Oil Prices Still Have Room To Run

At mid-year 2021 we find that we are in an unsettled state with respect to crude supplies. Of the three largest contributors to global supply, the U.S.A., Russia, and OPEC+ (Russia is the “+” in OPEC+), all capable of producing more than 10 mm BOPD, we find that it is OPEC+ in a bit of disarray. With the world now in deficit status with regard to oil production and demand by 2-3 mm BOEPD, there is little room for error.

In an article carried in Reuters, the emerging dynamics of the current OPEC+ meeting were in focus. The major topic of the meeting- the rate at which the 2020 production cuts should be phased out, appeared to be teetering on impasse as the UAE voiced dissatisfaction with its production baseline. It was noted by the UAE that other producers had received increases from the early dates of the curtailment agreement. According to OPEC’s rules decisions on output must be unanimous.

In this article, we will review anticipated production trends from these two key producers, the U.S.A. and that of the OPEC+ cartel. The goal being projecting year-end exit rates of production for them. Once we have those data points we will sync with EIA projected rates for global production for 2021.

OPEC+

To say that the members of this cartel and their honorary member-Russia, are happy about the direction oil prices have taken recently, understates their glee. The arrival of near $80 Brent could not have arrived at a better time. Major producers like the Kingdom of Saudi Arabia (KSA) and Russia rely on oil revenues to fund their economies. In the case of KSA it is fairly well known that it takes Brent at $80 to balance their books. For the last several years they’ve been drawing down cash reserves and selling off a portion of their core wealth reserve, Aramco.

Russia has seen massive increases in their sovereign wealth fund this year. A Reuters article notes that these funds will be used to fund much needed social programs, and pension increases. With a parliamentary election scheduled for this fall, the timing of this cash bounty is just what the doctor ordered.

At stake in the current meeting was the addition of 400K BOPD to OPEC+ output. An action that would reduce their output cuts of originally 10-mm BOPD, just over 4-mm BOPD today. This additional volume would be increased monthly through December if the decision was approved, for a total 2-mm BOPD increase by year-end 2021. 

Talks later foundered as noted in this report due to demands by the United Arab Emirates-UAE, for an increase in their baseline production. This the level from which individual cuts are calculated, and represents their capacity to produce. The UAE has spent billions upgrading its infrastructure since this limit was set and wants its baseline to reflect its new productive capacity.

With no change to output levels, OPEC output would remain at the current level of ~25.4 mm BOPD. There is general agreement among all the entities that more barrels are needed to balance the market. The expectation is the OPEC members will work through this disagreement and come up with these additional barrels. Estimates are that OPEC has enough spare capacity eventually ramp back to ~34 mm BOPD if economic circumstances warrant. There remains some questions as to just how long this would take, however, with some estimates being as long as a year for key fields to produce at full potential. And, it should also be noted that some OPEC producers, notably Iran, Nigeria, Libya, and Venezuela are under-producing their quotas due to field declines, or neglect.

Russia is producing about 10.75 mm BOPD currently and has been increasing this output gradually throughout the year. Bloomberg estimates that they have about 950K BOPD spare capacity to increase output. 

USA

One thing that has changed fundamentally, is that the U.S. has lost the desire and the ability to ramp production higher in the face of higher prices. This was something that had been taken for granted a few years ago as U.S. shale production set new records higher every month. Political winds have shifted and low prices for oil have made this ever-increasing output uneconomic.

As I noted in an OilPrice article last month, years of underinvestment by producers reeling from epic low prices, have decimated this former well-honed capacity to about half what it could once achieve. For those who missed it the point is made that it took 1,100 rigs and 450 frac spreads in the field to get shale production to its all-time peak in 2020, of 9-mm BOPD.

Years of losses by the service and supply industry have made it improbable that this type of drilling and fracking “arsenal” can ever be reassembled. Industry leaders have made it clear that production growth at any cost is no longer acceptable, preferring instead to pay down debt and reward long-suffering shareholders with stock buybacks and dividend increases. An example of the industry’s attitude toward raising production was characterized by Clay Gaspar, CEO of Devon Energy in their Q-1 analyst call-

“We have no intentions of adding any growth projects until demand fundamentals recover, inventory overhangs clear up and OPEC Plus curtailed volumes are effectively absorbed by the world markets. Importantly, I encourage other producers to be very thoughtful and disciplined when it comes to capital plans. High returns on capital employed, reduced reinvestment rates and free cash flow generation will determine the winners and losers in this upcoming cycle, not just top-line growth. Devon will be a leader in this movement.”

Source

Where we stand now is detailed in the graphic below. In preference to new drilling shale operators have chosen to draw down DUC-drilled but uncompleted wells, in lieu of new drilling. This not a sustainable strategy for long periods and eventually shale production will start to decline. Hence the nearly five-fold increase in frac spreads as opposed to a doubling of new rigs being put to work.

Current U.S. shale production stands at 7.8 mm BOEPD as the most recent EIA Drilling Productivity Report.

Your takeaway

With global demand now about 97 mm BOPD on its way to an OPEC forecast of 99.7 mm BOPD by year-end, we will enter in a 2-mm BOPD deficit to production in the third quarter of 2021, or right about now. This can be seen in recent inventory declines which have taken inventory levels to near five-year lows. Current U.S. inventories, some 452 mm barrels are 6% below these averages.

New production from previously curtailed sources, like Iran, may impact this outcome to some degree, but at best we will maintain a very tight demand-supply balance going forward.

All of this is supportive for higher crude oil prices as the second half of 2021 begins.