Oil Market Continues to Tighten: $100 is Getting Closer

  • In January 2017, with global oil inventories at record levels, we predicted inventories would normalize over the next eighteen months
  • Today, inventories are approaching levels considered normal. Total OECD inventories topped out at 420 million barrels above 10-year averages in July 2016 and as of February, they had declined by 75%, and now stand only 100 million barrels above average
  • Inventories drew relative to long-term averages at a rate of 800,000 barrels/d over the last 12 months
  • Global oil markets have been, and are today, much tighter than originally predicted. This tightness, along with increased geopolitical tensions in the Middle East, has caused oil prices to rally to their highest level since 2014
  • Despite crude oil’s price strength, oil-related securities have lagged considerably
  • While oil prices are ~150% higher than their 2016 lows, oil-related securities have only advanced between 40-60% on average
    • Because of their underperformance, we believe tremendous investor opportunity exists in energy-related shares
  • Starting from a deficit of 650,000b/d in 2017, we expected global demand to grow by 1.6mmb/d in 2018. We predicted that the US could grow production by 1.1mmb/d while the rest of non-OPEC could grow by 400,000b/d. Were OPEC to maintain its cuts throughout 2018, we argued, the global oil market deficit would increase from 650,000b/d to 750,000b/d and inventories would draw to their largest deficit relative to long-term averages ever recorded
    • Even if OPEC rescinded their production cuts in June, the oil market would likely remain in deficit for most of 2018
  • Several new developments have emerged and our outlook has become even more bullish. Most importantly, OECD inventory data continues to confirm that the global oil market remains in substantial deficit and that this deficit is accelerating
    • Over the six months ending January 2018, OECD inventory draws relative to normal have accelerated to 950,000 b/d compared with 580,000 b/d for the six month prior
  • Global demand estimates for 2018 were revised higher over the last 3 months by 150,000 b/d
  • In particular, the demand figures coming in from India are incredible. It is shocking how few people are commenting on the large-scale developments currently underway in the world’s second most populous country
  • Indian oil demand growth likely exceeded 300,000 b/d y-o-y during the first quarter to reach another all-time high. India is transforming before our eyes and yet few people seem to notice. Indian oil demand is expected to grow by 300,000 b/d this year, representing a near 100% acceleration from its 175,000 b/d average over the last decade
  • On the supply front, the lack of any material investment in the non-OPEC world outside of the US is beginning to significantly impact production
  • Offsetting these bullish developments, the IEA revised its US shale production estimates for 2017 and 2018 higher by 120,000 b/d and a very large 520,000 b/d respectively
  • Over the past 5 years there have been three major trends affecting overall drilling productivity: longer laterals and larger “frac” jobs have both increased productivity while a shift to lower quality acreage has reduced productivity
    • Our hypothesis is that operators drilled longer and larger wells to help offset the shift from Tier 1 to Tier 2 acreage. As drillers reach the limits of both lateral length and frac size, deteriorating acreage quality will quickly come to the fore
  • While drilling productivity per lateral foot has steadily increased in the Bakken and Eagle Ford over the last five years, our model suggests this has occurred as larger frac loadings have more than offset the move to lower quality acreage
    • Sand loadings in the Bakken and Eagle Ford respectively have increased by 150% and 70% over the last 5 years
    • Most industry experts agree that the 150% and 70% increase in Bakken and Eagle Ford loadings should have resulted in production increased of approximately 70% and 35% on a like-for-like basis
    • However, average well has seen initial production per lateral foot increase by only 50% and 17% respectively for the Bakken and Eagle Ford over the same period
    • We believe the shortfall could very well be the result of operators moving from Tier 1 drilling locations to less productive Tier 2 locations
  • The shift towards more Tier 2 wells will likely continue as operators appear to have largely depleted their Tier 1 inventory
  • It is unlikely larger loadings will offset this quality degradation going forward. If operators go from their current 30% of Tier 2 wells to a 50/50 mix over the next 18-24 months while sand loadings remain the same, the average Bakken and Eagle Ford drilling productivity per lateral foot would decline by 15%. Based upon the current rig counts in both plays, production growth would turn sharply negative for both the Bakken and Eagle Ford
  • Recent developments in the OPEC world:
    • Humanitarian crisis in Venezuela continues to impact the national oil industry. Over the last 29 months, production has fallen sharply by 870,000 b/d and these declines are accelerating. Without a material change in that country we cannot see how production will not continue to decline substantially from here
    • Tensions in the Middle East have again raised the issue of an “instability premium” in the oil market – a dynamic not seen for several years. In particular, oil prices have responded to the recent events in Syria. With Saudi supporting the Syrian rebels, and Iran and Russia supporting the Assad regime, the recent actions by the US now means that four of the world’s top five oil producing countries are involved in a proxy-conflict in the Middle East
  • Oil markets are in deficit, and we believe prices are heading much higher. Investors should maintain their exposure to oil-related investments

Goehring & Rozencwajg 1Q18 Market Commentary

Image Source: EIA, Goehring & Rozencwajg Models


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