Energy Prospectus

In a new report from Morgan Stanley that I received this morning (3/31) it confirms a suspicion that I've had: that the increase in U.S. crude oil storage levels is really just oil moving from ships to onshore tanks. OECD inventories are falling and the rate of decline will accelerate in the 2nd quarter, primarily because most refiners have finished annual maintenance and will ramp up draws from crude oil storage to produce more gasoline. Comments below from the MS report. - Dan

Three concerns have been front and center during recent investor meetings
across Europe and the US: 1) Why are US crude stocks building whilst the market
is supposed to be tightening? 2) how fast will shale production rebound given
the recent surge in the oil-directed rig count? And 3) Will OPEC extend its
production cuts beyond the end of May?

Uncertainty over these three issues has driven the correction that started three
weeks ago. However, this now appears to be coming to an end,and for good
reasons: the incoming data has been more constructive than flat prices suggest.
Less visible inventories have been drawing: For example, take inventories: in
exhibit 3 we show the most comprehensive picture on global inventories that we
can put together. It includes data for the US from the EIA, data for 'other OECD'
from the IEA, China data from the Xinhua news agency, 'other non-OECD' data
from JODI, and floating storage data from Reuters. As shown, total oil
inventories (i.e. crude plus products) built in January, indicating a well supplied
market. Beyond the end of January, we need to rely on those countries that have
weekly reporting: the US, Japan, Europe (ARA) and Singapore.

The highly visible US crude inventories published by the US DOE have continued
to built throughout February and March, by a relatively hefty 39 mln bbl.
However, US product stocks have drawn by 52 mln bbl over that period. On top,
Japan, Singapore and the ARA region (Antwerp, Rotterdam, Amsterdam)have
shown draws of another 10 mln bbl in total oil stocks since the end of January.
Finally, floating storage has nearly halved, falling 52 mln bbl from 119 mln bbl at
the end of January to around 67 mln bbl at the moment, based on data from
Thomson Reuters. Altogether, this makes for a total draw of 72 mln bbl in the last
two months.

More from the MS report:

US shale cost inflation appears to be accelerating: On the topic of US shale, our
current forecast is for ~700 kbbl/d growth from 4Q16 to 4Q17. Given the
increase in the oil rig count of ~14 units-per-week since mid-January, risks to this
number are skewed to the upside. However, even if exit-to-exit growth turns out
to be 1 mln bbl/d, the impact on our average 2017 balance would probably be
limited to a more modest 100 k/d as this growth is back-end loaded in the year. If
this were to transpire, it would arguably be a greater risk to our 2018 balance.
Still, there are reasons to be somewhat wary about some of the very high growth
forecast for US shale in 2017: Discussions with our US oil service and E&P
colleagues highlight that inflation is already taking hold: dayrates for high-spec land rigs
have already increased 15-20% from the lows, prices for drill pipe and other OCTG are
up 20-30%, pressure pumping services have increased similarly in price, and frac sand
has approximately doubled. < Bullish for those of you that hold HCLP

Also, data from the BLS shows that employment in 'oil and gas extraction and support
activities for oil and gas has practically not increased yet. Every rig creates jobs for 200-
250 people, so growing the rig count at 14 rigs/week should add 12,000 - 15,000 jobs
per month. That is not visible in the data yet.

Perhaps growth in the rig count has been accommodated by the existing work force so
far. However, continued strong growth in drilling activity should drive employment
higher at some point at the rate mentioned above. That looks challenging to us, given
the large number of people that have left the industry and growth elsewhere in the
economy. At a minimum, it is likely to be inflationary.

An OPEC extension is more-likely-than-not: It is very unlikely that OPEC will have
achieved its objective of bringing back inventories towards their 5-year averages by the
time of the next OPEC meeting on May 25th. That would probably requires constrained
output also in 2H. Still, ever since the comments at CERA Week from Khalid al-Falih,
Saudi Arabia's oil minister, that OPEC did not want to provide a 'free ride' to others,
investors have been concerned about whether production will indeed remain
constrained.

Whether it will or not depends to an extent on oil prices. If prices - which we do not
expect - were to recover to $60/bbl by end-May, OPEC cohesion will be difficult to
maintain. However, if prices were broadly similar to today's levels, our expectation is that
OPEC production will remain constrained into 2H. There are a few reasons for this
expectations:

First, the oil academic Robert Mabro once commented that OPEC should change its logo
to that of a tea bag "because it only works when in hot water". This downturn has shown
this once again. With the OPEC basket still below $50/bbl as off today, the organisation
appear still sufficiently in "hot water" that the members will likely find common interest
and extend the cuts.

Second, OPEC compliance is not only strong at the aggregate level but so far also
broadly supported: out of the 11 OPEC countries subject to quota, nine showed
compliance of 75% or more in February. The two outliers are Gabon, which produces just
0.2 mb/d, and Venezuela. This shows that there is broad-based buy-in for the current
agreement.

Finally, the cost of not extending the agreement are likely to be high. Fundamentals
notwithstanding, oil prices will likely come under strong pressure if investors believe
that OPEC will revert to its market share-driven strategy again.

Our balances suggest, however, that OPEC quotas do not necessarily need to be as low
as they currently are in 2H. With a seasonal tailwind to demand, we estimate there is
room for OPEC to grow ~700 kb/d between 1Q and 3Q, so production can start to creep
higher but only in a constrained manner. That does not seem insurmountable to us.
However, if OPEC-11's output were to revert back to the highs of 2H16,then our balances
would look meaningfully different.

After the correction, risks skewed to upside: Putting all this together, we continue to
forecast an acceleration of stock draws over the next few months that could work off
250-300 mln bbl of excess storage over the balance of the year. That should support
prices going forward.

Recent comments from officials from Libya, Iraq and Russia suggest that production in
those countries is tracking below our forecast, although this could be partially offset by
slightly higher-than-expected production in Nigeria and the US.

Also, demand growth remains on track with healthy growth in China across Jan/Feb,
India rebounding to a record level in February and even Europe showing healthy growth.
With macro economic data coming in strongly - see exhibits 7 to 10 - we see little
downside risk to our 1.5 mb/d demand growth forecast this year.

Given the market's focus on US crude inventories, it is worth highlighting the rapid
decline in refinery maintenance in the US in the last two weeks, which will continue over
the next few months. Higher refining runs should increasingly help work off the excess
crude inventories.

A reduction in visible crude inventories will help the forward curve move into
backwardation, and a backwardated curve is hard to keep down. Despite the market's
recent correction, we believe this thesis is intact. If inventory draws do not come through
over the next 4-6 weeks, we will need to revisit our balances. For now, however, we
think risks to flat prices are skewed to the upside.
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MY TAKE: Baring a global economic meltdown, I think OPEC could raise their production quotas by 500,000 BOPD year-after-year and the price of oil would stabilize over $60/Bbl. I see very little chance that the U.S. shale plays can produce enough oil to keep up with global demand that goes up by 1.5 million barrels per day. At some point there are so many high decline rate wells on decline that new drilling cannot keep up. Of course, this is an extremely bullish scenario for the oilfield service and frac sand companies. - Dan