US Shale will crush OPEC's dream rally

US Shale will crush OPEC's dream rally

The resurgence of U.S. shale will undermine the OPEC-fueled price rally, capping oil prices at roughly $50 per barrel through 2017. That is the conclusion from the EIA’s latest Short-Term Energy Outlook, which forecasts WTI to average $50.66 per barrel and Brent to average just $51.66 per barrel next year.

The agency also cast doubt on OPEC’s ability to follow through on its deal. “The extent to which the announced plans will be carried out and actually reduce supply below levels that would have occurred in their absence remains uncertain.” But even if they do, any price rally above $50 per barrel will merely spark a revival in U.S. shale drilling, which will “encourage a return to supply growth in U.S. tight oil more quickly than currently expected.” In other words, the OPEC deal won’t fuel the sustained rally that oil bulls have hoped for.

In fact, the oil bust could persist for another year, according to the EIA. Rising U.S. oil production next year will postpone the projected withdrawals in oil inventories, pushing drawdowns off until 2018. In fact, the EIA actually projects inventories to climb once again, rising by 0.8 million barrels per day (mb/d) in the first half of 2017. For the entire year, inventories could build at an average rate of 0.4 mb/d. In other words, the EIA does not expect the global supply/demand equation to come into balance until the end of next year, a much more pessimistic prediction than the markets have come to expect, especially following the OPEC agreement. One prevailing theory about the state of the oil market before the OPEC deal came from the IEA, which forecast a convergence of supply and demand by the middle of 2017. The OPEC deal was supposed to accelerate that adjustment, tightening the market and moving up the “balance” to early 2017.

But the EIA is much less bullish. That is because of the expected rebound in shale production. The U.S. shale industry has succeeded in lowering the cost of drilling, as rock bottom oil prices forced efficiencies throughout the supply chain over the past two years. Even at today’s prices, a lot of shale drilling is profitable, especially in the booming Permian Basin. The agency expects overall production to be essentially flat, but supply would grow if prices increased from current levels.

The EIA found that a group of 91 publicly-traded international oil companies reported a collective profit in the third quarter of this year, the first quarterly profit since the end of 2014. The 91 companies earned a combined $2.3 billion in the third quarter, up sharply from a $54.1 billion loss in the third quarter of 2015, despite Brent prices dropping from $51 per barrel to $47 per barrel over the same time period (see chart).

That demonstrates the remarkable reduction in drilling costs, although it also captures the fact that the industry has written off so many assets over the past two years (which lower quarterly earnings figures) that there are fewer assets to write off these days. The damage is done and companies are starting to emerge from the wreckage.

The upside for oil prices is that demand could be stronger than previously expected next year. The EIA revised up its demand forecast for crude oil, which is set to grow by 1.4 mb/d this year and an additional 1.6 mb/d in 2017. But those numbers are debatable – the IEA has a more bearish take on demand, predicting growth of just 1.2 mb/d this year and next.

Higher oil prices, should they occur, could also have a self-defeating effect on demand. As Michael K. Farr, President of Farr, Miller & Washington, writes in CNBC, the price rally will be due to restricting supply and not necessarily because demand warrants higher prices. “In a tepid economy, like our current one, supply-driven price increases act as a tax and slow discretionary consumption. As gas prices rise for consumers, there is less money left over for discretionary spending and savings.” Demand-driven price rallies are much more sustainable, but that is not what we have today. Add to that the fact that the dollar has strengthened significantly and the Federal Reserve is set to hike interest rates this month, trends that act as a drag on any price rally. So, despite the euphoria surrounding the OPEC deal, we could be right back where we started – a slowly adjusting oil market that is still a bit oversupplied, at least for much of next year.