The increase in oil prices in recent weeks, in the face of rising U.S. crude stocks, suggests market participants are beginning to focus on production adjustments both in the U.S. and abroad. In January, I noted several data points that indicated oil prices were near a low. Fast forward six weeks and oil prices have risen more than 20% – which while sounding like a lot, is a paltry $6 per barrel.
This is not to say the coast is all clear yet. Relatively weak refined product markets are weighing on prices and oil inventories remain extremely high, creating near-term headwinds. But as the year progresses and adjustments accelerate, higher prices will likely ensue.
U.S. production has been trending down since peaking in April 2015, registering the first drop on a year-over-year basis in December since 2011, according to a 29 February report from the U.S. Department of Energy. It’s quite a big change from annual growth in excess of 1 million barrels per day (b/d) reported only one year ago.
The decline was centered in onshore short-cycle production, which was more than sufficient to offset growth in investment in longer lead time output in the Gulf of Mexico. Company guidance released in recent weeks suggests this direction will continue.
Non-OPEC output outside the United States is also turning lower, declining on a year-over-year basis for the first time in three years. Reduction in capital expenditures is evident on every continent and some companies have even reported closing flowing wells. While shut-ins are a drop in the bucket in aggregate, it points to challenges companies will face sustaining output when reducing maintenance expenses.
In addition, geopolitical risks have begun to reappear, which creates some upside asymmetry to market risks. Attacks on the infrastructure in Nigeria and Turkey have reduced supplies by 800,000 b/d from peak production. While pipelines are generally easy to fix, the root causes of the increase in violence and instability are unlikely to be addressed.
As to recent talks of a “deal” with OPEC and Russia to freeze output at January levels, there are a myriad of implementation issues that will greatly limit effectiveness. We are watching developments with interest, but for now we view the deal as not likely to meaningfully alter the global balance.
Despite near-term downside risk we view this as the beginning of the end of this down move. As demand growth improves this year (just returning to normal weather would be a welcome reprieve) and production declines, inventory draws starting in the second half of year should enable prices to move back to a level where producers see sufficient incentives to begin investing once again.