By Michael Corcoran
The year just ended was a happier one for energy investors than the one prior. Despite a volatile ride, oil prices managed to recover from February lows and ended the year at a high.
The year-end rally was spurred by Donald Trump's surprise election victory and the market's subsequent anticipation of accelerated economic growth and hence increased oil demand. The rally was given a further boost by OPEC's Nov. 30 announcement of an agreement to cut production starting in 2017. This was followed by a Dec. 10 announcement of further production cuts from Saudi Arabia and non-OPEC producers, including Russia.
So after this solid finish to 2016, what should we expect oil in 2017?
I expect oil prices to continue to trade in a $45-$60 (figures in U.S. dollars) range this year. They have had a solid rally but there are a number of obstacles to overcome for prices to sustain current levels, let alone increase from here. The main ones are the OPEC agreement itself and the threat of increased U.S. production. Let's look at the supply/demand situation in detail.
Supply
OPEC oil production of 34.2 million barrels per day (bpd) in November was a record high. The quotas announced on Nov. 30 specified production of 32.5 million bpd, which is a decrease of 1.7 million bpd from November levels. This is a significant cut. Can they do it?
The market seems to think so as the reaction to the announcement was immediate and overwhelmingly positive. This is interesting in that OPEC has a terrible track record in actually observing production quotas. Numerous studies have shown that OPEC members cheat and they do so regardless of whether oil prices are rising or falling.
OPEC's heyday was in the early 1970s when it produced 55% of the world's oil. Today, it accounts for around 40%. That's significant to be sure but only if its members are able to act in concert in a disciplined and sustained fashion, something they have almost never been able to do.
The problem is that OPEC has no mechanism to enforce the production quotas - it is left to the goodwill of the members. Given that the majority of revenue for most OPEC members is derived from oil sales, there is tremendous incentive to cheat. So they do. The last time OPEC had an agreement to limit production, members exceeded their quotas the majority of time before it was abandoned at the end of 2015.
The bulk of the cuts are being taken on by producers in the Persian Gulf (Saudi Arabia, Kuwait, UAE), which means that the rest of the OPEC countries are almost guaranteed to ignore their assigned quotas. The offset to this is that the only producer that truly matters is Saudi Arabia. It is considered the swing producer - it can ramp supply up or down to meet demand as necessary and, as a result, plays a crucial role in determining the supply/demand balance of the global oil market.
The Saudi decision to produce all-out over the past couple of years ensured oil prices would stay weak. Similarly, its decision to do the heavy lifting in the cutbacks gave the OPEC announcement teeth. It agreed to cut production by 486,000 bpd on Nov. 30 and followed that up on Dec. 10 with an announcement that it was ready to cut production "substantially to be below" levels agreed on only days earlier. Essentially, the Saudis have signaled that they are willing to do whatever it takes to balance the market, which is the main reason the oil price is up.
The Saudi's actions were supported by the announcement by non-OPEC producers of a 600,000 bpd cut of their own. This was particularly notable due to Russia's agreement to gradually cut 300,000 bpd of production as well. Production cuts by Saudi Arabia and Russia, two of the three largest oil producers in the world, gave hope that the oil market might come into balance sooner than otherwise expected.
And sure enough, the oil price reacted positively. U.S. oil futures have increased 20% since November. Expectations are that the oil market will now come into balance by the middle of 2017, rather than the end of 2017, or even later.
Perhaps overlooked is the fact the agreement is only for six months. OPEC is scheduled to meet on May 25 to gauge how successful the plan has been. At that point, it has the option to extend it further, which is all but assured. But there are other concerns.
Iraq and Iran are significant OPEC producers and their desperate need for oil revenue makes it likely that they will have difficulty maintaining their agreed upon production level. Both countries have excess capacity that they can, and are trying to, bring on-stream. Iran was able to carve out an exception in the agreement that allows it to increase production by 2.2% to help make up for lost production experienced due to international sanctions. Expect them to do this and more. As the largest OPEC producer, the Saudis are taking the brunt of the production cut and this will give both Iran and Iraq an opportunity to step in and surreptitiously steal market share.
Another factor that is not well understood is that OPEC uses two different sets of official data to measure oil production by its members. One is based on numbers provided by the member states to the organization and the second is derived from secondary sources. Not surprisingly, the numbers from secondary sources are seen as being slightly more reliable. But the numbers used for the announcement of the cuts were the direct numbers, which are higher than the figures provided by secondary sources. This helps producers stack the deck. It's a little easier to cut numbers when you're beginning from an elevated starting point. And members that self-report their production numbers are very likely to match their assigned quota.
Lost in the noise of the celebrations was the news that Libya, which is excluded from the production cut agreement, is ramping up output. It has almost doubled to 600,000 bpd since early September. Libya recently announced that it has reopened its two largest oilfields and has begun loading its first crude oil cargo in two years at its largest oil terminal. Libya plans to double production by the end of 2017 to 1.2 million bpd. In the short term, it plans to increase production by 175,000 bpd in one month and 270,000 bpd within three months. Before the 2011 uprising in that country, production was 1.6 million bpd so there is room for further increases as well if the peace holds, which is far from assured.
Nigeria is another major oil producer that is exempt from the production cut agreement. Its production has been hobbled by attacks by militants against its oil infrastructure but production there could easily increase by nearly 100,000 bpd or more next year.
The other major obstacle is the U.S., which is one of the three largest oil producers in the world. Domestic production declined by approximately 600,000 bpd in the past year but that could reverse fairly quickly if the price is right.
The breakeven price for U.S. shale producers used to be in the $60-$80 range but that has dropped to $40-$60, meaning that many U.S. producers are profitable at current levels. U.S. independents have been taking advantage of strengthening oil prices to lock in forward contracts since September, guaranteeing future revenues. This also enables them to increase capital expenditures (capex) as U.S. exploration and production (E&P) companies usually invest any excess cash flows back into production. In early December, U.S. E&Ps added the largest number of weekly rigs since July 2015. And bank lending will likely become more available given higher oil prices, potentially paving for the more for more capex, and hence future production.
Also note that at present, there are 5,000 drilled-but-uncompleted (DUC) wells in the U.S. and of those, 2,500-3,000 are located in the most productive oil producing regions. These wells could swiftly be completed and put into production. There are signs that this is already starting to happen. The oil labor market is heating up as job postings are showing signs of life. Since hitting bottom in early 2016, job postings in the oil patch have increased by over 50%.
All of these factors point to higher U.S. production in 2017.
An additional factor to consider is the impact of the Trump's victory. In the aftermath of the election, the market quickly built in expectations of higher U.S. economic growth that could result from his promised stimulative economic policies. Higher economic growth would put upward pressure on interest rates. Higher interest rates would likely push the U.S. dollar higher as well, which is a negative for holders of different currencies as oil and most other commodities are priced in U.S. dollars. This could put downward pressure on oil prices.
Sustained strength in oil prices is not a given. Current oil prices reflect confidence that OPEC, and non-OPEC, producers will live up to their agreements and additional production will not materialize in the U.S. or elsewhere. That's an outcome that is far from assured. If the OPEC deal collapses or we see production increases elsewhere that offset the OPEC cuts - which the U.S., Libya, Nigeria, and a cheating Russia, Iraq and Iran could easily do - the market will likely be oversupplied through 2017 and prices could easily test $45 and lower.
Demand
As always, the other half of the equation is demand. Demand growth of 1.7 million bpd in 2015 was the strongest increase since 2010. The past year is expected to be solid as well with a more than 1.2 million bpd increase. Strong demand from the OECD and India helped offset the deceleration in demand growth from China. In 2017, the International Energy Agency (IEA) is forecasting a 100,000 bpd increase for total demand growth of 1.3 million bpd.
One wrinkle in the demand picture is that the 2016 figure may have been underreported, in large part due to China, which is always difficult to get good data on. For example, in 2015, Chinese demand grew by 710,000 bpd but in 2016 that slowed to an estimated 260,000 bpd. This drop explains the decline in global demand. The drop occurred despite factors such as car sales increasing 20%, truck sales increasing 8%, and gasoline demand increasing 9% over 2015, which would point to accelerating oil demand. Chinese oil imports are also up 14% over 2015 (an increase of 1 million bpd). The oil imports help offset a decline in domestic production (-250,000 bpd) and reduced oil imports of refined products (-220,000 bpd) due to increased domestic refining, but that still leaves nearly 500,000 bpd unaccounted for. This amount was either consumed or put into storage.
China has its own Strategic Petroleum Reserve but the official capacity of that Reserve is 200 million barrels. If China has been storing excess oil imports that means their Strategic Reserve is more than double the official capacity. China may also be underreporting its refining production because the government loosened restrictions on independent refiners earlier this year and data from the independents may not be available or comprehensive.
Even if we assume China is underreporting demand numbers, the expected demand growth for 2017 may not to be enough to offset supply growth if the OPEC agreement falls apart or production increases elsewhere.
At present, the market is optimistic that the supply/demand balance will be achieved by mid-year as production cuts are felt and inventories are drawn down. This may happen but OPEC's poor history of compliance and the ability of the U.S. and others to ramp up production give reason for caution. Currently, the risk for the oil price is to the downside.
Natural gas
I expect natural gas to trade between $3.00 and $3.50 per million cubic feet (mcf) in 2017. The industry continues to be oversupplied and this is likely to persist throughout 2017 and beyond. Given this, weather will be the key determinant of price, as over half of U.S. homes use natural gas for heating. Colder than expected weather can increase demand and prices in the short term.
The overall supply/demand picture for natural gas remains the same: supply remains high as natural gas resources continue to be developed and pipeline infrastructure to get that gas to market continues to be built. Partially offsetting the rise in supply are increasing LNG exports, increasing exports to Mexico, more demand for electricity generation, and inputs for chemicals and fertilizers. Taken together, sources of demand are not high enough to absorb current inventories and increased supply, thus natural gas pricing will continue to face ongoing pressure in 2017.
In 2015, natural gas production was 32.9 billion cubic feet while demand was 27.3 billion cubic feet, leaving a 5.6 billion cubic feet surplus. In 2016, U.S. natural gas production is forecasted to decline from 2015 - the first decline since 2005 - but the supply surplus will continue to overhang the markets.
Natural gas inventories were at a record high a little over a month ago but cold weather has led to larger than expected withdrawals and inventories now stand at levels below where they were a year ago, although at the time, those levels were record highs.
The bottom line is that both oil and natural gas prices will face challenges in 2017. Prices for both have rallied recently so future gains will be harder to come by. The OPEC agreement could become unraveled, production elsewhere in the world could replace what's been cut, and winter weather could prove to be warmer than expected. Given this, investors should tread cautiously in making new stock purchases. Monitor well-managed and well-capitalized companies, look for market dips, and take advantage of them.
Michael Corcoran is an oil and gas analyst, based in New York.
