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Re-published from Dialogues, United States Association for Energy Economics These are interesting times for economists charged with predicting oil markets. As the new year begins and the dust somewhat settles from challenging political and geopolitical climates, the question arises: what are the prospects for oil supply in the year ahead? Is the expected tightening of supply really going to manifest? First, OPEC and non-OPEC producers of Russia-plus have pledged to cut production of approximately 1.8 million barrels per day and their ability to comply with the caps is under scrutiny. Second, U.S. exploration and production companies, particularly those with a shale oil focus, are increasing production based on better pricing. Market prices, producer incentives and demand also play their parts on the stage of world oil, and more on that in a follow-up article.
OPEC's dilemma
In late November 2016, OPEC announced it would reduce oil production levels by 1.2 million b/d to a ceiling of 32.5 million, beginning in January. Bloomberg estimates OPEC produced 33.1 million in December, down over 300,000 barrels since November. Still, according to the Energy Information Administration (EIA), OPEC crude oil production is expected to average 33.2 million b/d in 2017. USAEE member and oil market economist Anas Alhajji notes, "Some OPEC members, especially Saudi Arabia, are serious about the cut. When it comes to production cuts, Saudi Arabia matters the most." He says OPEC would need to shave off 2 million b/d from December's output to meet its target, but that a cut of 1.2 million b/d is sufficient to increase prices. As for the forces driving prices in 2017, Alhajji cautions that production increases in both Libya and Nigeria, countries that abstained from any cuts, could have an impact as well.
In the past, OPEC production quotas have been predictably unpredictable. It is possible that the latest round will fall prey to an "animal spirits" syndrome in hindsight — "a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." The urge to action is not spontaneous, but the intentions are good and the real options challenging. According to James Smith, USAEE's immediate past president and financial economist at Southern Methodist University, he expects about 75% of the cuts to occur in the first couple of months, but then production begins expanding again, resulting in a limited and temporary impact on prices. "The agreement among the parties is not “incentive compatible” from the perspective of economics," Smith states.
Incompatible incentives
In the grand scheme of production cuts, this incompatibility, specifically smaller producers ex-Saudi Arabia and Russia, stems from these producers' output comprising a small fraction of world output. "Their production levels have no perceptible impact on the market price," Smith adds. "However, their production levels have a large impact on their own revenues, which rise due to extra sales gained from departing from the agreement." With no enforcement mechanism, a repeat of violations by OPEC countries is expected to happen again, as in the past.
Then there is the case of the many thousands of U.S. oil and gas producers, beholden to their own company-level economic incentives. As prices for West Texas Intermediate crude oil approached and passed the $50 per barrel mark, numerous U.S. producers began increasing production. In the Energy Information Administration's recent forecast, U.S. crude oil production is forecast to average 8.9 million b/d in 2016 and 8.8 million b/d in 2017. Incidentally, about 500,000 barrels per day of crude oil were exported through October 2016, with more than half arriving at shores other than Canada, the chief U.S. export market. According to Smith, "each shale producer is a price taker. Every barrel of shale oil that can be developed economically will be developed and put on the market," he relays.
In the Permian Basin, for example, a falling rig count began to increase in June of 2016. In the October to November period, rigs increased by 16 to 223 in the region that has seen less production declines (even gains) relative to others.[1] One executive of a top Texas-based independent oil and gas firm expects 100 rigs to be added over a year from a late September statement. With economic incentives similar to the smaller OPEC countries, "Their collective production may drive the price down—to their collective misfortune," Smith surmises. U.S. shale production increases are not expected to reduce prices but limit an increase, according to Alhajji.
The price is right?
Suffice to say, supply could conceivably be kept in check for 2017, mirroring demand growth. "Shale may dampen longer term price movements, but not short-term volatility," notes Smith. Demand for oil in general and demand growth in particular are difficult to predict in this post-financial crisis world, one in which monetary policy has been playing an outsized role in investment decisions. The jury may still be out regarding the new normal.
Jennifer Warren is a writer and communications specialist focusing on energy, resources and thought leadership work for companies and institutions. Her work has appeared in numerous academic, policy and business publications.
[1] See December 16, 2016 report at the Dallas Federal Reserve Bank
In spite of and because of recent OPEC activity to cut production, oil markets have continued to be volatile in terms of price. In late November, NYMEX crude oil futures were at $45, and today they hover around the $50 mark. In the U.S., the Permian Basin continues to grow oil production. The Energy Information Administration's DPR projects a 27,000 barrels per day increase from November to December in the Permian, with the Niobrara region increasing by 2,000 barrels per day. In the Bakken and Eagle Ford, production is still declining. The following link is a short feature about Pioneer, a leading Permian producer, and Tim Dove's transition as the new incoming CEO: • "How Tim Dove Will Move Pioneer Natural Resources Forward" published in D CEO, December 2016. (The chart caption should say shale oil, not oil shale.)
To catch up with recent writings, I'm posting two items that capture noteworthy trends in oil markets: 1) "U.S. Shale Gale: A Whale Of A Tale, And Permian Walkabout," that speaks to U.S. producers' activities in light of the new normal in pricing; and
2) "Cartels, Sci-Tech And Breaking Bad: Oil Markets' New Normal?" offering more scenarios possible in oil markets than answers.
The upcoming OPEC meeting may offer little new information, as the strategy to pursue market share, particularly for the Saudis and Gulf states, continues to manifest. Geopolitics in the Middle East are in a perilous status quo.
While often writing about oil markets and U.S. shale resources, the advances in renewables, infrastructure developments (including U.S. midstream), and other energy and resource developments are being studied and considered. A recent article about global infrastructure firm Fluor captures some of the diversity in energy that overlays the global map. An excerpt follows since this article will be inaccessible in a couple of days:
Natural gas demand is expected to grow by 30% between 2014 and 2025 and production will increase by almost 40%, notes an IHS study. This demand is driven by power generation and industrial users. With low natural gas prices and ample NGL supply, the American Chemistry Council expects investment of $135 billion in 211 projects; this estimate was upped from a February 2014 estimate of $100 billion and 148 distinct investments.[i]
Fluor is also involved in the highly technical work of nuclear power plants, including their decommissioning. Recently, the company acquired 98% ownership of a nascent nuclear technology called NuScale. Majority-owned by Fluor, NuScale Power, LLC is developing a new kind of nuclear plant considered a safer, scalable version of pressurized water reactor technology, designed with natural safety features.
A big bet, Fluor believes NuScale could revolutionize the nuclear power industry and offer a $400 billion-dollar market.[7] In two decades, the business could be 'huge,' especially with their exclusive rights to build the smaller-scale, modular units. These 50-megawatt (MW) units can be stacked, like six packs, creating a 300 MW plant or more scaled-up plant based on the need. A recent Wall Street Journal article mentioned how the West, and particularly the U.S., is being usurped by China and Russia in nuclear build expertise. However Fluor may capitalize on the trend regardless of who leads the effort given their global footprint and ability to scale nuclear energy in diverse and new ways.
As previously mentioned, the report titled, "U.S. Oil and Gas Going Places: Parsing a Midstream Perspective," is available. After detailing shale oil developments, trends and players in production for over a year, this inaugural report kicks off hopefully a first of many. Many of the articles that chronicle these developments are housed on Seeking Alpha. However, over the last five months, I have spent time delving into how the trends in shale oil and gas production are trickling down to the midstream area. In June, I was very fortunate to interview Energy Transfer CEO Kelcy Warren. The interview from D CEO's October special oil and gas issue inspired the report; the report is the backstory to some of the interesting investment choices and directions of Energy Transfer but also indications and analysis of the larger trends occurring in the industry. Link to the report page.
