Miller/Howard Investments

Capturing Every Drop: OPEC cuts, shale production,
and framing 2017 oil price expectations

Recorded April 12, 2017
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Good day. This is Michael Roomberg, a portfolio manager and research analyst with Miller/Howard Investments. Today's podcast will discuss the major factors which I believe are at work in global oil markets and describe some of the things we are looking towards as we attempt to determine the trajectory of oil prices over the remainder of the year. Having failed to bring shale oil to its knees with its policy of aggressive production increases and bearish rhetoric in the 2014/15 time period, OPEC spent much of 2016 trying to find common ground in order to restore the cartel to its historic function of supporting prices during times of oversupply by cutting production. This process ultimately led to the supply cut agreement that was reached last fall and that went into effect on January 1 of this year.

But what does this cut mean in tangible terms, and what is the magnitude of the supply glut that this cut is designed to mitigate? During 2016, the amount of oil demanded by all people worldwide was about 96 1/2 million barrels per day. The amount of oil coming out of the ground was about 97 million barrels per day. That's a half a million barrels more than was needed. That oversupply represented an improvement from the end of 2015 when excess supply was about 1.5 million barrels per day.

This may seem small; 1.5 million barrels is equivalent to about 60 Olympic-sized swimming pools worth of oil that had no buyer, but that excess is what collapsed the price of oil in 2014 and 2015. Building each day, this daily glut eventually led to an inventory buildup of about 300 million barrels above the long-term average amount that's normally stored at any given time worldwide. OPEC's production cut agreement is focused on drawing down that 300 million barrels by creating an artificial supply deficit. In simple terms, if the world runs at a one-million-barrel-per-day-deficit for 300 days, that would achieve OPEC's goals, balance the market, and lead to a situation where supply rises again to meet steadily increasing global demand.

So, how do we get there from here? The math is fairly simple. OPEC has agreed to reduce production by 1.2 million barrels a day through the end of June. Markets are currently reflecting, in part, that this cut will be maintained through the end of the year, though the current consensus view is that the cut may be reduced in size when a second half agreement is reached. For now, a 1.2 million barrel a day cut should shrink that oversupply of 500,000 barrels per day to a deficit of 700,000 barrels per day. Additionally so called NOPEC parties, mainly Russia and Mexico, have agreed to cut another 600,000 barrels from the market supply, which added to the OPEC cut leads to 1.3 million barrel per day deficit, but world demand is also growing and should increase by 1.2 million barrels a day this year―which, added to those cuts previously mentioned, would lead to a 2.5 million barrel per day deficit, a massive improvement from the oversupply situation last year. This simple math is what's behind the oil price recovery thus far.

In recent weeks we've heard some conjecture that shale will overwhelm the market again by pushing up the supply. The context is important. Even in a dream scenario, US shale could only likely bring back about 500,000 barrels per day in 2017 versus last year. This amount is a level of magnitude below the numbers that I just discussed with respect to OPEC.

In 2018, this may be a different story, as depending on price, shale could accelerate, bringing on 1.2 million barrels of additional supply next year. But a lot can happen between now and 2018 from a global supply and demand standpoint. For now, shale supply remains a concern for a later day. For the near term, we're laser focused on OPEC as the only thing that really matters: whether OPEC complies and whether they extend the agreement at the end of June. If compliance remains high, and all signs point to the fact that this will be the case, inventory should draw down dramatically as summer driving season gets underway.

There's been some conjecture that the lack of inventory draw downs in the US, thus far, is a sign of cheating, but, rather, this is likely due to the fact that the US is the cheapest place to store oil and will be the last to decline after international inventories, including floating inventories on tanker ships, liquidate, which has been happening. The last major variable we're focused on is demand, which is primarily a function of economic growth. Simply put, demand growth is dependent upon global economic health. Any signs of a recession or a pickup in global growth could swing the supply-demand dynamic quite significantly. For context, a 2% to 3% change, plus or minus, in global GDP is probably equivalent in magnitude to an OPEC cut.

What could it all mean from a price standpoint? Excluding some sort of supply disruption or geopolitical event, if OPEC complies with the agreement and extends it for the duration of the year and if the global economy remains healthy, it's easy to envision a scenario where prices rise into the $60s on WTI. This level would incentivize significant acceleration of shale drilling activity, which would likely preclude prices from sustaining above $70 a barrel for too long. On the downside, if the OPEC agreement falls completely apart or the global economy should slide into recession, it's not hard to envision a scenario where oil slides back into the $30s or even the $20s for a period of time. I'll conclude by saying that our expectation is somewhere in between these ranges, with a moderate upward bias on prices from here.

The base case points to continued OPEC compliance and a healthy global economy and significant earnings growth across the energy value chain. But we'll be watching the developments of the next few months closely, and we hope this gives you a frame of reference to do the same. Thank you.

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