The combination of the coronavirus (Wuhan flu) and an overemotional trading frenzy has masked – and probably delayed – a development in the crude oil market: There are increasing indicators that an inversion is on its way.
An inversion occurs when demand begins to outstrip supply. Traditionally, this has been linked to some idea of “peak oil,” the situation in which the amount of crude available for lifting worldwide began an inevitable decline. The approach is founded on the argument that oil is a nonrenewable resource.
Well, that simple view is pretty much obsolete, buried under an onslaught of shale and tight oil reserves. Solely from the standpoint of what Mother Nature provides, there is plenty of oil left. The peak oil theory itself is these days cast more in terms of environmental concerns or pricing; and even then, it is not convincing.
If environmental concerns end up curtailing oil usage it will not be because there is a natural attrition in volume available. As for the pricing position, popular when a barrel cost upwards of $140, what took place for almost two years following a Saudi-inspired OPEC defense of market share made on Thanksgiving 2014 laid that one to rest.
Any inversion discussion, therefore, has little to with the peak oil folks. The one coming is a result of quite something else entirely. This is not a result of what is in the ground but the recent period of dramatic collapses in oil prices caused by a deliberate manipulation of the normal supply-demand dynamic.
Here’s What’s Really Behind the Oil Slump
The huge dive in oil from well over $100 a barrel to less than $30 dried up forward field developments for any but the most inexpensive step out wells (those drilled near existing reducing wells). Anything else was simply cost prohibitive. As the following figure clearly indicates, the capital expenditures (capex) dried up…and production to replace declining mature well volume along with it.
Now despite this, U.S.-based production has been rising, fueled by massive rises in Permian Basin extractions. That period is drawing to a close as existing volume declines and has to be replaced by more expensive alternatives.
The sector is also facing another related matter. Virtually all of the U.S. volume secured over the past several years (i.e., after the late 2014 OPEC decision) has come from half-cycle fields. These are wells were there is already contiguous production, fully completed and operational infrastructure, and a known well-head price.
This last factor addresses what the operating company actually receives in revenues and comprises the first sale to a distributor once the oil comes out of the ground. A well-head price is at substantial discount to the WTI or Brent market price provided each day in the financial news.
The lack of investment in more expensive production expansion is now becoming the cause of the inversion. And there is not enough time to flatten out the oncoming decline.
The result is pointing toward a continued constriction in capex and an inversion results.
This is also a situation that will take a while to counteract. Latest indications point toward a lagging recovery in oil field service (OFS) commitments. OFS finance is finally showing a recovery moving forward for the next several years, but the projections are not at the level necessary to open enough new fields.
Source: Westwood Global Energy
OFS involves both early upstream commitments to locate and prepare drilling sites, initial drilling, and well completion – such laying pipe and cementing to position and fill the anulus (the area between the pipe and the borehole wall).
The rise of an increasing number of DUCs (drilled but uncompleted wells) is another illustration of the finance-to-revenue quandary operators are in. Neither the pricing levels nor the market picture justifies the completion of these new drilled wells.
Most DUCs are intended to replace declining production from existing mature wells, not to contribute to an overall aggregate rise. Any spike in demand, therefore, will aggravate the situation.
Some current estimates put the inversion hitting as early as mid-summer, although most still put it later in the year.
Of Course, There Are Also Other Caveats
Demand estimates are still all over the place as the Wuhan flu continues to attract attention. It is not helping that premature claims of a drug breakthrough are fueling market advances only to have these fall back in short order.
Then there is the now inevitable move by OPEC+ (the cartel plus Russia) to advance another production cut at an upcoming emergency meeting. My sources indicate about a million barrels a day, with a Saudi assurance of additional if necessary.
Yet two matters to keep in mind here. First, the Saudis are feeling the pressure of declining prices adversely affecting the market value of Aramco. The recent minority IPO in the world’s largest oil producer is intended to provide massive revenues moving forward for investment as an instrument if diversifying the Saudi economy and addressing a spiraling budget deficit.
Put simply, Riyadh requires a higher oil price and quickly. Further production cuts will assist in this regard.
But, secondly and moving in the opposite direction, there are now strong indications that other OPEC members will be evading lower quotas and producing in excess to generate as much of their own revenue as possible. There is also some question about whether Russia will genuinely abide by whatever cut Moscow signs onto.
This means that the external forces pulling in both directions will continue to muddy the waters.
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