Tuesday, February 13th, 2018

Randy Kenworthy Oil & Gas 2017 & Q417 Market Update

Oil and Gas 4Q17 Report Highlights

  • Oil and Gas Market Update 4Q17 by Randall KenworthyCrude oil moves up and flips into steep backwardation while natural gas prices remain pressured across the forward strip
  • Geopolitical risks and concerns over crude supply disruptions move to the forefront
  • Growing contradiction in global crude supply as OPEC and non-OPEC partners show restraint while volumes in the U.S. surge higher
  • Demand growth for crude remains quite robust, but within a wide forecast range
  • Crude inventories across parts of the globe continue to inch down, but will OPEC’s targets be reached during 2018
  • Major wildcard will be potential cheating on the OPEC cuts due to rising prices and, more critically, a consensus and pathway out of the deal without flooding the market with oil

Overview

Oil and Gas Market Update by Randall KenworthyThe oil and gas industry appeared to turn a corner this past year, but the path of the next cycle is fraught with uncertainty. The crude oil and natural gas markets, while historically linked, remained diverged over the past year. Crude markets continued to firm up as global data increasingly supports declining global inventories (measured by crude as well as refined products). However, resiliency in U.S. production and those exempt from the OPEC agreement remain a near-term challenge in achieving supply and demand balance. Meanwhile, natural gas prices were little changed and kept in check during the quarter and year as ample supply was met with tempered demand from mild weather for most of the period.

Oil & Gas Market Updates Newsletter SignUpSome major hurdles were finally overcome during 2017 as demand growth remained strong and high OPEC compliance accelerated both the normalization in excess inventories and the steepening of oil’s backwardation (condition where the price of a commodities’ forward or futures contract price trades below the current spot price). As we have stated in the past, Coachman Energy Operating Company’s (CEOC) longstanding belief that the laws of supply-and-demand would prevail—as they almost always do—is bearing out. More than a year of restrained production out of OPEC has curtailed global supply. Coupled with persistent robust demand growth, record levels of inventories finally began to come down during the back-half of 2017.

Crude Oil

Colorado Pump JackCrude markets pushed higher during the fourth quarter as supply and demand fundamentals improved. Pricing during the quarter was also aided by supply disruptions in the North Sea, increased geopolitical risks, and OPEC and Russia reaching a formal agreement to extend the production agreement another nine months through the end of 2018.[1] Over the near-term it appears that supply will continue to be restrained and global inventories will likely be further reduced. The average price of West Texas Intermediate (WTI) spot during Q4’17 moved up by 15.1%. Over the course of 2017, WTI spot price averaged $50.82/BO and was up 17.7% versus 2016. WTI ending the year at $60.46/BO.

OPEC, Other Oil Producers Agree to Extend Cuts Through 2018

The Organization of Petroleum Exporting Countries (OPEC) originally reached a deal among all 14 member countries to curtail oil production in November 2016. It was the first production cut agreement since 2008. The cuts were extended through 2018, which signals that the world’s biggest oil-producing countries believe that global oversupply is still weighing down prices.

Increased Oil Recovery Methods of Coachman Energy Operating CompanyOPEC production cuts remain in full swing and positive news of historically high conformity continues to be reported. OPEC and the Joint OPEC/Non-OPEC Ministerial Monitoring Committee announced they had achieved a conformity level of 129% for the month of December 2017 and an average monthly conformity for the year of 107%.[2] Despite historically high compliance with OPEC/Non-OPEC production cut agreement, exempt members are also offsetting some of this achievement. Libya and Nigeria remain exempt from the agreement and significantly lifted production in 2017. U.S. production has also continued to rebound.

OPEC’s efforts to limit production growth have undoubtedly helped improve market fundamentals, but global crude production, largely driven by the United States, has proven stubbornly resilient. The U.S. Energy Information Administration (EIA) estimates that December production in the U.S. hit 9.91 MMBOPD, up 1.14 MMBOPD from year-end 2016 levels, and forecasts it to surpass 10 MMBOPD during the first quarter of 2018.[3] Driving these forecasts for U.S. production growth are gains from various basins, including significant gains in the Permian Basin in west Texas/eastern New Mexico. The EIA forecasts that production in the seven major U.S. shale basins (Anadarko, Appalachia, Bakken, Eagle Ford, Haynesville, Niobrara, and Permian) will rise by a combined 111,000 BOPD from January to February, with over 70% of the growth coming from the Permian alone.[4] Global crude supply is also still slightly above demand needs. The International Energy Administration (IEA) notes that “if OPEC countries plus their non-OPEC supporters maintain compliance then the market is likely to balance for the year as a whole with the first half in a modest surplus and the second half in a modest deficit.”[5]

U.S. Production Growth Driven by Permian Gains

Crude Oil ProductionThe Permian is now nearing 2.8 million bpd of oil production, EIA data shows. To compare, in October 2013, before the oil price crash, Permian production was 1.29 million bpd. In January and February 2016, when oil prices dipped to below $30 a barrel, the Permian production was still ticking up and exceeded 2 million bpd, compared to drops in all other main producing shale regions, including the Eagle Ford and the Bakken.

Robust demand growth has picked up much of the slack due to ongoing strength in the crude supply. On average the EIA, OPEC, and IEA estimated 2017 demand increased by 1.50 million BOPD (up 30,000 BOPD from September averages), with total demand of 97.7 million BOPD. The three groups currently forecast 2018 demand growth of 1.52 million BOPD with total demand reaching 99.2 million BOPD.[6],[7],[8] If demand growth is not derailed and we continue to see overall restraint in near-term production, the reduction in global inventories could accelerate as we move into 2018.

Progress is clearly being made in reducing global inventories. U.S. crude inventories began to decline in April 2017 and ended the year at 424 million barrels, down over 110 million barrels over the last nine months of the year.[9] More broadly, OPEC reported OECD commercial crude inventories stood at 1,486 million barrels in November 2017, down 63 million barrels since March 2017 but still 114 million barrels above the five-year average.[10] More broadly, the IEA reported OECD total commercial inventories fell for a fourth consecutive month in November 2017, with preliminary data showing a further decline of another 42.7 million barrels for December 2017.[11] Given the generally more timely and reliable reported data in the U.S., the improved inventory situation stateside is being closely watched by market participants and remains a key indicator that balance is improving and being restored.

Capital investments during 2017 remained depressed for a third-consecutive year and led to yet another year of historically low levels of new discoveries. Oil and gas are depleting resources, with high reserve replacement needs. While crude prices react to near-term data, the questions of where the market is heading cannot be overlooked as crude remains the globe’s primary fuel, essential in transportation and chemicals. These are critical areas where broadly available and economically attractive alternatives are scarce. Not only have oil discoveries slumped to the lowest level in decades, the global economy remains heavily reliant on crude supply from political hotspots. This implies that the market could swing from oversupplied to scarcity with lightning speed if there is a major, prolonged supply disruption.

Accelerating Capital: 2018 Oil & Gas Industry Planning Outlook

With oil prices firmer and the benefit of a much lower operating cost base, the industry looks set to cautiously press the accelerator, increasing capital spending in 2018.

Permian Basin Pump JackThe great question today is how quickly and at what cost the industry can ramp output back up as the market continues to tighten. Shale drillers in the U.S. are nimble, but even they need time to recruit and retrain staff and reach full momentum. Massive layoffs across the energy sector over the last few years impacted all, but the worst-hit segment was oilfield services. Countless workers transitioned to other industries, leaving the labor market strained as it rebounds.[12]

Labor Shortage Weighs on Oil Industry Recovery

“Halliburton and its oil field services rivals Schlumberger and Baker Hughes cut more than 100,000 jobs worldwide between them as oil prices fell in 2015 and early 2016. Since the middle of last year, as crude prices and drilling activity recovered, oil producers and service companies have hired around 30,000 workers in Texas, after cutting more than 100,000 oil field jobs across the state – roughly one in every three such jobs – between December 2014 and July 2016.”

A sustained recovery will require more drilling and completion activity and therefore more rigs, more crews, and likely leading to pricing pressure from service companies. More importantly, U.S. shale is simply not big enough to make up for cancelled mega-projects across the globe that tend to make up over 90% of world supply. If global investment does not materially pick-up, or we see a rapid slowdown in demand growth, the stage is getting set for the next boom-and-bust cycle for crude.

Natural Gas

Natural Gas Industry Market UpdateDomestic natural gas markets were relatively stable and effectively moved sideways for much of 2107 as natural gas markets are much less affected by international developments than global crude markets. Henry Hub prices are driven primarily by market players’ traditional considerations of local supply and demand and not geopolitical and other outside influences. Supply grew modestly as a benign pricing environment restrained some natural gas-focused capital investment, but associated gas production from oil-centric regions helped support some production gains. A mild 2016-2017 winter season lead to below average natural gas demand for heating, but demand for liquefied natural gas (LNG) exports and pipeline exports to Mexico both helped counter some of this weakness. Taken together, this all helped to restrain prices most of the year, with Henry Hub spot pricing bouncing around $3.00/MMBTU most of 2017. The average price of Henry Hub natural gas spot during Q4’17 fell by 1.7%. Over the course of 2017, Henry Hub spot price averaged $2.99/MMBTU and was up 18.9% versus 2016. Henry Hub ended the year at $3.69/MMBTU.

Demand for natural gas tied to heating remains uncertain and at mother nature’s whim. Beyond winter heating demand, the market continues to see a strong pull from exports to Mexico as well as a new wave of industrial demand in its infancy and new LNG export facilities. ExxonMobil recently commenced production on the first of two new lines at its plastics plant in Mont Belvieu, Texas.[13] Demand for additional plastic is set to rise following China’s decision to stop accepting plastic for recycling as of January 1, 2018.[14] As a result, China has begun buying brand new plastic to replace all the recycled scrap and U.S. exports of polyethylene plastic to Asia are forecast to rise more than fivefold by 2020.[15] On the LNG front, the Cove Point liquefaction terminal on Maryland’s Chesapeake Bay—the second LNG export facility in the Lower 48 states—began its commissioning process in early-December and could receive authorization for commercial operations in January 2018. When fully operational, Cove Point could process around 750 MMCF/d of natural gas for export.[16]

Dominion’s Cove Point export project begins producing LNG

Production has started at Dominion Energy’s Cove Point liquefied natural gas export terminal in Maryland, the first natural gas export terminal on the U.S. east coast. Royal Dutch Shell is providing the natural gas needed for liquefaction during the commissioning process and will off-take by ship the LNG that is produced.

LNG TerminalThe natural gas withdrawal season (typically November through March) is underway. Inventories at the end of the 2017 injection season stood at 3.790 TCF, a 71 BCF deficit to the 5-year average and the first time since 2014 we entered the winter withdrawal season below the 5-year average.[17] The EIA recently forecast end-of-season storage at 1.623 TCF.[18] This would be close to 20% below the 2 TCF level most market watchers like to see entering injection season. If this materializes and other demand drivers remain intact, it could be bullish over the short-term for prices.

Conclusion

Coachman Energy Operating Company believes crude pricing may move still higher in the short-term due to geopolitical risks, but could see a retreat back if some tensions cool and financial traders sell out of their record number of bullish crude bets in large numbers. Strong participant adherence to the production cut agreement has no doubt improved global balances, but a pathway forward without flooding the market remains a major question mark. We increasingly see the potential for a balanced market over the second half of 2018. As always, wildcards remain and some bear repeating. Will geopolitical risks in Iran, Nigeria, and Venezuela among others reach a point where they impact global supplies? Will solidarity among OPEC members remain intact? How and when will OPEC exit their production cut agreement? Can strong demand growth be sustained or will rising prices crimp demand? Will the resurgence of U.S. shale continue or follow a different path? Answers to these questions, among others, will likely hold the key to how the energy markets unfold over the course of 2018.

[1] Declaration of Cooperation, Organization of the Petroleum Exporting Countries, 11/30/17
[2] Participating countries conclude successful year with record-breaking conformity level, Organization of the Petroleum Exporting Countries, 1/21/18
[3] Short-Term Energy Outlook, Energy Information Administration, 1/9/18
[4] Drilling Productivity Report, Energy Information Administration, 1/16/18
[5] Oil Market Report, International Energy Administration, 1/19/18
[6] Short-Term Energy Outlook, Energy Information Administration, 1/9/18
[7] Oil Market Report, International Energy Administration, 1/19/18
[8] Monthly Oil Market Report, Organization of the Petroleum Exporting Countries, 1/18/18
[9] Weekly Petroleum Status Report, Energy Information Administration, 1/4/18
[10] Monthly Oil Market Report, Organization of the Petroleum Exporting Countries, 1/18/18
[11] Oil Market Report, International Energy Administration, 1/19/18
[12] The Labor Shortage In The Shale Boom, OilPrice.com, 1/15/2018
[13] ExxonMobil Begins Production on New Polyethylene Line at Mont Belvieu Plastics Plant, ExxonMobil, 10/17/17
[14] China’s Blow to Recycling Boosts U.S.’s $185 Billion Plastic Bet, Bloomberg, 12/5/17
[15] U.S. Chemicals Are Rocketing Back, Bloomberg, 11/3/2017
[16] Dominion Energy Cove Point LNG Facility Introduces Feed Gas, Dominion Energy, 12/5/17
[17] Natural Gas Weekly Update, Energy Information Administration, 11/9/17
[18] Short-Term Energy Outlook, Energy Information Administration, 1/9/18

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Coachman Energy Operating Company’s Weekly and Quarterly Oil & Gas Market Updates provide an aggregate look at various trends in the oil and gas industry. CEOC and any third parties listed are separate and unaffiliated and are not responsible for each other’s products, services or data. Information is provided for educational purposes only. 

by Randy Kenworthy


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