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2016-01-22 18:55:00



There's an old saying in journalism that goes, "Never let the facts ruin a good story." This accurately describes what should be called The Incredible Shrinking Oil Price. Combined with sagging world stock markets, a global economy that has all but quit growing because near-zero interest rates are no longer stimulating the economy and the continued strength of the U.S. dollar, oil cannot hide from the overall bearishness. Shorting commodities may be the only thing traders can make money at nowadays. After all, to earn quick profits trading anything, prices have to move. The direction is less important than volatility.

At this moment, short-sellers are delighted by two major international events which, on the surface, appear to reflect a continued world oil glut and little hope of returning to crude prices that reflect something related to replacement cost. International sanctions against Iran were dropped January 17, allowing that country to resume exporting oil to anyone who wants to buy it. Meanwhile, China is having difficulties maintaining its rampant economic growth. Apparently, the official 6.9% growth rate that country reported in 2015 is appallingly low, adding more credibility to the case commodity prices should stay at historic low levels.

Noteworthy is the fact world oil markets started pricing the return of Iranian crude exports six months ago when the framework of the agreement to end international sanctions was announced in July — the last time WTI traded over US$50 a barrel. While Iran has been all over the map on how much oil it can produce and when, a Bloomberg News article January 17 quoted several analysts, none of whom believed Iran could add 1 million barrels a day (b/d) of production to export markets this year. Iran admits it needs some US$100 billion in new investment to significantly raise output. Others think this number is low. At US$30 a barrel, most oil companies don't want to invest anywhere, let alone Iran. As oil prices fell again the day after Iranian sanctions were dropped, markets did not care that a single additional barrel of Iranian oil had yet to be sold. How many times can you price the same news into one commodity price?

Meanwhile, whatever economic problems China experienced did not affect that country's oil consumption in 2015. A Reuters story January 19 reported Chinese oil demand may have hit an all-time record of 10.32 million b/d last year, 2.5% higher than 2014. In fact, China has put in place a floor price of US$40 a barrel for its consumers to encourage domestic production and discourage accelerated demand growth. There is no question China is consuming less iron ore, coal and copper than in the past as its economy retools to be less export oriented and focus more on domestic personal consumption. But that means transportation and transportation means hydrocarbon fuel.

On top of world events, two major reports emerged in the past week which send completely contradictory signals to global oil markets. In a way, all this information actually leads to higher oil prices. The trillion-dollar question is when.

On January 14, respected oil and gas research outfit Wood Mackenzie released a study indicating low oil prices have resulted in the delay of US$380 billion in capital projects globally in the latter half 2015 alone. These were classified as pre-final investment decision (FID) developments put on hold until economics improve. In total, 68 projects that would ultimately yield 27 billion barrels of oil equivalent have been shelved. Wood Mackenzie estimated these projects would have added 1.5 million barrels per day of incremental production by 2021 and 2.9 million barrels a day by 2025. The main cutbacks have been in deep water offshore (Brazil has officially delayed its so-called "pre-salt" reservoirs which were thought to contain billions of recoverable barrels) and in Canada's oilsands. Rig counts are falling all over the world, except for some countries in the Middle East.

Combined with the annual decline rates of every oil source in the world except oilsands mining, one would have thought this information would be in some way positive for oil prices. In 2008, research firm IHS estimated global oil reservoir decline rates at 4.5%. That same year, the International Energy Agency determined it was closer to 6.7%. The average is 5.5%. In a world producing 95 million b/d this means 5.2 million b/d of production will fall off the table in the next 12 months without continued investment. Wood Mackenzie has made it clear the spending which created current market conditions will not continue.

However, the International Energy Agency (IEA) once again sided with the bears in its January 19 monthly report. Calling world oil markets massively oversupplied, the IEA reported supply would exceed demand by about 1.5 million b/d in the first half 2016. The IEA admitted world oil demand grew in 2015 at one of the highest rates this century, but did not foresee this level of demand growth being sustained in 2016, despite the most attractive (read low) fuel prices since 2003. The IEA recited the global economic slowdown that has dominated headlines so far this year as the basis of its pessimism (despite what appears to be contrary data coming out of China).




On the plus side, the IEA sees the world exiting 2016 with oil demand at 96.49 million b/d, nearly 6 million b/d higher than just three years ago. The IEA sees non-OPEC production declining by only 600,000 b/d, which will neutralize their estimate of Iran adding 600,000 b/d. While the IEA does not forecast supply with the same granularity it estimates demand, in the latter half of the year the agency sees output exceeding consumption by the lowest amount in two years. The tone of the IEA's report is mostly negative, but the numbers it published for the last half of this year are positive and have not changed significantly in the past four monthly reporting periods.

Two Canadian investment managers have concluded the current oil price is unsustainably low and therefore the share prices of Canadian oil producers are grossly oversold. In an interview with the Globe and Mail on January 18 Eric Nuttall of Sprott Asset Management revealed the Sprott Energy Fund is now 100% invested in Canadian oil stocks after being as high as 70% cash twice last year. Nuttall admits he invested too soon but still believes a "meaningful price recovery" is imminent. He told the Globe, "The biggest risk today isn't being invested in energy stocks. It's not being invested in energy stocks." Following short-term volatility, he sees a meaningful oil recovery in Q2 or Q3 and some handsome gains to be made by investing at the bottom, which he thinks is now.

On January 19, Martin Pelletier, a portfolio manager with TriVest Wealth Counsel in Calgary, wrote an article in the Financial Post titled, "Why the price of oil will recover faster than you think." He sees the crude production declines required to make a meaningful impact on the global supply / demand equation coming from U.S. light tight oil (shale) producers. Pelletier wrote, "Having covered the industry as a sell-side analyst, I've seen my fair share of reservoir models and production profiles. Shale wells have what is termed a hyperbolic decline curve, meaning they have upwards of a 75% decline rate in production in the first two years before they stabilize at substantially lower levels. They require continual drilling and a lot of capital reinvestment just to keep production flat, let alone grow it. Capital markets closed for business early last year and debt markets quickly followed suit, so these producers have had to rely on rapidly falling cash flows to continue drilling wells. The average U.S. producer was using more than 80% of its cash flow just to service interest payments when oil was at US$50 a barrel. Imagine the situation at US$29 a barrel, or even negative oil prices for North Dakota Sour crude." (A separate news report January 18 reported North Dakota sour crude was selling at negative U.S.$0.50 per barrel, meaning producers had to pay buyers to take it).

Looking at the big decline in U.S. drilling, Pelletier concludes, "When that impact comes, both the speed and magnitude of the fall in production may surprise many and there will be little that can be done to stop it, given the massive staffing cuts at North American service and production companies and a quickly aging and under-maintained fleet of service and production equipment."

CIBC Institutional Equity Research came to a similar conclusion in its January 17 research note titled, "U.S. Rig Count Now >40$ Below the Level Needed to Maintain Flat Production." CIBC wrote, "...we believe the Lower 48 market could lose somewhere between 700 to 1,000 MBbl/d (thousands of barrels per day) by YE (year end 2016) and, after taking into account the incremental volume adds in the oilsands and GoM (Gulf of Mexico) in 2016 and the reductions we're forecasting in the WCSB conventional market, we believe North America is on course to lose 500-700 MBbl/d of output in 2016."

This is in sharp contrast to the IEA which sees total non-OPEC production worldwide declines in 2016 of only 600,000 barrels. Somebody is clearly wrong.

There are a few inescapable conclusions from the foregoing. Sustaining supply requires drilling and investment, which is in precipitous decline because of low oil prices. Demand will continue to grow at these prices and, as China proved in 2015, possibly at faster rates than macroeconomic models may reveal. The price is so low right now production is being withdrawn from the market, which will help rebalance it. Oil is selling at a fraction of replacement cost while supplies dwindle and demand grows. Something's gotta give.

Therefore, oil prices will rise once more people study the long-term dynamics of oil markets instead of trading on and exploiting the short term news. Futures markets seem to agree. On the Chicago Mercantile Exchange, WTI for delivery in February 2017 closed at US$37.08 a barrel on January 19, 23% higher than the market closing price for the day.














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