I think there are two separate reasons for domestic oil producers to be nervous about the price of oil going forward. There are two commonly traded oil price benchmarks that are the most heavily traded on the futures exchages. West Texas Intermediate (WTI) is priced in Cushing Oklahoma and traded on the NY Mercentile Exchange. This was historically the most important benchmark, but due to wild fluctuations in WTI most of the major producers have switched to Brent, a North Sea grade which is traded on the ICE exchange in Europe.
The WTI-Brent spread (the price difference between the two grades) had usually been +/- $3/bbl or so until 2010. Please ignore the "QE2" marker on here which really has little to do with the spread. I just used this chart because it is otherwise very nice. In 2010 it grew due to production growth in the Bakken and Permian Basin regions, both of which had pipelines that fed Cushing Oklahoma, where there were several refineries. So much crude was going into Cushing, but there was no effective way to get it all out and down to the mega refineries on the Gulf Coast of Texas and Louisiana. This oversupply caused depressed prices relative to seaborn grades like Brent.
So recently two things have been happening. The spread has been collapsing, and is now only $4, down from highs of as much as $25. I think a big reason for this is that the logistical constraints that created the spread have been largely alleviated by new rail capacity, and to a lesser extent new pipelines. The collapse of this spread has been good for producers and bad for refiners.
The second thing that has been happening is the collapse in the Brent price. Brent has been in freefall over the past few months, despite major turmoil in the Mid-East, which has historically been good for a supply scare. Demand has been surprising to the downside and supply, mostly from North America, has been surprising to the upside. US crude production was
8.6mm bbl/d in August, and EIA is now projecting 9.5mm boed average for 2015. The US really does have a shot at becoming the number one crude producer in the world in 2016 or 2017. Meanwhile EIA and other forecasters have been downgrading world crude consumption growth to about 1% per year, which works out to about 1mm bbl/d. So US projected supply growth will fulfill total projected world demand growth if non-US production stays flat. Meanwhile there is a whole lot of oil out there that is very economic to produce at prices far lower than the current price. Libya, Iran, and Iraq all have tremendous capacity to grow output if they were not constrained by political turmoil. It never pays to underestimate the odds of political chaos disrupting production in ME or Africa, but production capacity does certainly have the potential to grow in that region, even in a period of falling prices. On the opposite side of the ledger there is Russia, which is currently the largest producer. Their production has been growing since bottoming in the mid 1990s but is now showing signs of flattening out due to underinvestment. It could fall further if sanctions are widely expanded. This is not a very likely scenario, but it remains a possibility. Even the possibility of sanctions is a disincentive to investment. The current, relatively mild sanction regime is also keeping the most competent service firms out of the area.
In order to slow production growth the market needs to send a signal to the fast growing American producers to slow down. Price trends can last for very long periods, because capex cycles are so long. Breakeven price with a 10% cost of capital is probably around $40-80/bbl depending on the region. If we do get a fall in price, supply may be somewhat more elastic than in the past because tight-oil capex can be turned on and off remarkably quickly, as was demonstrated in shale gas in 2009. Tight oil wells also decline more quickly, so declines in capex may be followed by production declines relatively quickly.
And that chart is ugly, ugly, ugly.
Then there is the other potential piece of bad news for US producers. Although the brent/WTI spread has tightened recently, to their benefit, it is in some danger of blowing out again. Supply constraints have been effectively alleviated by rail capacity. But there is a major potential constraint ahead. The US has now displaced substantially all light oil imports, and it is illegal to export crude oil from the USA. Now there is still the possibility of "lightly refining" oil and exporting it, as they are currently doing with some condensate (extremely light oil that is in gaseous form in the reservoir). But this issue may well cause a blow out of the Brent/WTI spread again. Congress may come to the rescue by passing a waiver to this very outdated law, but one should never count on congress to do anything.
This chart shows how small US imports of light oil are. For domestic production to displace more imports, it would have to be displacing heavy crudes. This would require substantial discounting because the US refining system is set up to take large amounts of heavy crude from Canada, Mexico, and Venezuela. Note that the above chart can give a misleading impression that the US depends on imports more heavily than it actually does. We are now a net exporter of about 4 million barrels per day of refined products and other non-crude petroleum liquids like propane, so net imports of petroleum products are only about 4.6mm bbl/d (as of June according to EIA). This is down from a peak of 13mm bbl/d in 2007.
Might OPEC come to the rescue and cut supply? OPEC supply has been flat, and the Saudi's have been dutifully balancing the market, so a production cut in the short term may well happen. OPEC really hasn't ever had terrific supply discipline. The Saudis will balance the market by taking off or adding 1 or 2 million barrels a day, but I'm not sure OPEC can support the price of oil over a long period. It is always risky to be too short oil during a decline, because it only takes an announcement by the Saudi's to send it back up. Right now it is also important to note that about 3 mm bbl/d of OPEC capacity is "disrupted" by political turmoil. If that were to come back online (a big if), it is hard to see Saudis cutting by that much to balance the market.
So far US land Rig Count is Stable - Prices only really started to drop three months ago. But spot prices have plummeted for drill ships, particularly for deepwater. Look at the prices of Transocean or Ensco over the past few months. According to some reports the breakeven cost for deepwater oil is now higher than US shale, although this breakeven price might come in if we have a collapse for day-rates on the rigs, a major factor in deepwater drilling costs. The sharpest capex cutbacks may come in Canadian oil sands, North Sea, US Gulf deepwater, deepwater Brazil, and deepwater West Africa. These regions may already be higher cost than tight oil.
So overall, as you can probably tell, I'm a bit nervous on oil prices, and the E&P stocks tracked on this blog all have tremendous correlation with oil. But I also hate to sell WLL and APA badly. EIA US production numbers have been great, so I think earnings season could be a positive catalyst for some of these stocks.
