The start of the new year signals the beginning of the much anticipated production cuts totaling over 1.7 MMb/d from OPEC, Russia, and others. However, this leaves several questions still outstanding: Who will follow-through with the promised cuts? What are each country’s incentives? And will growth in the US disrupt even the best executed cuts?
For the sake of this analysis, we will focus on the last two questions and make a simplifying assumption that the stated target of 1.7 MMB/d of cuts is reached in January 2017 and held through June 2017. While there continue to be mixed incentives about whether or not each country will adhere to the stated production quota, Saudi’s motives are less ambiguous.
In 2016, rumors of a Saudi Aramco’s IPO surfaced and were later confirmed, and steps are now being taken towards a target 2018 initial public offering. To this effect, strong oil prices in 2018 would drive up the bottom line and thus support a higher valuation of the shares offered in the IPO. The capital raised from the IPO will then be invested in the diversification of the Saudi Arabian economy. A successful IPO with a strong valuation is a critical step towards this goal of moving away from natural resource extraction. Therefore, in the context of a 2018 IPO, it is in Saudi Arabia’s interest for the global oil market to rebalance before launching its shares on the global equity market.
As Middle East producers continue to jostle for market share, while striving to re-balance the oil market, another threat looms in the global oil market… the Permian Basin.
The Permian Basin continues to be the hot bed of oil activity in the US as well-productivity surges ever higher, driving breakeven prices ever lower. At current rig count and rig efficiency, the Permian Basin is on a trajectory to grow almost 0.6 MMb/d in 2017.
In this projection, over half of that production growth (350 Mb/d) would occur in the same period that OPEC and others are cutting production to support prices by creating a global oil shortage to work off bloated storage inventories around the globe.
The global supply and demand balance (sans storage) improved throughout 2016 as global crude oil production peaked and started to decline, but never flipped from being long to short. In 1Q 2016, the market was long by well over 1 MMb/d, but shifted back to almost balanced in 3Q 2016. However, in 4Q 2016, as Middle East producers increased production to jockey for higher production quotas under an OPEC cut, the balance increased again.
Factoring in the announced cuts of 1.7 MMb/d, implemented in January 2017 and held through June 2017, swings the balance firmly into the much needed supply short scenario required to work off the global storage glut that has been accumulating since late 2014. However, this is an artificial shortage, which not only helps OPEC members and other oil economies stabilize budgets, but it is also a boon to US E&P companies. In fact, since the OPEC announced it would cut, prices stabilized closer to $50/Bbl allowing producers to add rigs to the field. If January rig activity and drilling efficiencies are held constant through time, there are currently enough rigs running in the US to not only stem declines, but also put the US back on a growth trajectory. This could dampen the impact of production cuts on global scale, stretching the global storage overhang out longer, which could potentially affect the value of Saudi Aramco’s IPO in 2018.
Under a current activity scenario, once the 1.7 MMb/d of cuts are rolled back and production is resumed at previous levels, the global market will be tenuously balanced. Any supply increase on the part of OPEC or a rebound in Libyan and Nigerian production will be enough to tip the market back into a supply long case. Suggesting increased price volatility in 2017 and perhaps even into 2018. To hear more on our views of the Permian, be sure to attend What Lies Ahead 2017 taking place on February 8th in Houston, TX.