USOI - Oil Pops On Unnecessary Action By OPEC+

2023-06-06 07:00:00 ET

Summary

• Oil prices have recently recovered from a downturn due to optimism regarding potential action by OPEC+ and Saudi Arabia's decision to cut daily production by 1 million barrels starting in July.
• The oil market is sensitive to small imbalances between supply and demand, and the recent actions taken by OPEC+ imply a shortage of oil for the remainder of this year.
• Despite concerns of a potential glut, there are fundamental reasons why crude prices should remain elevated, including low commercial crude inventories, a nearly decade-long low in drilled but uncompleted wells, and increased drilling activity.

The past several days have been very interesting for the oil market. With concerns over a potential glut due to both economic concerns and production levels, prices have plunged. In the four days leading up to and including May 30th, for instance, the price of WTI crude dropped 6.6%. Since then, however, about two-thirds of that loss has been made back. This reversal of fortunes can be chalked up first to optimism regarding potential action by OPEC+ to prop up energy markets, and then to the group actually coming through to some extent. As I have maintained for a few months now, I believe that there is a fundamental disconnect between what the market seems to think about oil and what reality is actually serving up. Even though higher oil prices can have negative consequences for consumers and companies, I do believe that the recent downturn in crude was unwarranted. Right now, there are fundamental reasons why crude prices should remain elevated. And absent something unexpected coming out of the woodwork, I do not believe we are likely to see oil drop below $70 per barrel again for some time.

An interesting move by Saudi Arabia

One of the most difficult things about the oil market is that you do not need a significant imbalance between supply and demand in order to send prices skyrocketing or plummeting. As an example, consider that, for the 2023 fiscal year, the EIA (Energy Information Administration) expects global production of crude to be around 101.34 million barrels per day. Demand, meanwhile, is expected to be around 100.99 million barrels per day. This disparity comes out to roughly 350,000 barrels per day, meaning that there should be 350,000 barrels per day of extra crude on the market compared to what the world should consume. Over the course of a year, that would allow about 127.75 million barrels of crude to build up.

Given this massive impact from such a small difference, it should not be surprising that markets hang on every data point that they can get. And with prices having dropped in recent days, all eyes moved to watch what would transpire when OPEC+ met over the past weekend. For the past couple of months now, concerns have been building regarding a potential recession of either select countries or most of the world. A stronger dollar also played a role in this, with the US Dollar Index up 2.8% over the past month alone. Since oil is largely quoted in dollars, a stronger dollar can make oil more expensive for countries outside of the US and, in turn, can serve to blunt demand.

Immediately leading into the OPEC+ meeting, there was speculation amongst market participants that the group would cut daily production by 1 million barrels. Last October, the group cut production by two million barrels per day. And in April of this year, they made voluntary cuts of 1.6 million barrels per day. Interestingly, the end result was slightly different than what market participants thought it would be. It seems as though there was a great deal of disagreement over who should cut and by how much. In particular, the UAE (United Arab Emirates) had been pushing to get the group to accept an upward revision in its baseline production that would allow it to have a larger share of the group's overall output moving forward.

There were other topics discussed at the meeting. But the most significant development was that Saudi Arabia elected to cut daily production on its own by 1 million barrels starting in July of this year. Tentatively, that cut is only planned for a single month. This is especially interesting because the hot summer months involve increased consumption at home for the country because of power generation centered around a variety of things such as air conditioning. More likely than not, the country will continue to use greater power during this time. So all of the cut that they are committing to will be reflected in the form of reduced exports. They have not agreed to keep production cut beyond July. But they did say that they very well could.

I understand that there is a great deal of mistrust when it comes to relying on what Saudi Arabia says. But I have been writing about oil markets for nearly a decade now, and I have found their commitments to be incredibly reliable. This, unfortunately, is not the case when it comes to every country. Russia, for instance, has not necessarily complied with the promises it has made. During the meeting, UAE oil minister, Suhail al-Mazrouei, went so far as to say that, when it comes to Russia, there are often discrepancies between what the government reports and what independent sources estimate to be the country's output. With that being said, Russia's Deputy Prime Minister, Alexander Novak, mentioned that the voluntary cuts of the group that were supposed to expire by the end of this year will now tentatively be extended through 2024.

Truth be told, I don't believe that Saudi Arabia's decision to cut production was needed. For those who are bullish on the space, it is absolutely welcomed. But not needed. As I wrote in an article that I published in early May of this year, the recent actions taken by OPEC+ already imply a shortage of oil for the remainder of this year. If we use data provided by the EIA, the shortage will be around 350,000 barrels per day for the second quarter of this year. By the final quarter, it should grow to 1.05 million barrels per day. OPEC data is even more bullish, starting at roughly 500,000 barrels per day for a shortage in the second quarter of this year and growing to 2.64 million barrels per day by the final quarter. Absent a major drop in demand, or some sort of error in the math somewhere, any further cut, like the one that Saudi Arabia just committed to, will only exacerbate the shortage.

Those who disagree with my stance could point out that it's possible production from places like the US could rapidly grow in order to offset what is looking to be a sizable crude deficit for this year. But as I wrote in another article, crude inventories in the US have already dropped over the past several months. That drop would have been worse had it not been for the fact that the SPR (Strategic Petroleum Reserve) drastically depleted its inventories in order to prevent prices from climbing too much. Of course, you can make the case that there is a difference between existing inventories being low and production levels climbing in response to strong demand. But when you look at data on that front, this scenario looks unlikely in the near term.

To see what I mean, we should look at a couple of different data points. The first thing I would like to point to is the EIA's DPR (Drilling Productivity Report). In its latest report, the EIA revealed that there were 4,863 drilled but uncompleted oil wells in the seven largest oil and gas producing regions of the US. While this number may sound high, it's actually the lowest that we have seen since June of 2014. For those who don't know, the EIA reports data on three different types of wells. You have drilled wells, completed wells, and the drilled by uncompleted inventory levels. These are wells that have been drilled, but have yet to be completed and are not yet producing any oil or natural gas.

The significance of this is that the drilled but uncompleted figure is often considered to be indicative of how much oil can be brought onto the market in a fairly short period of time. The higher this number is, the more easily the industry can respond to higher prices. Unfortunately for oil bears, around the time the pandemic began, this number began shrinking considerably. Back in June of 2020, for instance, it came out to 8,822. So we have seen a substantial decline in just three years. As the chart below illustrates, we are seeing an increase in the number of wells drilled. However, elevated oil prices have resulted in completions outpacing drilling. It makes sense when energy companies are trying to preserve capital to tap into resources that require less investment than to drill entirely new wells and let the inventory of drilled but uncompleted wells remain unchanged or even increase. For context, bringing a drilled but uncompleted well online only takes about 65% of the capital that a well that needs to first be drilled requires. At the end of the day, what this means is that the industry lacks the ability to meaningfully step up output in a short period of time.

As I mentioned already, drilling is most certainly up. But as you can see in the chart below, the number of oil rigs and overall rigs is still substantially lower than it was in prior years. Back in June of 2018, for instance, there were as many as 758 rigs dedicated to oil drilling. Today, that number is down to 555. And these numbers are far lower than what we saw at the beginning of the chart. In June of 2014, for instance, there were as many as 1,558 rigs dedicated to oil drilling. It is true that improvements in technology and operational strategy can lead to greater efficiencies. But there is not much evidence to suggest that we would see improvements that are large enough to offset this meaningful decline.

This is not to say that we aren't seeing any action on the oil supply side of the picture. We most certainly are. The most recent weekly report from the EIA indicated that the US is producing around 12.2 million barrels of oil per day. This is down only slightly from the 12.3 million barrels per day that we saw one week earlier. To put this in context, the last time before late last year That we saw US production this high was in April of 2020 as the COVID-19 pandemic was picking up. And it is still meaningfully below the high point on the chart shown below of 13.1 million barrels per day.

Takeaway

For anybody who is bullish on the oil sector, I believe that this recent move from Saudi Arabia during the OPEC+ meeting was bullish. In truth, I believe that markets don't actually need this additional cut in order for prices to remain high. In fact, I would go so far as to state that I believe prices almost certainly would move higher in due time even without this voluntary production cut. Be that as it may, the picture is most certainly improving thanks to this action. Those who are more bearish may point out that even if my imbalance estimates are accurate, that higher prices should be temporary because they should result in greater investment in the space, my counter to that would be that such an increase in activity will take a while to develop. Commercial crude inventories, as well as SPR inventories, are low at this point in time. The inventory of drilled but uncompleted wells is at a nearly decade-long low. And drilling activity is up, but nowhere near what it has been in the past. Add all of these points together, and you end up with a situation that is incredibly bullish at this point in time.

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