When Will Oil Prices Turn Around?

Guest Post by Art Berman in The Petroleum Truth Report

Look for some good news about oil prices this week…maybe.

EIA releases its Short-Term Energy Outlook (STEO) on Tuesday (August 11) and IEA publishes its August Oil Market Report (OMR) on Wednesday (August 12). I hope to see a small increase in world demand and relatively flat supply.  That will bring the market somewhat closer to balance and prices may increase or, at least, stop falling.

Meanwhile, the view among most analysts is grim. On Monday, The Wall Street Journal’s Money & Investing headline read “No Relief in Sight for Crude: Oil’s Malaise could last for years.”  In late September, Bloomberg wrote, “Oil Warning: The Crash Could Be the Worst in More Than 45 Years.” As recently as mid-June, analysts were confident that oil prices were rebounding toward “normal” because both Brent and WTI had risen from low $40- to low-$60 levels.

When many were celebrating a return to higher prices, I warned that prices would fall. Now, when most are proclaiming lower oil prices ahead, I am looking for a bottom to the price slump.

Don’t get me wrong: this is not going to be anything dramatic but, if I’m right, it will add another month of data that suggests flattening production and increasing demand.

I have not changed my view that we have crossed a boundary and things are fundamentally different than before. My colleague Rune Likvern published a post today that details the key reasons why this substantive market shift has occurred.

As I wrote in late June, the world is a fundamentally different place post-the 2008 Financial Collapse and some markets, including oil, no longer respond as they did before. This is a function of even more massive debt than prior to the Collapse and monetary policies that have sustained artificially low interest rates for 6 years. Cheap money has fostered the expansion of oil and other commodity supplies beyond the weakened global economy’s capacity to absorb them. Also, the anticipated de-leveraging of debt has not occurred.

Market Fundamentals

So, where are we today?

Oil prices have fallen about 25% from May and June highs (Figure 1). The exuberance of rising prices in March and April has given way to a view that prices may continue to fall and may remain low for years or decades.

Figure 1. Crude oil spot prices, January 1-August 3, 2015. Source:  EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

WTI futures closed at $43.87 on Friday, August 7, almost at the previous low during this price cycle of $43.39 on March 17. Brent futures closed at $48.61 on August 7, still a few dollars above its previous low of $45.13 on January 13.

It seems reasonable that oil prices may have fallen to or at least near some natural bottom.

Traders are looking for hope that tight oil production will decline. IEA data showed that U.S. production fell 50,000 bopd in June (Figure 2). Assuming that OPEC over-production is partly aimed at reducing U.S. tight oil production, that process seems to have finally begun, albeit in a small way so far.

Figure 2. IEA top producers monthly liquids production change, June 2015. IEA and Labyrinth Consulting Services, Inc.
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The problem continues to be over-supply coming mostly from OPEC whose production increased 340,000 bpd in June (Figure 2).

Although there are positive indicators for demand growth for gasoline in the U.S. and China, production growth has continued to outpace increases in demand. The production surplus (supply minus demand) in the second quarter 2015 grew more than 1 million bpd compared to the first quarter (Figure 3).

Figure 3. World liquids production surplus or deficit comparison, EIA vs. IEA. Source: EIA, IEA and Labyrinth Consulting Services, Inc.
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That is what must change in order for prices to turn around. The fact that IEA and EIA estimates vary by almost 700,000 bpd shows that there is considerable uncertainty in the data.

We may get better resolution by using EIA monthly data rather than IEA quarterly data. EIA shows that the production surplus in June declined 1.2 million bpd compared to May to 1.9 million bpd (Figure 4).

Figure 4. World liquids production, consumption and relative production surplus or deficit. Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

This is because world demand reached a new high of 93.86 million bpd, an increase of 1.3 million bpd over May. Another month of demand growth and slowing production growth might go a long way towards turning prices around.

Second Quarter 2015 Earnings

Pessimism increased about oil prices last week as second quarter earnings for U.S. E&P companies were released. Many tight oil producers including Pioneer, Whiting and Devon announced higher production guidance for 2015. Others, however, like EOG and Southwestern Energy said they would continue to show restraint in production until prices improved.

Despite ongoing macho declarations from tight oil company executives that they are winning the war against Saudi Arabia and OPEC, the truth is that second quarter results were pretty awful, and that is good for oil prices because it may signal falling future production.

For the first half of 2015, the tight oil-weighted E&P companies that I follow spent about $2.20 in capital expenditures for every dollar they earned from operations (Figure 5).

Figure 5. First half 2015 tight-oil companies spending vs. earning: 2015-2014 comparison.
Source: Company 10-Q data, Google Finance and Labyrinth Consulting Services, Inc.
(click image to enlarge)

These companies are outspending what they earn by a dollar more today than they were a year ago during the first half of 2014. Anyone who believes that decreased service costs and drilling efficiency will allow tight oil companies to make a profit at $50-60 oil prices needs to think again.

The debt side of first half earnings looks even worse, if that is possible. Figure 6 shows that debt-to-cash flow ratios for sampled tight oil companies average 3.3. This means that it would take these companies 3.3 years to pay down their total debt using all cash from operating activities.

Figure 6. First half 2015 debt-to-cash flow For tight oil companies.
Source: Company 10-Q data, Google Finance and Labyrinth Consulting Services, Inc.
(click image to enlarge)

This is a standard measure used by banks to determine credit risk and to set loan agreement requirements (covenants). The average of 3.3 for the first half of 2015 (annualized) is more than twice the mean for the E&P industry from 1992-2012 (Table 1).

Table 1. S&P industry group total debt/cash flow and total liabilities/cash flow means (1992-2012).
Source: Bank of Finland Research Discussion Papers 11-2014.
(click image to enlarge)

This has profound implications for debt re-determinations that will happen during the third quarter of this year. It means that most of the companies shown in Figure 6 with debt-to-cash flow ratios above 2.0 may have considerably less access to revolving credit lines going forward. That equals more limited capability to drill and complete wells.

At the same time, favorable hedge positions, that allow companies to realize prices higher than current spot markets pay, will begin to expire in coming months. The drop in value for long-dated futures contracts since oil prices slumped in July means that tight oil companies are unable to hedge much above current low prices.

My colleague Euan Mearns recently did a forecast for U.S. tight oil plays and concluded that production from the Eagle Ford, Bakken and Permian would decline by about 830,000 bopd by the end of 2015. His estimate assumed that rig counts had stabilized but tight oil horizontal rig counts have increased 20 during the last 4 weeks.

The EIA forecasts approximately 390,000 bopd of production decline by year-end (Figure 7).

Figure 7. EIA U.S. crude oil production and forecast, 2015-2016. Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

What It Means

The significance of these production forecasts and the second quarter earnings reports is that U.S. tight oil production will decline. The fact that production has remained strong despite a 60% decrease in the tight oil rig count has incorrectly lead some analysts to conclude that production will not fall because of the ingenuity and efficiency of U.S. producers.

It takes time for production to decline because there are months of lag between the beginning of drilling and first production, and more months of lag before production data is released. Also, many of the rigs that were released were drilling marginal locations that didn’t contribute much to overall production–the 80-20 rule. And, there is the inventory of uncompleted wells that are unaffected by rig count.

Will a decline of 400,000 to 800,000 bopd in U.S. tight oil production make a difference in the global market balance? Obviously, it depends on what other producers do but it is certainly important to OPEC’s strategy of gaining market share from unconventional producers.

OPEC is producing more than half of the world production surplus and has the capacity to cut production by the entire amount of the surplus. This will not happen until its goals are achieved but Saudi Foreign Minister al-Jubeir will meet with Russian Foreign Minister Sergei Lavrov August 11 in Moscow to discuss global energy markets and other topics. EIA will release its STEO on the same day and IEA will release its OMR the next day.

I am hopeful that something positive will emerge that will at least help to stop the decline in oil prices.