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The Devil in the Oil Fields

Posted by Joseph Trevisani on Dec 7, 2016 3:55:35 PM

The self-limiting nature of the OPEC deal on crude production surfaced this week after West Texas Intermediate reached its highest barrel price in sixteen months on Monday.

The U.S. crude standard (WTI, CL1 generic) was trading at $49.94 on the Nymex in New York in the late afternoon on Wednesday, 2.5 percent below its intra-day high at $51.20 and 4.7 percent beneath Monday's peak of $52.42.

Wednesday’s price decline came after the Energy Information Agency (EIA) in the U.S. increased its oil production forecast for this year and next, domestic exploration companies employed the greatest number of drilling rigs since January, and sources within the Organization of Petroleum Exporting Countries (OPEC) told Bloomberg that the organization would accept natural output declines as part of the 600,000 barrel a day in reductions agreed with non-OPEC members, primarily Russia.  

The EIA boosted its current estimate for U.S crude production for 2017 to 8.78 million barrels a day from 8.73 million barrels in November and increased its 2016 forecast to 8.86 million barrels from 8.84 million barrels. 

Baker Hughes, the oil field services company reported that the active rig count in the United States rose 6.6 percent to 580 in November from the previous month. The rig count in Canada jumped 11 percent to 171.  

Drilling rigs are used as a measure of industry appetite for investment in new exploration and production and are closely influenced by the outlook for prices and demand.

On November 30th, the Organization of Petroleum Exporting Countries, (OPEC) announced that it had reached a deal to cut production among its members by 1.2 million barrels a day beginning in January, its first production limit in almost a decade.  Saudi Arabia, Iraq, the UAE, Kuwait and Qatar agreed to reduce production, Iran accepted a cap and non-OPEC member Russia said it was willing to limit its output.

Crude oil soared 16 percent in the four sessions following the deal, from its close on the 29th at $45.23 to $52.42 on December 5th.  

The deal brought to an end the Saudi sponsored attempt to drive North American shale producers from the market and damage its Middle Eastern political rival, Iran, by forcing prices lower with unfettered production. 

As viewed from Persian Gulf two years ago the cost of crude production was the lever to limit the burgeoning supply of oil from the North American shale fields.

Production costs at American oil shale and Canadian oil sands fields were, because of the more complicated process of extracting the crude, initially far more expensive than the existing fields in the Middle East and Russia.  

When barrel prices for WTI were over $90 as they were for most of 2013 and 2014, the North American shale producers could profitably bring as much oil to market as they could pump.  But rising U.S production threatened to eliminate the Saudi role as the world’s largest swing producer and potentially replace Middle Eastern imported oil with domestic U.S. production. 

The high production cost of shale producers, estimated in a wide range from $40 to over $80 depending on the location, was seen as an exploitable weakness. If prices were forced low enough for long enough, many North American shale produces would be driven out of business. The eventual restriction of supply would move prices higher.  

As the crude oil price fell from over $105 a barrel mid-June 2014 to just under $30 a barrel by February 2016, the number of U.S drilling and exploration rigs in operation collapsed, plunging 79 percent from 1930 in September 2014 to 408 in May 2016.

But U.S. production was not erased from the world market. In roughly the same period U.S domestic crude production dropped only 11 percent, from 9.267 million barrels a month in April 2015 to 8.580 million barrels in September 2016. 

Three factors have limited the impact of crude prices on U.S production. First the cost of shale production has fallen dramatically.  While most shale oil is still more expensive to produce than the traditional extraction fields in the Middle East and elsewhere, many North American producers are now competitive down to $40 a barrel or even lower

Second the majority of crude production expenses are the sunk costs of exploration and initial production. Once the well is active running costs are a fraction of the original outlay.  Production at an individual well can be mothballed until prices rise and then returned to operation relatively quickly and inexpensively. 

Third and probably most important, many Middle Eastern and foreign producers, including Russia are dependent on oil revenues for a large portion of their national budgets.  The pressure of domestic finances in Moscow, Riyadh, Baghdad, Kuwait City and Tehran are as intense as those in the office of any shale driller in Alberta, Texas or Oklahoma.  

The price boom in crude oil from 2011 through 2014 has transformed the industry, helping to create a new technology that in turn has installed a permanent lid on prices.

As the old commodities axiom truly states, 'The cure for high prices is high prices’. ". 

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Charts: Bloomberg

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