Monday, March 30, 2015 12:49:24 PM
Stop Obsessing Over Inventories And Rig Count... Focus On The Cash Flow
Summary
Commercial crude oil inventory is increasing by 30 million per month and is on track to breach oil working storage capacity by May 22nd.
Despite a 49% decline in rig count as of March 20th, US oil production keeps rising due to increased well productivity.
WTI price maximum downside is at $30 and maximum upside is at $85 based on cash costs and production costs, respectively.
From its 52-week high of $107.73 to its current price of $48.51, crude oil (NYSEARCA:USO) has declined 55%. The decline has been attributed to growing US shale oil production and OPEC's decision to not cut output which has created a supply/demand imbalance. Since OPEC's swing producer, Saudi Arabia, refuses to cut production and cede market share, oil prices will only rebound when US oil production falls. This has created an obsession with two data points: the number of US oil rigs and commercial crude inventories, which the market is using to extrapolate US oil production.
Commercial Crude Inventory
Commercial crude inventory is tracking strongly above the 5-year average and started the year above the 5-year range. While crude oil stock usually accumulates from January through April, the rate of accumulation is much higher as demonstrated by the much steeper incline. Historically, stocks start declining in April, as refinery maintenance is completed, and decrease 20 million by the end of June. Despite higher inventories this year, an uptick in refining mid-April will have a similar effect because most refineries are not capable of using light sweet crude being drilled in the US.
The EIA estimates total crude oil working storage capacity in the US is 521 million barrels. However, it warns that:
"...it is not possible to completely fill all the working storage capacity because operation of crude oil storage and transportation systems requires some amount of working storage to be available to be filled at all times in order to receive deliveries by pipeline, tanker, barge, and rail."
Yet, for the purposes of calculation, let's assume that all storage can be filled and that inventory is capped at 520 million. Crude oil stocks rose from 390 million on January 16, 2015 to 450 million on March 13. At its current pace, crude oil stock is increasing by 30 million per month and is on track to breach oil working storage capacity by May 8th. However, refinery utilization will increase by then, so assuming that refineries manage to consume 20 million more barrels, capacity will be full by the 22nd of May.
Crude oil inventory count continues to grow because the US market is oversupplied and excess production is stored. The demand side of the equation is not going to change much because crude cannot be exported from the US, making refineries the only consumers of US crude. Refineries base their crude demand on the WTI-Brent spread, which is above $10, so refineries are already attempting to consume the crude as fast as possible and further price declines cannot incentivize them. On the supply side, it is possible that US production declines, causing stocks to rise at a slower pace or start falling. This is why the market is looking at the rig count for clues to oil production.
Rig Count
As of March 20th, the number of US rigs fell to 825, down 49% from the peak of 1,069 rigs hit in late October. Many market participants are expecting the fall in rig count to result in lower oil production. According to Harold Hamm, CEO of Continental Resources:
Once enough rigs go offline, supply will fall, simply based on the physics of shale production. No new investment, no growth in output, and likely a reduction in supply.
A WSJ article published on March 12th titled, "North Dakota Crude Production Falls from Record Highs as Oil Prices Slide", offers evidence to support this hypothesis.
North Dakota crude output fell 3.3% on the month to 1.19 million barrels a day in January, down from a record 1.23 million barrels a day in December.
"We're going to see some months of declining production," Lynn Helms, director of the department of mineral resources, told reporters at a news conference. "It's really mostly about oil prices," he said.
But North Dakota's oil production might increase in June, he said, due to a combination of new tax incentives linked to lower oil prices and pressure to complete drilled wells subject to regulatory deadlines.
However, this decline is not significant, according to data taken from the Official Portal for North Dakota State Government. January's production was still higher than production in October 2014 when oil prices were still above $80 per barrel. Despite the MoM decline, North Dakota's January production of roughly 35 million barrels represented a 29% YoY increase from January 2014.
The story of technological advancement causing an unprecedented increase in supply, resulting in a steep drop in price is not a new one. It's similar to the natural gas narrative back in 2011. Today, the Henry Hub Natural Gas spot price is at $2.7, significantly below its previous price of $7. The number of rigs being used has fallen by 75%, yet production keeps growing.
And the sequel seems to be following the same plot line.
The declining rig count is not demonstrating a negative correlation with US oil production due to improved well productivity.
Forecasts
OPEC is expecting US production to start declining in late 2015.
Tight crude producers are aware that typical oil wells in shale plays decline 60 percent annually, and that losses can only be recouped by drilling new wells.
As drilling subsides due to high costs and a potentially sustained low oil price, a drop in production can be expected to follow, possibly by late 2015.
On the other hand, the IEA forecasts that US oil production will continue to grow through 2020. However, the most recent February 2015 estimates are lower compared to previous estimates made in 3Q 2014.
Despite the QoQ decline forecasted by OPEC, it agrees with the IEA that US oil production growth will be positive in 2015. The IEA forecasts growth of 0.6 mb/d, while OPEC forecasts lower growth of 0.2 mb/d. Even in the more pessimistic OPEC forecast, 3Q15 and 4Q15 production will be 0.05 mb/d and 0.02 mb/d higher than current 1Q15 production.
Rising crude oil inventory numbers, improving well productivity, and official forecasts all point towards higher US oil production in 2015 and beyond.
Cash Flows
US oil production will continue growing as long as cash flows are positive because companies need to service their debt burden.
The most shocking realization will be that growth in production will continue," says Joseph Stanislaw, the veteran oil industry prognosticator. He sees U.S. oil supply rising another 600,000 bpd this year, and thinks that companies in financial distress will keep producing all they can in order to generate dollars to keep lenders at bay or justify acquisitions done at the top of the market.
While the larger E&P companies like ConocoPhillips (NYSE:COP) or EOG Resources (NYSE:EOG) have room to maneuver, a significant number of smaller E&P producers need to keep pumping to meet obligations.
However, there is a price point at which drilling becomes cash flow negative. The price at which it is not economically feasible to keep drilling is below $30 for conventional onshore (Eagle Ford) and below $25 for US tight oil/shale (Bakken).
However, the price floor for WTI oil is slightly higher than that. The price floor is cash cost of production plus the spread between local benchmarks and WTI. The spread for conventional onshore oil is $4 and the spread for tight oil is a massive $15. Thus, the breakeven price for tight oil is $34 and $40 for shale oil. Neither of these price points has been breached in the current market selloff.
If it is possible to reach a price floor based on cash cost assumptions, it may be possible to reach a price cap based on the production cost curve. According to this post on FT Alphaville, E&P producers will automatically ramp up production once prices rise above their costs and lock in profits by hedging. The production curve of a shale well which lasts around three years allows companies to be the swing producer on both the upside and downside. According to the chart below, companies will invest in production if the futures forward price is above $85 and can pay for the cost of production and hedging.
[img]
static.cdn-seekingalpha.com/uploads/2015/3/28/7756551-14275927713920696-Negative-Returns.png[/img]
However, the cost curve will not stay in this shape long. It will be brought much lower due to advances in drilling techniques and materials. The price cap will probably be much lower by the end of 2015 or 2016.
It used to be that Bakken wells needed $48 per barrel oil prices to break even, he says. But as drilling costs come down, the new break-even mark will be more like $40. "Back in 2003 it took us 45 days to drill a Bakken well," says Hamm. "Now we can do it in 17. In five years we have gone from drilling wells that average 350,000 barrels over their lifetime, to where now we average 750,000 barrels. And remember that's just with today's technology. We keep learning more. We keep getting better."
How to trade
There are two trades offering imbalanced risk-reward scenarios worth acting upon.
Going short the June 2015 contract currently trading at $49.87. By my estimates, crude storage will be full by the last week of May, and prices will drop until it touches the cash flow negative level of $40.
Going long the June 2016 contract currently trading at $57.74. However, I would not place these trades concurrently. I would only go long the June 2016 contract if the price fell to the $50-53 range with the expectation of exiting at $60-63.
The logic for higher prices in the future is very simple. E&P companies are investing less for the development of new wells, resulting in less supply hitting the market in the future. Existing supply will temporarily dwindle due to the nature of the decline curve, allowing the equilibrium price to rise.
However, prices are going to fall further before rising.
Source: http://seekingalpha.com/article/3037906-stop-obsessing-over-inventories-and-rig-count-focus-on-the-cash-flow
Summary
Commercial crude oil inventory is increasing by 30 million per month and is on track to breach oil working storage capacity by May 22nd.
Despite a 49% decline in rig count as of March 20th, US oil production keeps rising due to increased well productivity.
WTI price maximum downside is at $30 and maximum upside is at $85 based on cash costs and production costs, respectively.
From its 52-week high of $107.73 to its current price of $48.51, crude oil (NYSEARCA:USO) has declined 55%. The decline has been attributed to growing US shale oil production and OPEC's decision to not cut output which has created a supply/demand imbalance. Since OPEC's swing producer, Saudi Arabia, refuses to cut production and cede market share, oil prices will only rebound when US oil production falls. This has created an obsession with two data points: the number of US oil rigs and commercial crude inventories, which the market is using to extrapolate US oil production.
Commercial Crude Inventory
Commercial crude inventory is tracking strongly above the 5-year average and started the year above the 5-year range. While crude oil stock usually accumulates from January through April, the rate of accumulation is much higher as demonstrated by the much steeper incline. Historically, stocks start declining in April, as refinery maintenance is completed, and decrease 20 million by the end of June. Despite higher inventories this year, an uptick in refining mid-April will have a similar effect because most refineries are not capable of using light sweet crude being drilled in the US.
The EIA estimates total crude oil working storage capacity in the US is 521 million barrels. However, it warns that:
"...it is not possible to completely fill all the working storage capacity because operation of crude oil storage and transportation systems requires some amount of working storage to be available to be filled at all times in order to receive deliveries by pipeline, tanker, barge, and rail."
Yet, for the purposes of calculation, let's assume that all storage can be filled and that inventory is capped at 520 million. Crude oil stocks rose from 390 million on January 16, 2015 to 450 million on March 13. At its current pace, crude oil stock is increasing by 30 million per month and is on track to breach oil working storage capacity by May 8th. However, refinery utilization will increase by then, so assuming that refineries manage to consume 20 million more barrels, capacity will be full by the 22nd of May.
Crude oil inventory count continues to grow because the US market is oversupplied and excess production is stored. The demand side of the equation is not going to change much because crude cannot be exported from the US, making refineries the only consumers of US crude. Refineries base their crude demand on the WTI-Brent spread, which is above $10, so refineries are already attempting to consume the crude as fast as possible and further price declines cannot incentivize them. On the supply side, it is possible that US production declines, causing stocks to rise at a slower pace or start falling. This is why the market is looking at the rig count for clues to oil production.
Rig Count
As of March 20th, the number of US rigs fell to 825, down 49% from the peak of 1,069 rigs hit in late October. Many market participants are expecting the fall in rig count to result in lower oil production. According to Harold Hamm, CEO of Continental Resources:
Once enough rigs go offline, supply will fall, simply based on the physics of shale production. No new investment, no growth in output, and likely a reduction in supply.
A WSJ article published on March 12th titled, "North Dakota Crude Production Falls from Record Highs as Oil Prices Slide", offers evidence to support this hypothesis.
North Dakota crude output fell 3.3% on the month to 1.19 million barrels a day in January, down from a record 1.23 million barrels a day in December.
"We're going to see some months of declining production," Lynn Helms, director of the department of mineral resources, told reporters at a news conference. "It's really mostly about oil prices," he said.
But North Dakota's oil production might increase in June, he said, due to a combination of new tax incentives linked to lower oil prices and pressure to complete drilled wells subject to regulatory deadlines.
However, this decline is not significant, according to data taken from the Official Portal for North Dakota State Government. January's production was still higher than production in October 2014 when oil prices were still above $80 per barrel. Despite the MoM decline, North Dakota's January production of roughly 35 million barrels represented a 29% YoY increase from January 2014.
The story of technological advancement causing an unprecedented increase in supply, resulting in a steep drop in price is not a new one. It's similar to the natural gas narrative back in 2011. Today, the Henry Hub Natural Gas spot price is at $2.7, significantly below its previous price of $7. The number of rigs being used has fallen by 75%, yet production keeps growing.
And the sequel seems to be following the same plot line.
The declining rig count is not demonstrating a negative correlation with US oil production due to improved well productivity.
Forecasts
OPEC is expecting US production to start declining in late 2015.
Tight crude producers are aware that typical oil wells in shale plays decline 60 percent annually, and that losses can only be recouped by drilling new wells.
As drilling subsides due to high costs and a potentially sustained low oil price, a drop in production can be expected to follow, possibly by late 2015.
On the other hand, the IEA forecasts that US oil production will continue to grow through 2020. However, the most recent February 2015 estimates are lower compared to previous estimates made in 3Q 2014.
Despite the QoQ decline forecasted by OPEC, it agrees with the IEA that US oil production growth will be positive in 2015. The IEA forecasts growth of 0.6 mb/d, while OPEC forecasts lower growth of 0.2 mb/d. Even in the more pessimistic OPEC forecast, 3Q15 and 4Q15 production will be 0.05 mb/d and 0.02 mb/d higher than current 1Q15 production.
Rising crude oil inventory numbers, improving well productivity, and official forecasts all point towards higher US oil production in 2015 and beyond.
Cash Flows
US oil production will continue growing as long as cash flows are positive because companies need to service their debt burden.
The most shocking realization will be that growth in production will continue," says Joseph Stanislaw, the veteran oil industry prognosticator. He sees U.S. oil supply rising another 600,000 bpd this year, and thinks that companies in financial distress will keep producing all they can in order to generate dollars to keep lenders at bay or justify acquisitions done at the top of the market.
While the larger E&P companies like ConocoPhillips (NYSE:COP) or EOG Resources (NYSE:EOG) have room to maneuver, a significant number of smaller E&P producers need to keep pumping to meet obligations.
However, there is a price point at which drilling becomes cash flow negative. The price at which it is not economically feasible to keep drilling is below $30 for conventional onshore (Eagle Ford) and below $25 for US tight oil/shale (Bakken).
However, the price floor for WTI oil is slightly higher than that. The price floor is cash cost of production plus the spread between local benchmarks and WTI. The spread for conventional onshore oil is $4 and the spread for tight oil is a massive $15. Thus, the breakeven price for tight oil is $34 and $40 for shale oil. Neither of these price points has been breached in the current market selloff.
If it is possible to reach a price floor based on cash cost assumptions, it may be possible to reach a price cap based on the production cost curve. According to this post on FT Alphaville, E&P producers will automatically ramp up production once prices rise above their costs and lock in profits by hedging. The production curve of a shale well which lasts around three years allows companies to be the swing producer on both the upside and downside. According to the chart below, companies will invest in production if the futures forward price is above $85 and can pay for the cost of production and hedging.
[img]
static.cdn-seekingalpha.com/uploads/2015/3/28/7756551-14275927713920696-Negative-Returns.png[/img]
However, the cost curve will not stay in this shape long. It will be brought much lower due to advances in drilling techniques and materials. The price cap will probably be much lower by the end of 2015 or 2016.
It used to be that Bakken wells needed $48 per barrel oil prices to break even, he says. But as drilling costs come down, the new break-even mark will be more like $40. "Back in 2003 it took us 45 days to drill a Bakken well," says Hamm. "Now we can do it in 17. In five years we have gone from drilling wells that average 350,000 barrels over their lifetime, to where now we average 750,000 barrels. And remember that's just with today's technology. We keep learning more. We keep getting better."
How to trade
There are two trades offering imbalanced risk-reward scenarios worth acting upon.
Going short the June 2015 contract currently trading at $49.87. By my estimates, crude storage will be full by the last week of May, and prices will drop until it touches the cash flow negative level of $40.
Going long the June 2016 contract currently trading at $57.74. However, I would not place these trades concurrently. I would only go long the June 2016 contract if the price fell to the $50-53 range with the expectation of exiting at $60-63.
The logic for higher prices in the future is very simple. E&P companies are investing less for the development of new wells, resulting in less supply hitting the market in the future. Existing supply will temporarily dwindle due to the nature of the decline curve, allowing the equilibrium price to rise.
However, prices are going to fall further before rising.
Source: http://seekingalpha.com/article/3037906-stop-obsessing-over-inventories-and-rig-count-focus-on-the-cash-flow
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