LIV: Oil Price Indicators - Tempering a bullish outlook
WTI oil prices increased 12% in the last 4 months, stimulated by increased world oil demand as a result of a slightly improved global economic outlook and extreme cold across the northern hemisphere in December. Surplus global oil inventories fell sharply in November and a bigger drop is indicated for December. Commodities continue to gain favor as an asset class.
World oil demand grew 2.7 MMBD in 2010 and is expected to grow 1.4 MMBD in 2011, assuming a 4.5% rate in global economic growth. Current demand estimates reflect a 320 MBD upward revision from the prior month. Overall, 2010 (+1.1 MMBD) and 2011 (+0.6 MMBD) non-OPEC production estimates remain unchanged, as well as OPEC NGL production, which increases the call on OPEC crude in 2011 to 29.9 MMBD, up 0.7 MMBD Y/Y from OPEC 2010A crude oil production. At this level, OPEC’s effective spare capacity is reduced to less than 5 MMBD for the first time in 2 years (after adjusting for production constraints on Nigeria and Venezuela).
Tempering the bullish trend is evidence Saudi Arabia and other leading OPEC producers are increasing production and cutting prices. OPEC production in December increased to 29.6 MMBD, up 240 MBD for the month, reaching the highest level of the year. The Saudis have reiterated their preference for crude prices in the $70-80/B range as “a perfect price for the world.”
Moreover, the global oil burden (defined as global oil expenditures as a % of nominal global GDP) is approaching levels that in the past have coincided with weakening global economic activity. The global oil burden in 2010 was 4.1% with oil prices near $80/B. At $100/B, the global oil burden would exceed 5%, which in the past has been clearly associated with economic problems.
Oil markets are likely to be in reasonable equilibrium with crude about $90-95/B over the next 12-18 months, then rising with nominal GDP growth, balanced by risks to global economic growth from higher oil price inflation on the one hand, and geopolitical risk which could disrupt supply on the other.
While the US oil service market is expected to move sideways in 2011, the industry believes it is in the early stage of a multi year up-cycle, with growth shifting to markets outside North America. The outlook for the oil service industry is positive.
Superior performance from energy stocks is linked to the oil price outlook.
Crude oil prices currently approximate $91/B, near the May 2010 high. Oil prices for 2010 averaged about $79.50/B, up 29% from $61.83/B in 2009. While crude oil is up15% over the past 12 months, it has underperformed gold, which is up 25%. Over the past 4 months, oil prices have been driven 12% higher by bullish sentiment supporting commodities in general and stronger than expected global oil demand. Commodities continue to gain favor as an asset class. Over the past 12 months, the XLE energy SPDR is up 20%, while the OIH oil service index and the S&P 500 were both up 15%. The lagging XNG natural gas index increased 13%. Volume in equity markets for December and the year was extremely low.
The increase in oil prices was supported by a decline in inventories. After an increase in October to 60.1 days forward demand cover, near the 60.9 day peak in August, OECD oil inventories declined to 58.7 days cover in November, and a significant further reduction is indicated for December. The largest decline occurred in the US. Something like 54 days forward demand cover is normal.
In its latest report, the IEA increased its estimate of world oil demand for 2010 yet again to 87.7 MMBD, the highest on record (up 3.2% Y/Y or +2.7 MMBD), largely on a slightly healthier economic outlook in OECD economies and severe cold northern hemisphere weather. (The strongest prior annual increase in world oil demand was 3.0 MMBD in 2004 and the prior peak in world oil demand was 86.4 MMBD in 2007.) Unusual freezing conditions prevailed in November and December, but January has been remarkably mild particularly in Europe. Still, 2011E demand across the OECD of 45.9 MMBD is expected to be down 3.5 MMBD over the past 5 years, reflecting what appears to be a structural decline in heating oil demand, the result of efficiency gains and increased use of natural gas globally. While the US economy appears more resilient than expected, it is still not growing fast enough to curb high unemployment. The secular demand outlook for the OECD has not changed materially. Global oil demand is expected to increase 1.4 MMBD, or 1.6%, in 2011 to 89.1 MMBD.
Demand growth is being driven entirely by the non-OECD. Non-OECD demand grew 2.1 MMBD in 2010 to average 41.6 MMBD, and is expected to increase more slowly by 1.6 MMBD in 2011, as inflation (5.1% in November in China, well above the official target of 3%) creeps up on the back of rising commodity prices and exchange rate rigidities. 2011E demand in China is expected to be 9.8 MMBD, up 2.2 MMBD over the past 5 years (and up 0.5 MMBD Y/Y), while the 5 year increase in other Asia is 1.1 MMBD, and the Middle East and Latin America combined increase another 2.3 MMBD.
Apparent oil demand in China rose over 15% Y/Y in November, with most of the surge related to rising gasoil consumption, which accounts for roughly 1/3 of demand. Soaring use of gasoil is related to extensive use of small scale electricity generators, the alternative to government mandated closures of coal fired plants to meet energy efficiency and emission standards. Gasoil demand should fall by January since the government has officially declared its targets have been fully met. 2010 oil demand in China increased a remarkable 0.9 MMBD on the back of GDP growth of 10%. Its stock market was up 7% in 2010 and 2% in 4Q10, lagging the S&P 500 in each period.
Iran has finally implemented its oil subsidy removal legislation. It has a population of 73 million, and, with inflation surging perhaps as high as 70% in 2011, social unrest could weaken the government. Real household expenditures will likely fall sharply, and the domestic industry, already hard hit by international sanctions, is likely to suffer more, further depressing the economy and hitting internal oil demand. Iranian oil demand is currently expected to rise 4% to 1.9 MMBD in 2011.
Iran produces 3.7 MMBD. New sanctions have disrupted normal crude oil flows due to banking and other credit related problems with European refiners. Some 400 MBD of exports to India are also in jeopardy due to stricter banking regulations there. Moreover, steeper field decline rates are likely because much needed access to technology and equipment has been effectively cut off. The IEA anticipates Iranian crude capacity will decline to just 3.1 MMBD by 2015. Geopolitical risks remain prominent.
Estimated non-OPEC oil supply is unchanged at 52.8 MMBD in 2010 (up 1.1 MMBD Y/Y) and 53.4 MMBD in 2011 with added supply from the US (liquids rich shale plays), Mexico (reflecting Pemex success in stabilizing production from mature oil fields), and biofuels. This will be the strongest 3 year run in increased non-OPEC production since 2002-2004 when recovery in Russia was the driving force. Russia produced about 10.5 MMBD in 2010, the highest level in the post-Soviet era; its production is expected to be flat in 2011.
Non-OPEC supply is forecast to continue to grow minimally thereafter to 54.0 MMBD in 2015. For the period 2009-2015, overall non-OPEC supply is expected to grow by 2.3 MMBD, with the bulk of the increase coming from biofuels (+800 MBD to reach 2.4 MMBD in 2015 from 1.6 MMBD in 2009), oil sands (+1.1 MMBD), and NGLs. Conventional crude production is expected to increase by only 255 MBD, with strongest increases largely from Brazil (+480 MBD), Colombia (+210 MBD), and the Caspian (Kashagan Field). Conventional crude declines are strongest in the UK, Norway, and Mexico.
Total US crude and liquids supply is expected to be flat 2009-2015 around 7.45 MMBD. No permits for deepwater drilling in the Gulf of Mexico have been granted since the moratorium was lifted and permits for shallow water drilling, not covered by the moratorium, have been very slow in coming. Some 7 deepwater rigs have left the Gulf of Mexico since the BP spill, which idled 33 rigs. With tighter regulations and protracted delays, decline rates at post-peak Gulf of Mexico oil fields will increase. The impact is expected to reduce Gulf of Mexico production in 2015 by 300 MBD to 1585 MBD, then representing 21% of total US production.
But a brighter outlook for US unconventional onshore oil production more than offsets the impact of drilling delays in the Gulf of Mexico. For example, the Bakken/ Three Forks horizontal shale play in North Dakota and Montana is the largest continuous oil accumulation in the Lower 48, with 3-4.3 bn B of undiscovered, technically recoverable oil. Advances in horizontal drilling and fracturing technology are making this possible. As a result North Dakota oil production is now approaching 300 MBD from 85 MBD in 2002, and could reach 450-700 MBD in 5-7 years. The Bakken Shale has evolved into a low risk `exploitation’ play since well results are becoming repeatable and predictable. The Bakken currently is constrained by equipment availability; shortages have made the capital cost per well increase from $4.2 mil last spring to $5.8 mil (+38%!) currently for a 640 acre lateral, to the great benefit of oil service companies. A typical well produces 15-16 MBD in the first month but drops like a rock to about 4.5 MBD within 12 months. It generates an IRR about 25% with crude at $90/B, but at $60/B, the Bakken comes to a screeching halt.
The Kashagan oil field in the Caspian Sea offshore Kazakhstan is scheduled to begin production by the end of 2013. Its original start date was in 2005. Phase 1 production of only 375 MBD is scheduled to ramp up to 1.5 MMBD about 2018-2019. Kashagan has proven reserves of 7-9 bn B and is the largest oil discovery in over 30 years. Kazakhstan currently produces 1.6 MMBD.
OPEC NGL production estimates remain at 5.3 MMBD in 2010 (up from 4.5 MMBD in 2009), and 5.8 MMBD in 2011, as additional LNG trains in Qatar are brought on stream. Sequentially, 0.4 MMBD of 2011 incremental capacity will be added in 1Q11. The IEA’s medium term outlook then anticipates OPEC NGL production will grow to 7.1 MMBD in 2015 with new supplies from Qatar (2015E capacity 1.36 MMBD), Iran (2015E capacity 0.9 MMBD), UAE (2015E capacity 0.9 MMBD), and Saudi Arabia (2015E capacity 1.86 MMBD). OPEC NGL supplies are adding meaningfully to supply.
OPEC crude oil production in December increased to 29.6 MMBD, up 240 MBD for the month and the highest level of the year. Saudi Arabia, Kuwait, the UAE, Iraq, Nigeria, and Venezuela all increased output. With the global oil burden (defined as global oil expenditures as a % of nominal global GDP) approaching levels that in the past have coincided with weakening global economic activity, there appears to be tacit recognition by OPEC’s leading producers of the need to increase production to take some of the steam out of oil price increases. The Saudis recently reiterated their belief that oil prices in the $70-80/B range was “a perfect price for the world.” (The global oil burden in 2010 with oil prices near $80/B was 4.1%; at $100/B, the global oil burden would exceed 5%, which in the past has been clearly associated with economic problems.)
Saudi output in December reached 8.6 MMBD. Their OPEC quota is 8.1 MMBD. Market data indicate they are on track to increase production again in January. In addition, Aramco lowered prices on key grades for February, making sales more attractive. Following Aramco, several Gulf member producers reduced prices for next month’s liftings as well.
Saudi capacity, currently 12.1 MMBD, is expected to decline to 11.6 MMBD in 2015 reflecting normal field decline. It has indicated its trigger for adding new capacity would be if global crude demand began eating into the 1.5-2.0 of strategic spare capacity it likes to have available for unexpected supply shocks. If demand growth looks likely to erode this comfort level by 2015, Saudi Arabia stated it would initiate capacity expansion by 2012. Without new investment, decline rates in OPEC production are in the 3.5-5% range, according to a former Aramco official. The IEA estimates combined OPEC and non OPEC normal field decline approximates 3 MMBD.
Iraqi oil production of 2.44 MMBD in December reflects a minimal increase from 2.4 MMBD in 2009. Plans to increase production in 2010 failed to materialize, but progress by international oil companies in renovating its fields promise production may reach 2.7 MMBD by 4Q11. The IEA does not expect Iraqi capacity to exceed 3.6 MMBD by 2015. Iraq does have substantial resources to sustain much higher production if it is able to overcome its above ground challenges. It recently increased its estimate of proven reserves to 143 bn B based on a 34% recovery factor, which compares with 259 bn B for Saudi Arabia, 211 bn B for Venezuela, and 137 bn B for Iran. Iraq’s official production target is 12.0 MMBD by 2017, but a panel of experts in the Middle East recently stated production of 4-5 MMBD at that time was a more reasonable goal, with a plateau of sustainable capacity of 6.3 MMBD maintained for 12-14 years. The complexity of building a pipeline through Syria and maritime border issues with Iran will be a barrier to oil export expansion. Iraq stated its goal is to boost revenue, not production.
Nigeria increased production from 1.8 MMBD in 2009 to 2.3 MMBD in December, the high for the year, where it is expected to remain assuming the fragile cease fire with former militants endures. Capacity is expected to increase slightly from 2.5 MMBD currently to 2.8 MMBD in 2015, if its proposed new Petroleum Industry Bill does not discourage investment. As it currently stands, the proposed PIB is described by industry sources as `very flawed’ and equivalent to `resource nationalization’. Nigeria’s remaining fields to develop are ¼ to 1/3 the size of its already developed giants but will involve the same costs, with the new law resulting in a disincentive to invest.
The IEA raised the estimated call on OPEC crude to 29.8 MMBD for 1Q11 and by 0.4 MMBD to 29.9 MMBD for all of 2011. As a result, OPEC’s effective spare capacity fell below 5.0 MMBD for the first time in 2 years. About 65% of OPEC’s current spare capacity is in the hands of Saudi Arabia. Assuming world oil demand growth about 1.2 MMBD annually 2012-2015, and relatively flat non-OPEC conventional oil production from 2011, the call on OPEC crude will increase from 29.9 MMBD in 2011 to about 31.5 MMBD in 2015 after adjusting for growth in biofuels (+0.8 MMBD), Canadian oil sands (+1.1 MMBD), and OPEC NGL production (+1.3 MMBD). Over the same time frame, OPEC crude capacity is expected to increase by 1.4 MMBD by 2015, excluding any expansion by Saudi Arabia. Thus, 2015 effective OPEC spare capacity (ex Nigeria and Venezuela) would be about 4.8 MMBD, or 5.1% of world oil demand (2015E 93.5 MMBD). Oil markets are likely to be in reasonable equilibrium at $90-95/B crude going forward, balanced by risks to global economic growth from oil price inflation on the one hand and geopolitical risk which could disrupt supply on the other.
The global refining environment is expected to remain difficult in 2011, offering little investment opportunity until growth in world oil demand absorbs surplus capacity. Global distillation capacity is expected to increase by 9.2 MMBD by 2015, even though significant surplus capacity persists, with 40% of the expansion in China and 70% in the broader Asia and Middle East regions. China has a strategic goal to be self sufficient in light product demand. Identified global capacity closures since 1Q09 amount to 2.0 MMBD. More rationalization is anticipated but will be slowed by stringent exit regulations and the high cost of closures.
Globally, demand for oilfield services is driven mainly by the price of crude oil and oil company spending levels for exploration & development, each of which have been highly cyclical in the past. Most projects need an oil price over $75/B before spending is increased. Overall, upstream spending increased about 5% to $380 bn in 2010, still off 10% from record 2008 highs. It declined 13% in 2009. Spending is expected to increase 9% in 2011 and continue to grow thereafter. The North American oil service market overall is expected to grow at a rate in the low single digits the next few years. Secular drivers in the market include oil and gas shales, heavy oil, and deepwater after a near term delay caused by the BP spill. International activity is believed to be at the beginning of a multi year up-cycle in e&p spending. Brazil is a key focus market with expectations that Petrobras will order at least 7 and possibly as many as 14 deepwater drilling rigs in 1Q11. Economically recoverable reserves in the Tupi, Iracema, and Guara discoveries are assessed at 10.8 bn B, operating costs about $9/B, capital costs of $5/B, and transportation costs in the $3-4/B range. Pronounced growth in Russia and Iraq is also expected in 2011 and current weakness in activity in Mexico, Algeria, and Libya is not expected to last into 2011. Long term growth in the low double digits is expected in markets outside North America. Major secular drivers include the emergence of Iraq, maintaining a production plateau in Russia and the Caspian Basin, and Australian natural gas resources. Most projects outside North America need an oil price over $75/B before spending is increased. The global economy is extremely energy intensive and the cost of producing the marginal barrel is expected to rise over the next few years.
