The Daily Update - Oil inventory and shale impact

Oil continues its positive momentum with Brent crude futures touching $61.70 earlier today. Yesterday we wrote on the positive broader impact of this on the Middle Eastern exporters and particularly Saudi Arabia, and here write further on the likely direction of US government oil inventory data and the longer term impact of US shale production capacity.

Between now and the next OPEC meeting, scheduled for the end of this month, it’s hard to envisage any major developments from the region. With the recent success of Saudi and Russia agreeing to extend supply curbs, and adherence to OPEC production limits already surpassing 92%, they have played their cards as best they can and await the US oil industry’s response. When OPEC meet it will have been a year since they first agreed the 1.8mbpd supply curb that remains in place. With Russia agreeing to cuts “until the end of 2018 as a minimum”, it is likely that Saudi will use this to convince the rest of the smaller players to fall in line and further extend what clearly seems to be working. It would be hard, however, to make convincing arguments for further cuts (and output in Venezuela has already declined more than 8% this year).

It would be difficult for them to find any feasible way to push prices higher than the current ~$60s level. “Shale” is the dirty word amongst OPEC members, and the US can ramp up production at a whim with little cost. US crude exports have jumped to almost two million barrels per day (bpd), more than enough to counteract the 1.8mbpd cut from OPEC. The vast majority of proven and probable tight/shale reserves in the US would become profitable to extract around $60-80 per barrel. This present level is practically a trigger to ramp up exploration and production (E&P). The US shale industry is aiming to reach as high as 10mbpd, from the current 6mbpd level, and output has already risen for 10 consecutive months. There is no obvious reason why this trend won’t continue. The fact that Brent touched below $45 little more than 4 months ago may create a little hesitancy to ramp up production in traditional drilling, but not for shale. And even the Baker Hughes Total World Oil and Gas Rotary Rig Count, at 2081, is up almost 50% from June 2016 lows. Such is the sensitivity of supply at and above current levels. You can see hints of the US driving this supply in the price difference between WTI and Brent futures: which touched a high of $7 yesterday; such wide a spread not seen since August 2015. With today’s US Total Change in Crude Oil Inventories reading at -2,435 only one of the past six readings has been positive. This was lower than the expected -1,600 (the historic average for December) but oil prices still dipped half a percentage point on the release; perhaps markets were hoping for even more upside for oil. But even with winter approaching and declining inventories breaching this resistance level looks to be a struggle, especially as a likely uptick in US production could soon increase inventories in coming weeks.

With OPEC fiscal breakeven prices ranging from $47-95 we touched on how some states are much better protected from bouts of low prices or sustained periods of sub-$60 oil prices (this December will mark the 3rd year of sub-$60 oil). Many of the states (all the ones we would consider investing in) are investment grade, strong Net Foreign Creditors and whose fiscal and external oil breakeven points are modestly above or even below current and recent average oil prices. Whereas we talked of Saudi’s $70 fiscal breakeven oil price not being of any real concern, given their huge pile of reserves and an enormity of proven and easily accessible liquid gold; other countries we invest in, at current levels, actually become noticeably profitable again which may afford investment opportunities not feasible for others.

We wrote how Qatar and Kuwait now both have fiscal breakevens of $47; to put this into perspective Brent has traded below this level just 10 days in the past 11 months with the average price of Brent for the past 12 months at ~$53. At prices as high as $60 Qatar is making 13 bucks on each of the 1.5m barrels of oil it produces each day beyond covering all its typical expenditure, and whist continuing to pursue more sensible economic policies. Moreover it remains one of the highest income countries with GDP per capita of $60k and is one of the largest net foreign creditors as a percentage of GDP. Yet Qatar Aa3 rated bonds still offer attractive yields with the 2030s yielding 4% which is a spread of 150bps over US Treasuries where, according to our models a typical Aa3 rated bond of like duration would yield only 3% with spread of just 50bps. This additional yield and the counterbalancing vast economic strengths we believe more than offset and compensate for the assumed risk.

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