Oil Prices - Where to they go after OPEC extension?

[dan_s]

Comments below are from Martijn Rats, an energy sector analyst with Morgan Stanley. My thoughts are in blue. - Dan

Martijn Rats is head of the MS European Oil & Gas Research team and lead analyst on key stocks including Royal Dutch Shell, BP, Total, and Eni. He is also the strategist for Morgan Stanley Research's oil price forecasts.

OPEC's Extended Cut – Between a Rock and a Hard Place

OPEC's extended cut will likely lead to stock draws in 2Q/3Q and provide some oil price support. However, when this agreement ends, and coincides with strong shale growth, the market looks oversupplied again. This has become our expectation for 2018, and we lower price forecasts as a result.

OPEC chooses the lesser of two evils: In recent weeks, OPEC found itself faced with a difficult choice:extend the production cuts to bring down bloated inventories, or end the cuts to prevent further loss of market share. The experience of the 1980s has shown that the latter can become as problematic as the former. Clearly, OPEC decided for the former, but it is storing up problems for 2018, in our view.

Near-term we see inventories drawing and providing support for oil prices: Global oil inventories finally started drawing in March, at a rate of 900,000 b/d based on monthly data. Weekly data suggests this has continued in April and May. With demand getting a seasonal tailwind, and OPEC extending its cuts, we expect inventory draws to accelerate in 3Q. Altogether, we estimate that global stocks will fall by ~100 million bbl in the balance of the year. Although these draws are smaller and are coming later than we once expected, this should nevertheless provide some price support in coming months. We forecast WTI to end 2017 at $55/bbl, down from our previous forecast of $60/bbl.

Anyone that thought global inventories would drop in January and February does not grasp the complexity of the global oil market. OPEC members ramped up production in Q4 2017 and it took some time for that oil to work its way from the oilfields to the tanks in the U.S. Plus, it took OPEC members several months to get their act together and get into compliance with the first production agreement. As of today, OPEC is in full compliance with the 1.2 million barrel per day cuts (thanks primarily to Saudi Arabia). We saw OECD oil inventories fall in March and the rate of decline should accelerate as refiners come out of the annual maintenance season and draw more crude from inventory. The other group of producers, lead by Russia, that agreed to cut production by 558,000 barrels per day, has been slow to get into compliance. It looks like they are getting there, but my assumption is that they are around 50% compliant today and never quite get to 558,000 BOPD. - Dan

But the outlook for2018 is starting to look troublesome – End of OPEC agreement+ Strong shale growth = Loose market: We do not expect that OPEC will extend its output cuts much beyond 1Q. By historical standards, that would be an unusually long period of output restraint. (I disagree with this. I think OPEC will raise the quotas by 500,000 BOPD after 3/31/2018 and keep rolling their production agreement forward. OPEC's official "mission" is to balance oil supply/demand and help maintain a stable oil market. If they abandon their mission, then OPEC has no reason to exist. Saudi Arabia needs oil prices to be higher when they sell part of Aramco. - dan)

However, non-OPEC production has already returned to year-on-year growth and is set to accelerate in 2018, driven by shale. When the end of the OPEC production cuts meet strong shale
growth, the market is almost certainly oversupplied again. As a result, we lower our end-2018 WTI price forecast to $55/bbl, from $60/bbl before, although we could still see lower prices at some point during 2018.

U.S. oil production peaked in mid-2015 at 9,600,000 BOPD. It dropped to 8,400,000 BOPD in mid-2016 and it has rebounded to 9,300,000 BOPD. In my opinion, a lot of the rebound was a rush to complete DUC wells prior to year-end 2016. I do expect U.S. oil production to ramp up to 10,000,000 BOPD by 3/31/2018 (the date the new OPEC agreement is set to expire), but by then I think it will be clear that the rate of U.S. production growth has slowed. Keep in mind that the more the U.S. relies on shale oil and gas production, the steeper the depletion rate becomes. We will have to drill more and more wells each year just to keep production flat. Plus, there is already signs that oilfield services, frac sand and tubulars are being strained. - Dan

All of this has implications for long-term prices too: Our previous long-term price forecast of ~$70/bbl for WTI by 2019/20 was based on our estimate that ~1.5 mb/d of 2020 demand would need to be supplied by projects that have not been sanctioned yet, but that have break-even oil prices around that level. However, with stronger shale growth, slightly weaker demand and some additional cost deflation, the reliance on this 1.5 mb/d has almost entirely been wiped out. We still see 1.6 mb/d of 2020 demand that needs to come from
projects with break-evens of $55-65/bbl, so we lower our end-2020 WTI forecast to $60/bbl.

For my forecast/valuations I am now assuming WTI will average $52/Bbl in Q3 and $55/Bbl in Q4 and 2018. My opinion is that oil needs to be over $60/Bbl to insure that future demand will be met by supply. There is no chance that U.S. shale can meet future oil demand on its own. - Dan

[mkarpoff]

None of this bodes well for share prices. In Q4 2016 you said 2017 should be interesting. It sure is, but apparently in the wrong direction from what you expected.

[dan_s]

The markets perception must be that upstream companies need $60 to $70 per barrel for their oil to make money. That is not true.
> Completed well costs have come way down
> Production rates and EURs have gone up and are still going up (much better completion designs)
> Lease operating expenses are very low for producing wells (under $5/boe in most areas)
> Most of the Sweet 16 have all-in cash expenses around $10/boe of production. < I worked at Hess Corp. for 18 years and I cannot remember ever seeing our netbacks being over $30/boe.

Q1 results for all of the Sweet 16 were quite good and none of them reported realized oil prices over $50/Bbl. 2nd quarter results are also going to be strong. Oil prices have stabilized, production will be up and the outlook for natural gas and NGL prices is getting much better.

Remember that Wall Street's perception of a sector can change rather quickly. Right now they are down on the energy sector. Just going from a negative opinion to a neutral opinion can rotate a lot of money into a sector.

[mkarpoff]

From your mouth...