Production Cuts Lousy Panacea for Broken Oil Markets

As many expected, OPEC announced Nov. 30 that it will extend its crude-oil production cuts through the end of 2018. The impact of these cuts will fall short of what the cartel and its partners are hoping for, however.

Several months of stagnating shale growth, driven by a sharp increase in drilled-but-uncompleted wells and the fallout from Hurricane Harvey, have lulled oil markets into a false sense of security. The inevitable resumption of growth in the United States, coupled with expansion in Libya and Nigeria, will probably nudge crude stockpiles higher again in 2018, whether other OPEC members comply with fully agreed production targets or not.

Undoing the progress made by OPEC this year to bring inventories closer to the 2010-14 average will threaten oil prices next year. And the long-term picture doesn’t look much healthier, either. The shale industry, which sets prices in our global supply/demand framework, has gotten comfortable with lower prices after several years of relentless efficiency gains. Accordingly, our midcycle forecast is unchanged at $55 per barrel of West Texas Intermediate.

At their meeting in Vienna, OPEC and its partners chose to extend 1.8 million barrels per day worth of crude production cuts through the end of 2018. Though this extension was widely anticipated, the agreement was originally set to expire at the end of March 2018. This year, with the cuts in place, the cartel has made significant progress realigning global inventories with historical averages, but it’s taking more time than initially anticipated, which explains the extension. In 2018, however, we think OPEC’s efforts will be washed out by increasing U.S. shale production, increasing production from the few OPEC members not previously bound by quotas, and wavering compliance by other OPEC members.

Without deeper cuts, we don’t think OPEC will achieve its stated goal of bringing inventories back to normalized levels in 2018. In fact, we forecast OECD inventory levels will start increasing again in 2018. Even in a scenario where OPEC compliance is perfect, global inventories would probably still increase in 2018.

Our 2018 forecast for West Texas Intermediate is $48.75 a barrel, which would mark a 15% decline from current levels. This is the level that would induce enough of a supply response from U.S. shale to ensure that elevated global stockpiles eventually start heading south. Exactly how far prices could fall amid growing U.S. production is hard to peg, but we think one point is clear: The market is underestimating the trouble crude prices could see in 2018.

U.S. Shale Production Set to Move Oil Market Back Into Oversupply Although OPEC has certainly played a role, the roller-coaster ride in oil prices from over $100/bbl to below $30/bbl and back to above $50/bbl has largely been a product of flexing U.S. shale production, a theme we expect will continue. Even with our expectation that rig counts will decrease slightly, we think U.S. production will rise materially in 2018 and beyond. Rising U.S. shale production is a key component of our bearish 2018 oil price outlook.

In 2017, many exploration and production companies have locked in prices with derivatives and continued ramping up drilling activity. Given the recent strength in oil prices and the 6- to 12-month two-stage lag that accompanies the cascade from a change in oil prices to a change in rig count to a change in actual production, we think a floor for U.S. shale production in 2018 is essentially baked in. We expect 10.4 mmb/d of U.S. crude production in 2018, even with our expectation that the rig count will slightly decline in the back half of 2018 in response to our forecast for declining oil prices. Our forecast sits roughly 5% above Energy Information Administration estimates for average U.S. crude production in 2018.

Opponents of this thesis point to the muted production response through much of the year from the rapid escalation in rig activity (U.S. crude volumes increased only 0.9% from March to August). That contrasts with many analysts’ earlier forecasts (including ours) and is being taken by some as an early indicator that concerns about rapid U.S. shale growth are overblown. But investors claiming that shale output has stalled should bear in mind that only 72% of Permian wells drilled in 2017 have already been turned to sales. We previously overlooked the natural increase in drilled but uncompleted inventories that follows large activity increases, and this year the backlog increase was exacerbated by short-term pressure pumping shortages.

Hurricane Harvey also stymied growth in the past few months as a result of widespread shut-ins, especially in the Eagle Ford Shale. But none of these issues are likely to hold back production for much longer, now that rig counts have leveled off.

Indeed, the somewhat lagging pace of U.S. horizontal well completions has closely followed the pace of pressure pumping fleet reactivations. But while the reactivation of pressure pumping fleet capacity hasn’t happened overnight, we see few lasting barriers that would prevent the eventual ramp-up of capacity to meet whatever demand levels are needed.

We’ve heard of some pressure pumpers needing to spend extra time to train inexperienced crew members, as well as others struggling with shifting patterns of frac sand logistics. The common theme is that these problems are all readily fixable and hardly represent a potential ceiling on pressure pumping capacity.

The latest monthly U.S. crude production data released Nov. 30 by the EIA gives us confidence that our thesis for surging U.S. production is playing out. The U.S. produced 9.48 mm/d in September, a more than 3% sequential increase from August and a nearly 11% year-over-year increase.

Looking past 2018, we forecast that U.S. crude production will see a 5% compound annual growth rate from 2016 to 2020. We expect most of the growth in our forecast to come from the Permian Basin in Texas and New Mexico (17% CAGR). On the other hand, we forecast declining crude production from the Eagle Ford (negative 4% CAGR), which had previously been a major growth driver of U.S. production growth. Given current oil market conditions and our forecast for oil prices, we expect the number of light tight oil drilling rigs will increase over the long run, with some oscillations due to changing oil prices, but fail to reach the heights seen before the oil price crash by 2020.

Previously Exempt OPEC Production to Grow, OPEC Compliance to Wane At the Nov. 30 meeting, OPEC announced a collective production cap of 2.8 mmb/d for Libya and Nigeria, two OPEC members that had previously been exempt from production quotas. The two countries had combined production of under 2.6 mmb/d in the third quarter of 2017, meaning that OPEC is accepting the fact that combined Libya and Nigeria production will continue to grow. Our fourth-quarter 2018 forecast for Libya and Nigeria production of 1.20 mmb/d and 1.55 mmb/d, respectively, would put the countries just under the OPEC cap. Even if we were to assume flat production from Libya and Nigeria, we would still expect rising OECD inventories in 2018. We would need to assume a combined decline of 0.5 mmb/d from third-quarter 2017 production levels for our forecast of 2018 OECD inventories to remain essentially flat. This contraction scenario seems unlikely given the recent trajectory of production.

Compliance with production cuts has been uncharacteristically strong so far, thanks in large part to Saudi Arabia. Still, about half of the countries participating in the agreement are producing above their quotas.

We expect that OPEC compliance will waver more in 2018 than it did in 2017 and that producers, running out of patience with truncated production, will start responding to individual rather than group incentives. Many OPEC countries rely heavily on crude revenue to balance budgets, fund social programs, and enable costly fuel subsidies to shore up fiscal situations by increasing their own production. Venezuela is a prime example of an oil-dependent economy collapsing under the weight of lower crude prices. In effect, our U.S. production forecast makes cheating more likely over time, which is then likely to pressure oil prices even further.

Although we expect Saudi Arabian compliance to remain strong, with production flat at current levels, we expect several countries that have thus far failed to comply with OPEC cuts will continue ignoring production targets, mostly notably Iraq and the United Arab Emirates. Iraq has consistently missed its production target since cuts began in January 2017, and its production has even increased sequentially from the first quarter of 2017 to the third quarter.

Overall, we expect OPEC production to grow 120,000 barrels per day from the third quarter of 2017 to the fourth quarter of 2018. But even in a scenario where we keep OPEC production flat in 2018 compared with the third quarter of 2017, we would still expect OECD crude inventories to increase.

Our base case is that OPEC will let cuts expire at the beginning of 2019. With U.S. shale production continuing to ramp during this period, OPEC risks exacerbating share losses if cuts are extended further. Although new volumes cannot be brought on line immediately, shale production is more nimble than conventional forms of oil production. OPEC maintaining cuts or deepening cuts to prop up prices just makes it more likely that U.S. shale will step in to fill the void. We suspect this concern is why the current round of OPEC cuts starting in 2017 has been shallower than previous episodes and explains the delay after prices collapsed before OPEC initially acted. Further, there is no historical precedent for OPEC cuts succeeding in a supply-induced downturn, which is where we find ourselves today.

We don’t think perpetual OPEC cuts are likely, which is the only scenario that could change our midcycle price outlook and lead to a larger impact on our company valuations. Our midcycle forecast of $55/bbl for WTI is based on the marginal cost of development and production for shale producers.

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