Many industry viewers think global crude markets will become balanced by late 2016 or early 2017.
In the near term, experts say we are perilously close to reaching the top of tanks at Cushing, Oklahoma. Headlines joke that Americans will be asked to store excess oil in their swimming pools. Pundits seem to feel that full storage may even send WTI benchmark prices to the mid-teens.
While such a discussion makes for interesting fodder, it’s unlikely to be how events transpire. Here’s why.
Price troughs and global inventory peaks
U.S. inventories are now sitting at 534.8 million barrels—36.4% above the 5-year average and 13.4% above last year’s level (which was itself a record). A recent discussion attempted to correlate oil price troughs to oil inventory peaks. Once we are past the peak and inventories are falling, we can assume that demand is outstripping supply and that we’ve reached that balancing point where oil prices should bottom.
Chart 1, shows the inventory levels (expressed as days of demand) of crude graphically around time zero, when the oil price bottomed. The data is presented for the major crude-oil bear markets in the last 30 years: namely 1986, 1998 and 2009. But does the oil price anticipate a peak in inventories, or simply act as a coincident indicator? It depends.
Significant oil price corrections have occurred thanks to either a supply side increase or a significant demand decline. Most people feel the current collapse has been driven by the supply side. Since November 2014, OPEC and Saudi Arabia have largely abandoned their traditional stabilizing role. Instead, oversupplied oil markets have had a slower adjustment period in which the price level has driven out investment in higher-cost sources.
Seasonality and its impact
The majority of the world’s economic activity happens in the northern hemisphere. In fact, 9 out of 10 of the world’s most voracious oil consumers are above the equator.
In the U.S., the summer is typically referred to as the “driving season.” For that reason, refineries typically run as close to flat out as possible to meet the high seasonal need for gasoline. Maintenance activities typically occur in lower-demand periods like April to May, and again in September to October, when large refining units can be taken offline to be cleaned, overhauled and maintained. During these periods, refiners (the end users of crude oil) rely on tanks to store input material.
Chart 4 shows the expected amount of U.S. refining capacity that will be offline in 2016. The large increases in inventory levels that we’ve seen of late reflect this pattern.
So, this spring could quite possibly be a high-water mark for inventories.
Picking the inflection point
The pace of declines in U.S. production has driven the majority of non-OPEC growth in recent years, as technology and accommodative interest rates have driven a debt-fueled boom in the U.S.
Recent analysis suggests that if all U.S. onshore drilling were to cease, production would fall by at least 30%. Couple that with the fact that there are only 372 active rigs in the U.S.—less than half the 800 rigs experts say we need to keep production flat—and the simple math suggests that onshore production is currently on a trajectory to fall by a million barrels per day annually.
The rub in all of this seems to be OPEC producers. Saudi Arabia has made it clear they won’t reduce production levels to balance the market unless other cartel members share the burden. And it seems Iran is single-mindedly focused on restoring higher pre-sanction levels of production. What’s more, talk of Russia freezing production would seem to be just that—talk. Russia has a long history of agreeing to production targets, then increasing production.
We see a few themes playing out in the next few years. The main one is that the capital investment decisions we’re making today will have profound implications on supply-demand balances in coming years.
While the oil market seems focused on the short-term production response of U.S. onshore drilling, few are talking about the implications of capital expenditure decisions made today on major projects. Major projects typically have a slow adjustment process. In 2015, final investment decisions fell 80% from what might be expected in a typical year, and 2016 should have similarly depressed levels. And, the biggest oil producers, known as “supermajors,” have carved billions of dollars from their overall spending plans. In aggregate, this two-year hole in new supply could remove about 4 million barrels per day of new oil production in coming years, which will prove difficult to compensate for even with an eventual recovery in the U.S. onshore. The current OPEC spare capacity could be as little as half a million barrels per day, and if forecasters correctly predict a balanced market by the end of 2016, we may see a price spike in years to come.
In this difficult market, investors should remain cautious of companies with unmanageable leverage ratios, as well as low-quality assets. Instead, focus on stronger companies with access to capital and cost structures that are sustainable during the downturn.
One such company is Spartan Energy Corp., a Calgary-based producer that operates primarily in Saskatchewan. Lack of hedges, low leverage and its oil-weighted production mix make it an attractive investment option.
The company is well positioned to participate in attractive acquisition opportunities as 2016 unfolds, based on its strong balance sheet position and supportive capital markets.
Whitecap Resources Inc. is another oil-weighted producer. Headquartered in Calgary, it has core areas in Alberta and Saskatchewan targeting oil.
We believe Whitecap is a blueprint for the successful transition to the dividend-paying intermediate model, owing to the company’s sound operational execution, well-focused acquisitions in quality resource plays, and the associated management of its decline rates. In our opinion, it’s among the best-positioned dividend companies to persevere through the softer crude pricing environment.
by D. Mason Granger, P.Eng., MBA, CFA, is a portfolio manager in Toronto.