Well, if it’s the end of May, it must be time for another OPEC meeting. And sure enough it was. Yet again the representatives of the OPEC nations got together in beautiful Vienna (I hear it’s tremendous in the spring) to decide the future of the oil industry and set the course for everyone’s favourite and most hated commodity for the next few hours, days, weeks and months. Joining the OPEC flashmob this time were members of the non-OPEC nations who were participating in the first round of production rollbacks agreed to last November.

 

At issue: so we agreed to these cuts, and the price went up but those tight oil guys are making swiss cheese out of the West Texas desert and lately the market seems to be slipping. What next?

 

What did they decide?

 

Before we get to that answer, let’s do a quick review of where we are at. OPEC and NOPEC (as it’s now being called – I kid you not) collectively agreed to roll back production on a formula basis by about 1.8 million barrels per day for a six month period, due to expire June 30 of 2017. Compliance has generally been stellar, which is unusual, and anecdotal evidence suggests that the cuts are slowly working to rebalance the oil production/supply/inventory situation. Slowly of course doesn’t work for jittery markets that need immediate gratification so perversely, the longer the cuts are in place, the less effective they appear to become. Meanwhile, at around $50 oil, the US tight oil industry has been adding rigs like they are going out of style, hedging production at high prices and drilling like mad. The same of course is happening in Canada to a lesser extent.

 

So, what did they decide anyway? It’s not secret, everyone knew last week when Russia and the Saudis pre-announced the decision, but for the record, the agreement was to extend the cuts for another 9 months, continue to exempt Libya, Nigeria and, to a lesser extent, Iran. This was called by the media the “safe option” for some bizarre reason, because, you know, holding back a cumulative 800 million some odd barrels from the market is clearly the “safe” play for a bunch of countries that rely on oil revenues to placate their restive populations.

 

No, far from being safe, what OPEC/NOPEC did was acknowledge that the inventory draw-down was taking longer than expected and by setting the target so far out, they eliminate a lot of the uncertainty and quarterly speculation from the market. Many analysts in the last few days had been speculating that OPEC/NOPEC needed to actually cut even more to address the inventory, but this was never a realistic idea given how compliance issues would become greater with higher cuts and the fact that the 800 million barrels in cuts for exceeds what every self-respecting analyst acknowledges to be the actual inventory overhang.

 

What did the market do?

 

Predictably, when confronted by stability, commitment to support prices and a credible plan to get there, the market sold off oil by more than 5%. For all intents and purposes this appears to have been a purely speculative market move with a lot of short covering and people selling out of long positions purchased as a bet on additional cuts. The market had bid itself up by almost an equivalent amount in anticipation of the meeting. I’m actually inclined to say the run-up to the meeting was more surprising than the post announcement sell-off but all quite predictable.

 

How long will it last?

 

I would expect the cuts to last nine months.

 

No really, how long will it last?

 

Seriously, nine months. Maybe longer. The real question of course is not how long the announced cuts will remain in place, but how long can this herd of cats be kept in compliance with the cuts? The simple answer is that as long as the cuts are supportive of prices and data starts to finally flow regarding a significant draw-down in inventory the various members of the OPEC/NOPEC output cut team will play the compliance game. Resolve and discipline will falter in a scenario where prices spike or fall considerably.

 

How will we finally know the cuts are working?

 

We know the cuts are working when the OECD monthly storage numbers start reflecting the expected declines in inventory. Already the IEA stats have shown that “additions” to OECD inventories have slowed significantly signifying a coming supply/consumption balance. But remember, we are trying to eliminate an overhang of about 500 million barrels, this takes time!

 

Price is a decent signal about the cuts working, but price is driven too much by sentiment.

 

If you prefer your data to be, I don’t know, current… one good place to look would be the weekly import numbers into the United States as reported by the EIA. If you see imports from Saudi Arabia and Iraq (among others) start to drop in these numbers, we are on to something. The Saudi oil minister in fact said this himself, telling the market that Saudi exports to the US were going to be reduced.

 

But all the above aside, the cuts are already working.

 

Why not cut more like everyone seems to want?

 

As per the above comment about discipline, if the cuts are too deep a number of things happen. First, prices will rise too much creating a temptation to cheat. Second, the incentive to drill becomes stronger for those producers not part of the cut, which means the sacrifice is even more unbalanced creating a further temptation to cheat. Finally, and I think this is overlooked by the genius analysts and market commentators, when prices rise, the end products (i.e. gasoline) get more expensive which dampens demand, upsetting the other side of the equation. Could OPEC/NOPEC have cut more? Sure, but it probably wouldn’t make much of a difference. Mathematically, the current cuts will work. I call it the “Goldilocks” scenario – not too hot, not too cold. Let it play out.

 

Does this mean US inventories will finally start to shrink dramatically?

 

It is expected US inventories will continue to drop as they do every year at this time (7 weeks in a row and counting), but it probably won’t be overly dramatic.

 

Um, what?

 

Well, ironically, US inventories are probably the last place where you should look to assess the success of OPEC/NOPEC production cuts. There are a few reasons for this. First, the US supplies about 60% of its daily liquids production needs. Second, the balance comes from imports, the majority of course from Canada who isn’t part of NOPEC, so a decrease in OPEC imports into the US can be made up in the short term from Canada. Finally, storage in Cushing, the continental US and many OECD locales is the cheapest in the world. So all things being equal, you drain the most expensive storage first. By the time big drops start appearing in the US, the inventory depletion will be in full gear and the worry will be that this has all gone too far. I’m willing to place a bet on that. Anyone? Anyone?

 

What are risks to price in the short term?

 

Short term price risks appear to be mostly market driven. Perception, boredome, hype. OPEC/NOPEC has set a floor under prices. Other risks to keep an eye on are demand signals from China and India and of course the ever-present price bogeyman of US tight oil. I suppose these are all downside risks. Upside price shocks would come from a rapid decline in inventories (let’s not forget depletion too!) or some form of increased hostilities either on the Korean Peninsula or the Middle East.

 

What does this mean for tight oil?

 

I think it means more of the same. They will continue to drill but in the Goldilocks pricing environment we are currently in, things are getting tight in Texas. Latest data suggests the drilling boom is coming up against some labour and equipment constraints with prices up 10-15%, capex being left unspent because of lack of resources and break-evens creeping by $3 to $5 a barrel (say it ain’t so!). At the same time, recent data out of the EIA shows that drilling productivity has a hit a bit of a speed bump and declined in the latest reporting period. One measurement isn’t a trend, but the engine light just came on, time for a check up. End of the day, US tight oil is going to grow, the question is just how much can it actually grow given the realities on the ground in Midland as opposed to a corner office in Manhattan.

 

What does it mean for Canada?

 

Much the same as the US tight oil scenario, the current pricing scenario sets the stage for slow and steady growth in some of Canada’s most appealing plays and increased royalties into provincial coffers. As long as we can stop shooting ourselves in the foot from a regulatory standpoint, Canada should see steady growth in the energy sector over the next few years.

 

Why is backwardation important?

 

Mainly because it’s a really cool word and easier to say without laughing than contango. Seriously though, backwardation is a situation where the spot and close-in price of a commodity is higher than the forward price. In this scenario, there is less incentive to store a product for later sale than to sell it immediately. While this is a bullish signal for inventory depletion, it is also an incentive to increase short term production (i.e. tight oil) so it kind of kicks the can down the road. That said, it’s a net positive for dealing with the current oversupply situation.

 

I hear Donald Trump is going to flood the market by selling half the Strategic Petroleum Reserve, isn’t that going to send prices spiralling?

 

No, not really. First, the US government is already selling some of the SPR. Second, the proposed budget provision to sell off some 300 million barrels of oil is a longer term proposition and isn’t going to even generate much cash in a multi-trillion dollar budget. Not a fully formed or well thought-out idea and it has a low likelihood of happening.

 

Plus, even if it does happen, the planned sale is over a number of years and amounts to about 95,000 barrels of oil a day. Not enough to move a market.

 

Any other dumb energy policy ideas in the budget?

 

Count on it.

 

Who’s going to win the Stanley Cup?

 

Pittsburgh will be the favourite, but I am going to pick the Predators in 7 – mainly because I like the underdog and PK Subban, but also because one of the Preds owners is technically our landlord, so by supporting the team we are hoping for a whole bunch of really cool building improvements… Ahem

 

Prices as at May 26, 2017 (May 19, 2017)

• The price of oil rallied early before cratering on Thursday on the OPEC announcement, but rallied on Friday.
  • Storage posted a larger than expected decrease
  • Production was up marginally
  • The rig count in the US continues to grow, although at a slower pace
• Natural gas was down marginally during the week mostly on benign weather

• WTI Crude: $49.80 ($50.33)
• Nymex Gas: $3.236 ($3.256)
• US/Canadian Dollar: $0.7429 ($ 0.7403)

Highlights

• As at May 19, 2017, US crude oil supplies were at 516.3 million barrels, a decrease of 4.5 million barrels from the previous week and 10.7 million barrels ahead of last year.
  • The number of days oil supply in storage was 30.2, behind last year’s 33.1.
  • Production was up for the week by 15,000 barrels a day at 9.320 million barrels per day. Production last year at the same time was 8.767 million barrels per day. The change in production this week came from a decrease in Alaska deliveries and increased Lower 48 production.
  • Imports fell from 8.590 million barrels a day to 8.294, compared to 7.315 million barrels per day last year.
  • Refinery inputs were up during the week at 17.281 million barrels a day
• As at May 19, 2017, US natural gas in storage was 2.444 billion cubic feet (Bcf), which is 11% above the 5-year average and about 13% less than last year’s level, following an implied net injection of 75 Bcf during the report week.
  • Overall U.S. natural gas consumption was flat during the week – an increase in power demand offset decreases in retail and commercial demand
  • Production for the week was flat and imports from Canada were flat as well compared to the week before
• As of May 22, the Canadian rig count was 85 (13% utilization), 57 Alberta (13%), 11 BC (15%), 17 Saskatchewan (15%), 0 Manitoba (0%)). Utilization for the same period last year was below 10%. With breakup and road bans almost done, this count should start to rise modestly for the next month or so.
• US Onshore Oil rig count at May 26 was at 722, up 2 from the week prior.
  • Peak rig count was October 10, 2014 at 1,609
• Natural gas rigs drilling in the United States was up 5 at 185.
  • Peak rig count before the downturn was November 11, 2014 at 356 (note the actual peak gas rig count was 1,606 on August 29, 2008)
• Offshore rig count was flat at 23
  • Offshore rig count at January 1, 2015 was 55
• US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 56%/44%

Drillbits

• The BC election is finally over. A minority government with the Green Party holding the balance of power. Let’s see how long that stays civil.
• Undaunted by the BC election results, Kinder Morgan announced a positive Final Investment Decision on the Trans Mountain Pipeline Expansion pending the close of its IPO on May 31. Over to you Monsieur Trudeau.
• The Conservative Party of Canada is choosing their new leader this weekend. Remember that race that Kevin O’Leary played in? Anyway, the votes will be tabulated. Maxime Bernier is the favourite, but you heard it here first – the winner will be… Andrew Scheer. Just a guess.
• Trump Watch:
  • In a welcome break from domestic chaos, Donald Trump visited Saudi Arabia, Israel and the Vatican this past week, then went to Brussels to insult his NATO allies before heading to Sicily to eat Spaghetti with Sea Urchins with the leaders of the G7 (OK, maybe not). Interestingly, the reception he received got colder the further he went away from the desert.