In June 2017 we wrote about oil prices being likely too low; a lot has changed since then. With WTI now at over $60 per barrel (and Brent almost $70 per barrel), market participants are wondering how much higher we can go, or worse yet when prices will revert. One ‘signpost’ analysts quote very often is the (Baker Hughes) U.S. oil rig count, which is published on a weekly basis on Fridays. The logic is that if oil prices get too high, rig count will rise, production will grow, and prices will be depressed. Conversely, if rig counts stay flat or drift lower, oil prices will continue to grind higher.
However, we think U.S. production growth is a foregone conclusion. And you don’t need more rigs to increase production. In fact, we don’t think rig count will be an accurate predictor of prices going forward at all (barring an unusual spike in prices; more below). We expect oil rig count will continue on a downward trend (at least 30% lower from current levels over the next few years) while oil production trends higher.
Take a look at what happened in natural gas markets post-shale gas boom that lasted through 2011. For non-energy experts, for molecular and geological reasons (among others) the shale boom started with natural gas and eventually made its way to oil. (Natural gas is different from gasoline, which is a product of refined oil.)
Click on images to enlarge.
To highlight and summarize:
- 2011-2012: Gas supply boom leads to a collapse in prices (-50%) and rigs (-60%).
- 2013-2015: Low supply leads to price spikes (+50%).
- Rig count continued to fall and production rose rapidly in response to price increases.
- 2016: Higher production drove prices to new lows, and rig count fell even further; production finally fell.
- 2017: It wasn’t until rigs were 90% lower from peak that industry reached a point of actually needing more rigs to grow production.
We think this will be analogous to oil markets:
- 2014-2015: Supply boom leads to collapse in prices.
- 2016-2017: Low supply leads to price increases.
- Rig count will flatten out first, then trend lower again, while production continues to rise.
Of course, there are significant structural differences in oil vs gas markets, most of which are outside the scope of this discussion (e.g., oil is a more global market with fluid trade, whereas gas is a more captive market; geopolitics drive oil markets much more than gas, at least in the U.S.). That said, we think that at a minimum, the enigma around what will happen to U.S. production growth will not be answered by looking at rig count growth. Should oil rig counts drift lower, this should not be taken as a bullish signal.
So, what are the signposts investors should look out for to gauge oil markets? Unfortunately, it isn’t even the DOE’s (Department of Energy) weekly production estimates that can be relied upon (presumably it has the most all-encompassing real-time data from companies, and it has traditionally been viewed as such): recently they snuck in a negative 300,000 b/d revision, which is approximately 3% of total U.S. production and 30% of prior production growth estimate. Instead, it’s back to the basics: a nitty-gritty bottoms-up diligence on individual companies’ production outlook (management guidance, track-record, and cash flow) that would paint a “better” picture. We admittedly are leaving a plethora of other drivers such as DUCs (drilled but uncompleted wells), trajectory of breakeven levels, and many many others, but those again are outside the scope of this one article.
At a high level, feedback thus far seems to indicate an approximate 700kbd-1mmbd growth level, similar to growth levels in 2017. OPEC has assumed as much in their supply-demand models. Further indications are that shale company managements teams won’t change their CAPEX programs much unless WTI rises “meaningfully”. We think those levels are in the $65-$70/ per barrel WTI oil range. So as long as oil stays in the $55-$65/per barrel WTI oil range, the industry will be in a Goldilocks stage where it can grow production ~10%, enjoy $60 oil, and (could this be true?) positive free cash flow.
But since when did oil markets ever stay in a tight band for an extended period? Leave us your feedback in the comment section below.
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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.
To view the firm biographies of RSQ, click here.