The Supply Glut That Just Won't Go Away

In the last edition of The Five Star Standard, we wrote an article on CERAWeek. One of the more interesting comments to come out of the meeting, was Saudi Oil Minister Kahlid al-Falih stating that oil markets were taking longer to rebalance than he had anticipated, yet that he saw some signs of recovery.

We similarly reported optimistic projections by the IEA and others indicating markets should move into supply deficit in 2H 2017 with world demand increasing. OPEC compliance is running has high as 94%, and everything seemed rosy.

But then the last two weeks happened. This week, both API and the EIA reported substantially higher than predicted inventory builds. Oil started tumbling and entered into virtual freefall, breaking the key psychological barrier of $50.00.

And hedge funds and other money managers ran for the hills. During the week of March 14, money managers cut their net long positions by a record 153 million barrels in just seven days. Long positions were reduced by 84 million barrels while short positions were increased by 70 million barrels. The net effect was a reduction to a cumulative net long position of 230 million barrels from a peak of 951 million barrels on February 21, 2017. While long positions still outnumber short positions by a ratio of 4:4.1, this is down from a spread of 10:3.1.

And OPEC doesn’t seem to be the only one surprised that barrels aren’t exiting the market as soon as anticipated.   The key question becomes why? Certainly, refinery utilization is at a low because of routine maintenance in preparation for the summer driving season (on a high note, gasoline inventories are dumping more quickly than anticipated) and overall crude imports appear down. The U.S. shale resurgence is playing a role, but it cannot alone account for the slower than anticipated draw-down. Nor does it explain the rapid exodus from long positions.

This week, the venerable Goldman Sachs jumped into the foray, suggesting that new mega-production projects and a resurgent U.S. shale industry could boost output by a million barrels per day year-on-year and result in an oversupply in the next couple of years. According to analysts at Goldman, "2017-19 is likely to see the largest increase in mega projects' production in history, as the record 2011-13 capex commitment yields fruit."

 

What makes the Goldman Sachs analysis interesting, as compared to the hype surrounding U.S. shale, is that they believe the problem, while being contributed to by a resurgent shale sector, is more a result of decisions made in 2011-2012 when oil was hovering around $100.00 a barrel.

In other words, Goldman is saying that long term projects started in 2011-2012, that have a 7 year average lead time from plan to first barrel, will have a huge impact on global supply next year. When you combine that with a resurgent shale industry that has a short lead time of 7 months, you have the perfect storm brewing.

Viewed graphically, Goldman breaks down

 

In its report, Goldman Sachs said it expects 2017 to 2019 to be record years of startups in the industry as the “2011-13 boom in [capex] sanctioning comes onstream,” but a “key unknown is how well the industry will deliver.”

A Goldman Sachs’s bar chart shows peak oil production from giant fields that have long lead times peaking in 2017 and remaining high in 2018 and 2019. Another chart shows capex sanctioned per year on top energy projects, which peaked in 2011:

Perhaps this is why we see inventories rising: longer lead time, large dollar projects are starting to come online. Combined with a resurgent shale boom, OPEC may have a harder time balancing markets than they anticipated.

But part of the problem may simply be structural. According to Leonardo Maugeri, a Senior Fellow of Geopolitics of Energy Projects at the Belfer Center of Harvard’s Kennedy School, the narrative surrounding OPEC production cuts is misleading. First, as we explained in prior editions of The Five Star Standard¸ OPEC ramped up production ahead of the agreed cuts so that each country came to the table with a perceived better bargaining position. That means, when OPEC set the baseline as their October 2016 production of 30.9 mbd, they were already undercounting actual production – which actually stood at 33 mbd. Even accounting for the OPEC agreed cuts of 1.2 mbd, this means to hit the target of 1.2 mbd, they actually needed to cut 2 mbd more. In effect, they simply didn’t cut enough: particularly in an agreement that allowed certain producers (Nigeria, for example) to produce without limit.

The obvious problem is that OPEC also created conditions ripe for U.S. shale to fill the gap. While initial estimates had U.S. production increasing by 330,000 bpd in 2017, so far, the increase from October 2016 (OPEC’s baseline) in U.S. production has been 740,000 bpd.

Thus, the efficacy of OPEC’s cuts have been undermined. Further creating headaches for OPEC is that China and India, the largest countries for world demand growth for oil, do not seem to be performing as well as anticipated. Thus, where OPEC had relied on these two countries’ increase in consumption to eat away some of the increased production from others, that simply hasn’t happened.

While I certainly have my opinions, you now have the contrary view from our overall positive news from the last few weeks.

By: Ty Chapman

Five Star Metals, Inc.

Raising the Bar for Customer Service and Quality

Twitter: @FSM_TY

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