Well, the last few weeks in oil have been interesting to say the least!
Until recently, oil spreads traded in a very narrow range from the beginning of the year forward, indicating price stability and overall price volatility has been limited. That was true until Wednesday of this week, when EIA reports showed a tremendously larger than expected inventory build. At which point, WTI broke the key resistance point of $50.00 per barrel. And while markets had experienced some volatility, futures spread curves all indicated a market in which the vast majority of traders (or at least their money) indicated a move from contango to backwardation this year (i.e. – surplus supply to balance/deficit). The only question was when. For a long time, most seemed to be betting on second half of this year. Over time, that seemed to move out.
Nevertheless, we see and more optimism prevailing. The IEA has warned that by 2021, we could see a serious supply deficit of over a million barrels a day if a radical reversal of the last two years is not instituted sooner rather than later. As we reported in other articles this week, big oil seems to agree as comments by their CEOs indicate. And an uneasy truce seems to have been reached by OPEC and the shale players – both realizing they need each other.
While it is certainly disconcerting that oil has slipped below a key resistance point and inventories continue to build, I remain optimistic. First, we must remember that in the run-up to the OPEC freeze, OPEC produced at historically high levels for months – essentially trying to pump as much as they could before they turned off the spigot. Therefore, they in essence flooded the market with additional crude for several months prior to their agreed production cuts. OPEC needs to draw down some 350 million barrels of crude to cause markets to come into balance. At a rate of approximately 2 million barrels a month, that takes six months. Remember that refiners are in maintenance season, and thus, we are at a cyclically low time for crude draws. Thus, we shouldn’t be terribly surprised that storage tanks aren’t draining as quickly as anticipated. If OPEC maintains its production cuts, we can reasonably anticipate a fairly large drawdown in the second half of the year when the U.S. goes into peak summer driving season. OPEC compliance is currently estimated at around 94% - a strong showing of their commitment to balancing markets in the long-term.
And while U.S. shale is resurgent at a higher level than anticipated, we believe that optimism will be somewhat tempered. First, as we reported, service pricing is increasing. And while this may hurt us in the short term, it will save us in the long-term.
A significant amount of supply needs to exit storage before markets rebalance. Until that happens, any recovery is potentially fleeting. To truly initiate a new multi-year upcycle, we must let the downturn finish playing out. Service pricing increases will increase the cost of drilling and keep more marginal plays on the sideline – which will let markets more fully recover. And I believe personally that you will start to see some inherent delays in bringing equipment online. The fact is that a lot of manufacturing capacity that existed for oilfield equipment in 2014 simply does not exist today. I know, for example, that our own inventory in certain sizes that seemed enormous a year ago have already been depleted and we are several months away from replacement. One size depleted in a day. Yes. A day. 2 years of normal stock on the ground. Gone in a day. Replacement material for that size inbound in May.
Overall, I still predict that a few things will happen. First, I think that you see big players jumping into the shale game but being more cautious than the smaller players. Exxon is jumping into shale, but from my prior knowledge of Exxon, they will move in a more targeted, cautious manner. But you must remember these are shorter-term projects and do not have the life expectancy of say, a large offshore platform. And while shale has certainly demonstrated that it is robust, I think there will be at least some restraint until May and we see the output of the OPEC meeting.
At the end of the day, I believe that everything hinges on the May OPEC meeting. If OPEC extends cuts and its coalition of other willing participants agree to do the same, I believe you will see markets head to balance. I believe that will trigger a robust recovery, potentially starting within a matter of months, that is sustainable over a period of several years as new capital rushes to not only short-term, low cost projects but to longer term, higher cost projects. While I do not think OPEC’s continuation of output reduction is a foregone conclusion, I think it is a reasonable assumption.
OPEC has every incentive to balance markets sooner rather than later, to let the demand side continue to grow, and then to capitalize on that. Remember, OPEC doesn’t really want $100.00 per barrel oil. At $100.00 a barrel, oil simply becomes less cost efficient and people start more seriously considering alternatives to fossil fuel. Neither does OPEC want $20.00 a barrel oil because OPEC nations can’t balance their budget. At the end of the day, they want oil in a price range where consumers want to keep consuming, governments can’t make alternative energy more appealing to their populace by arguing that it is cheaper, and they get to keep pumping and supplying the world. The United States has an estimated 300 years of oil needed for our use under the ground. The last thing OPEC truly wants is people to decide they don’t need oil. They want oil to remain a cheaper alternative (but not too cheap) for years to come thereby making their otherwise overstated relevance to the world continue years longer than is truly necessary. And if oil is too expensive, and alternatives are put into place, they lose that relevance. Thus, they want shale in the game. Long term, they are seeking the golden window. And that golden window is open longer if they keep crude priced just right.
I apologize to our readers for missing the last issue. We have been crazy busy here trying to make sure we have enough steel inbound over the coming months to keep you all happily in supply.As always, I personally thank you all for your friendship and support! I am so happy that over the last few blog posts I’ve been able to deliver happy news!
By: Ty Chapman
Five Star Metals, Inc.
Raising the Bar for Customer Service and Quality
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