Reflections from IP Week in London

The atmosphere was far more upbeat at this year’s International Petroleum Week, given the sharp oil price increase since the previous IP gathering, with levels now considered healthy for the industry. Expectations are divided between three views: 1) the market will continue to trend toward USD 65 per barrel, which is the longterm cost trend and also the acquisition policy of many companies; 2) fall back to the marginal cost of production at USD 50, balancing around inventory held; or 3) hover between the two depending on the strength of one’s belief in the first two views. Few believe in oil breaking out of this price range in the short to medium term, so OPEC has clearly given the industry some time to breathe. However, the short-lived price recovery is already in danger as OPEC and Russia fail to deliver on agreed cuts and as US shale oil roars back to life.

US shale oil in great shape

The US is now the swing producer, and shale oil cost cuts, technology development and efficiency gains are astonishing across all basins. All wells that are able to drill will be active at current prices. Breakeven numbers are as low as USD 35/bbl with an average of about USD 40 (at 20% RoR), which is lower than some OPEC averages. Also, the effects of transportation infrastructure spending are now being seen: the latest statistics show a huge surge in oil exports this year with far more going to Asia. Technology development will increase yields, so even if US rig counts (now 741) are interesting, we believe it makes less sense to focus on this, as productivity per rig has soared tenfold since 2010 and will continue to grow. Permian fields account for most of the growth whereas Eagle Ford production is nearly flat. New capacity of 600,000 barrels is expected from US shale oil this year, with production expected to reach 4.87 million bbl/d in March. It is also worth mentioning that this trend started way before OPEC’s discussion on cuts.

OPEC’s back-stop works

OPEC compliance with production cuts was widely discussed. Shipping data evidence suggests that cuts are nowhere near the OPEC numbers of 93 percent, but rather closer to 40 percent, considering that Iraq, Venezuela, Algeria and the United Arab Emirates are over their reference levels, and non-OPEC producers such as Russia are showing only a third of its proposed 300,000 bbl cut and pleading for more time. How long will Saudi Arabia be over-compliant? Even if Saudi production numbers are down, exports are not falling as much, due to a domestic switch from oil to gas to cover Saudi energy needs. There has been a sharp reduction in Nigerian pipeline vandalism, with no major incidents reported so far this year. The government has implemented 20 key steps to end incidents by continued amnesty payments to former rebels, increasing security and closer dialogue with militants. In all, OPEC is not showing enough production cuts, and it seems very likely that the deal will be extended to OPEC in May to curb stocks, even if the market has fallen into backwardation again. Stock overhang is expected to be eliminated by Q4 2017 based on global demand/production growth of about 2:1, leaving a shortage of just below 1 million bbl/d this year.

Chinese demand outlook

How sustainable is Asian demand, and Chinese in particular, with imports equivalent to nearly two thirds of global demand growth last year? Chinese demand is likely to rise at a gentler pace, at around 3% or 600,000 bbl, when the economy is starting to slow again as authorities tap the brakes after another credit-driven boom, and as car sales are down this year along with tax incentives for small cars. It will also be interesting to follow government support for infrastructure spending to shore up GDP growth before the Communist Party´s 19th congress in October, helping to underpin demand.

Trump is everywhere

The Trump administration also creates a measure of uncertainty over the outlook for oil prices, first on demand and whether there will be a boost of stimulus in the US. Second is the possibility of new sanctions against Iran, which has been allowed to raise its output to 3.8 million bbl/d under the OPEC deal and regained market share in Asia-Pacific and Europe as rival OPEC producers cut supply and as sanctions were lifted.