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Outlook: Oil Price Recovery Fragile

Some degree of US producer restraint will be needed coupled with continued OPEC discipline and strong growth in world oil demand to sustain a recovery in oil prices.

Fourth quarter supply disruptions and increased geopolitical risk added more than $11 per barrel to WTI and $17 per barrel to Brent since August.

The spike provides producers an attractive opportunity to hedge their 2018 production. Whereas non-OPEC supply increased 390 thousand barrels per day year over year (YOY) in 4Q17, an increase of 2.28 million barrels per day (MMbpd) is indicated over the next 12 months. With a typical lag, U.S. oil production growth will likely accelerate from 2Q18 with added supply from Canada and Brazil. The 2018 increase in non-OPEC supply will require continued OPEC discipline and reduced production, consistent with its extended cut.

Much depends on continued robust growth in world oil demand, which was up an above trend line, 1.40 MMbpd YOY in 4Q17. After a seasonal dip in 1Q18, latest estimates anticipate a YOY increase in global demand of 1.70 MMbpd in 4Q18.

Surplus oil inventories will likely persist through 2018 with a decline to 108 MMbpd in 4Q18 based on OPEC estimates. This is still above the 5-year average but only 28 percent as large as the peak in early 2016.

WTI is at a 2-year high at nearly $62/bbl in response to pipeline disruptions and heightened geopolitical anxiety, lately concerning Iran. It is up from an average of $49/bbl for the first 9 months in 2017. In 2017, it averaged around $51/bbl; it was $43/bbl in 2016.

Geopolitical risk will likely persist in coming months, providing support for oil prices. WTI is likely to average $57/bbl in 2018, with a Brent average at about $62/bbl for the year.

OPEC Is Dedicated to Restoring Market Balance

When OPEC announced its production cut a year ago, it believed elimination of the surplus in OECD inventories would increase oil prices to $60-65/bbl. Its latest estimate indicates a surplus of 137 million barrels in October, down from a 318-million-barrel surplus earlier in the year. The surplus reached a record high in 1Q16 of 380 million barrels, above the 5-year average. The OECD accounts for 48 percent of total world oil demand.

OPEC is making progress. Current data indicates a 6-million-barrel increase in surplus inventories in 1Q18 with the seasonal decline in demand. A larger increase of 28 million barrels was expected a month ago, and a 57-million-barrel increase was anticipated 2 months ago. The outlook for world oil demand in 2018 is stronger.

The surplus in OECD inventories is now projected to decline to about 108 million barrels at the end of 4Q18, which is still above the 5-year average but only 28 percent as large as the peak in early 2016. Its elimination is heavily dependent on the growth in world demand.

The growth in world oil demand remains robust. Since 2015, global oil demand has grown about 5 MMbpd, twice as fast as the previous 3 years, supported by strong global economic growth, particularly in the OECD. In 4Q17, it will be up 1.4 MMbpd YOY to 98.2 MMbpd, which is well above trend-line.

Latest IEA estimates anticipate a 300 thousand barrel per day seasonal dip in demand in 1Q18. It is then projected to increase to 99.7 MMbpd in 4Q18, up 1.50 MMbpd YOY. China, India, and Africa lead the expansion.

November OPEC production was 32.36 MMBD, down 1.04 MMBD from 4Q16. OPEC production in 2018 is projected to remain near November levels except for a steady decline in Venezuela. A decline about 153 MBD YOY in total OPEC production in 4Q18 is indicated if supplies from Iraq do not vary significantly.

Venezuela produced 1.83 MMBD in November, down 286 MBD YOY, continuing the trend in recent years. Its worsening economic and political crisis is speeding a decline in production which will likely continue to 2019 and beyond.

Iraq’s future compliance with the OPEC agreement is uncertain. Its November production was 4.40 MMBD. Significantly above its OPEC quota. It says it must focus on rebuilding 1/3 of its territory devastated by the fight with ISIS. Its goal is to raise production to 5 MMBD.

More Rapid US Production Growth In 2018 Could Result In Lower Oil Prices

Non-OPEC production was 58.29 MMBD in 4Q17, up just 390 MBD from 4Q16. Declines in Russia, Canada, and other producers partly offset the growth in US production. Total non-OPEC production is expected to grow 2.28 MMBD next year to reach 60.58 MMBD in 4Q18.

U.S. producers are poised to resume rapid production growth in 2018. Latest data indicates U.S. liquids production will average 13.09 MMBD in 4Q17, up 787 MBD Y/Y. A still tentative estimate anticipates even faster growth over the next 12 months, up by 1.68 MMBD in 4Q18, maybe more. Primary growth will derive from the 4 major resource plays: the Permian Basin, Eagle Ford, Bakken, and DJ Basin. A risk is that production will be even higher and result in lower oil prices.

4Q17 Canadian production is 4.67 MMBD, down from 4Q16. The Keystone pipeline spill and railroad disruptions the past 2 months caused inventories to build in Western Canada. But the recent start-up of new projects will raise production by 425 MBD in 4Q18.

Russia produced 11.31 MMBD in November. It is strongly supportive of the OPEC cut extension, which indicates its production will remain relatively flat in 2018.

Other non-OPEC production outside the US, Canada, and Russia was 29.03 MMBD in 2017, substantially lower than in prior years. Latest estimates indicate a 183 MBD increase by 4Q18.

An Oil Shortage Could Develop In Later Years If Offshore Drilling Doesn’t Recover

The risk of an oil shortage beyond 2019 remains. In response, an oil price spike over $100/B would not be surprising. Roughly 52% of world oil supply is vulnerable to major depletion without a recovery in upstream spending which will require higher oil prices.

Deepwater oil production accounts for a sizable 14 MMbpd, 14 percent of world oil supply. After new fields reach plateau production for a few years, subsequent deepwater decline rates are steep, about 11 percent or 1.6 MMbpd annually. Production from the offshore drilling surge in 2011 to 2014 will be peaking in 2019 to 2021 and then a serious decline will begin without a strong recovery in offshore drilling activity.

Shallow water production represents another large 14 percent of world supply. Current shallow water annual depletion rates approximate 4 percent or 600 thousand barrels annually. Thus, the total annual offshore decline rate is about 2.2 MMbpd, substantially greater than the current growth in world oil demand, which is above average.

Only a relatively modest recovery in offshore drilling is indicated for 2018 as producers struggle with depleted balance sheets and cash flow constraints. Oil prices need to be in the $60s to stimulate a meaningful offshore recovery, and even then, it will take time.

For an in depth analysis, contact Paul Kuklinski at bostonenergyresearch@msn.com. Paul Kuklinski has selected equity investments in the energy sector for major institutional investors for over 30 years. In his experience, the future price of oil is the dominant investment variable. 

He founded Boston Energy Research in 1992 to provide independent research to large financial institutions. He was previously a Partner at Cowen & Company and a founding Partner of Harvard Management Company, which in the 1970s built a weighting over 50% in the energy sector in the Harvard Endowment equity portfolio.