That the war is not won and that current frozen state of a cease fire gives Iran opportunity to rebuild military and politically.
Global inventories are drawing down day by day. How much? In the meantime the Strait of Hormuz stays closed. There is varying measures and estimates of how much global inventories are drawing down. Our rough estimate, back of the envelope, is that global inventories are drawing down by at least some 10 mb/d or about 300 mb/d in a balance between loss of supply versus demand destruction. Other estimates we see are a monthly draw of 250-270 mb/d. The IEA only ’measured’ a draw in global observable stocks of 117 mb in April with oil on water rising 53 mb while on shore stocks fell 170 mb. But global stocks are hard to measure with large invisible, unmeasured stocks. As such a back of the envelope approach may be better.
Oil products is what the world is consuming. Oil product prices likely to rise while product stocks fall. Strategic Petroleum Reserves (SPR) are predominantly crude oil. Discharging oil from OECD SPR stocks, a sharp reduction in Chinese crude imports and a reduction in global refinery throughput of 6-7 mb/d has helped to keep crude oil markets satisfactorily supplied. But global inventories are drawing down none the less. And oil products is really what the world is consuming. So if global refinery throughput stays subdued, then demand will eventually have to match the supply of oil products. The likely path forward this summer is a steady draw down in jet fuel, diesel and gasoline. Higher prices for these. Then, if possible, higher refinery throughput and higher usage of crude in response to very profitable refinery margins. And lastly sharper draw in crude stocks and higher prices for these. But some 6 mb/d of oil products used to be exported through the Strait of Hormuz. And it may not be so easy to ramp up refinery activity across the world to compensate. Especially as Ukraine continues to damage Russian refineries as well as Russian crude production and export facilities.
Watch oil product stocks and prices as well as Brent calendar 2027. What to watch for this summer is thus oil product inventories falling and oil product premiums to crude rising. Another measure to watch is the Brent crude 2027 contract as it rises steadily day by day as the Strait of Hormuz stays closed and global oil inventories decline. The latter is close to the highest level since the start of the war and keeps rising.
The Brent M1 contract and the Brent 2027 prices and current price of jet fuel in Europe (ARA). All in USD/b
Our back of the envelope calculation of the global shortage created by the closure of the Strait of Hormuz. Note that 3.5 mb/d of discharge from SPR is also a draw. Note also that ’Forced demand loss’ of 2.5 mb/d is probably temporary and will fall back towards zero as logistics are sorted out leaving ’Price demand loss’ to do the job of balancing the market. Thus a shortfall of at least 9 mb/d created by the closure. More if SPR discharge is included and more if Forced demand loss recedes.
Brent is climbing higher. Front-month is at USD 106.3/bl this morning, close to a weekly high and a USD 9/bl jump from Mondays open. This is the move we flagged as a risk earlier in the week: the market shifting from ”a deal is around the corner” to ”this is going to take longer than we thought”.
Analyst Commodities, SEB
During April, rest-of-year Brent remained remarkably stable around USD 90/bl. A stability which rested on one single assumption: the SoH reopens around 1 May. That assumption is now slowly falling apart.
As we highlighted yesterday: every week of delay beyond 1 May adds (theoretically) ish USD 5/bl to the rest-of-year average, as global inventories draw 100 million barrels per week. i.e., a mid-May reopening implies rest-of-year Brent closer to USD 100/bl, and anything pushing into June or July takes us meaningfully higher.
What’s changed in the last 48 hours:
#1: The US military has formally warned that clearing suspected sea mines from SoH could take up to six months. That is a completely different timescale from what the financial market is pricing. Even a political deal tomorrow does not immediately reopen the strait.
#2: Trump has shifted his tone from urgency to ”strategic patience”. In yesterday’s press conference: ”Don’t rush me… I want a great deal.” The market is reading this as a president no longer feeling pressured by timelines, with the naval blockade running in the background.
#3: So far, the military activity is escalating, not de-escalating. Axios reports Iran is laying more mines in SoH. The US 3rd carrier strike group (USS George H.W. Bush) is arriving with two countermine vessels. Trump yesterday ordered the US Navy to destroy any Iranian boats caught laying mines. While CNN reports that the Pentagon is actively drawing up plans to strike Iranian SoH capabilities and individual Iranian military leaders if the ceasefire collapses. i.e., NOT a attitude consistent with an imminent deal!
Spot crude and product prices eased off the early-April highs on a combination of system rerouting and deal optimism. Both now weakening. Goldman estimates April Gulf output is reduced by 14.5 mbl/d, or 57% of pre-war supply, a number that keeps getting worse the longer this drags on.
Demand-side adaptation is ongoing: S. Korea has cut its Middle East crude dependence from 69% to 56% by pulling more from the Americas and Africa, and Japan is kicking off a second round of SPR releases from 1 May. But SPRs are finite.
Ref. to the negotiations, we should not bet on speed. The current Iranian leadership is dominated by genuine hardliners willing to absorb economic pain and run the clock to extract concessions. That is not a setup for a rapid resolution. US/Israeli media briefings keep framing the delay as ”internal Iranian divisions”, the reality is more complicated and points toward weeks and months, not days.
Our point is that the complexity is large, and higher prices have only just started (given a scenario where the negotiations drag out in time). The market spent April leaning on the USD 90/bl rest-of-year assumption; that case is diminishing by the hour. If ”early May reopening” is replaced by ”June, July or later” over the next week or two, both crude and products have meaningful room to reprice higher from here. There is a high risk being short energy and betting on any immediate political resolution(!).
Down on Friday. Up on Monday. The Brent June crude oil contract traded down 5.1% last week to a close of $90.38/b. It reached a high of $103.87/b last Monday and a low of $86.09/b on Friday as Iran announced that the Strait of Hormuz was fully open for transit. That quickly changed over the weekend as the US upheld its blockade of Iranian oil exports while Iran naturally responded by closing the SoH again. The US blew a hole in the engine room of the Iranian ship TOUSKA and took custody of the ship on Sunday. Brent crude is up 5.6% this morning to $95.4/b.
The cease-fire is expiring tomorrow. The US has said it will send a delegation for a second round of negotiations in Islamabad in Pakistan. But Iran has for now rejected a second round of talks as it views US demands as unrealistic and excessive while the US is also blocking the Strait of Hormuz.
While Brent is up 5% this morning, the financial market is still very optimistic that progress will be made. That talks will continue and that the SoH will fully open by the start of May which is consistent with a rest-of-year average Brent crude oil price of around $90/b with the market now trading that balance at around $88/b.
Financial optimism vs. physical deterioration. We have a divergence where the financial market is trading negotiations, improvements and resolution while at the same time the physical market is deteriorating day by day. Physical oil flows remain constrained by disrupted flows, longer voyage times and elevated freight and insurance costs.
Financial markets are betting that a US/Iranian resolution will save us in time from violent shortages down the road. But every day that the SoH remains closed is bringing us closer to a potentially very painful point of shortages and much higher prices.
The US blockade is also a weapon of leverage against its European and Asian allies. When Iran closed the SoH it held the world economy as a hostage against the US. The US blockade of the SoH is of course blocking Iranian oil exports. But it is also an action of disruption directed towards Europe and Asia. The US has called for the rest of the world to engaged in the war with Iran: ”If you want oil from the Persian Gulf, then go and get it”. A risk is that the US plays brinkmanship with the global oil market directed towards its European and Asian allies and maybe even towards China to force them to engage and take part. Maybe unthinkable. But unthinkable has become the norm with Trump in the White House.
Oil product price pain is set to rise as the Strait of Hormuz stays closed into summer
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