In a hindsight it is clear why oil and equity markets tanked last week. Overoptimistic equity investors became disillusioned with the lack of tangible progress in the fight against Covid-19. Although global manufacturing and service indexes have recovered impressively from the March bloodbath the future is becoming more uncertain than before. Infection rates are on the rise again, there are localized lockdowns introduced in a growing number of countries hindering regional economic growth and the number of unemployed is failing to fall significantly. This leads to dismal oil demand growth as reflected in last week’s weekly and monthly EIA report. US distillate and gasoline consumption were both down whilst global oil demand for the second half of the year was revised down by 240,000 bpd. Next year’s forecast is 560,000 bpd lower than last month.
Oil dances to the tune of demand considerations – when forecasts are optimistic prices strengthen and vice versa. Last week gloom set in. Front-month WTI lost $2.44 and settled at $37.33/bbl. Brent shed more of its value and closed $2.83/bbl lower at $39.83. Money managers deserted oil, amongst other risky assets, and cut their combined WTI and Brent net speculative length by 125 million bbls or by 24%. This is the lowest weekly reading since April and it clearly shows investors’ reluctance to commit themselves for a prolonged period of time.
When demand concerns are in focus the last thing the market needs is bearish developments on the supply side. The OPEC+ group is trying hard to do whatever it can to deplete bulging global oi inventories. They have been greatly aided in their efforts by involuntary cuts from Iran, Libya, and Venezuela. The North African OPEC member, however, might not provide further price support. The leader of the Libyan National Army, commander Khalifa Haftar is reportedly inclined to lift the country’s 8-month blockade on oil facilities and allow the full re-opening of the energy sector. Of course, reaching last December’s output level of 1.14 mbpd will not happen overnight but every single extra Libyan barrel added to the market will further discourage oil bulls. Short-term support might come from tropical storm Sally, which is forcing producers to evacuate in the Gulf of Mexico, however, demand concerns are likely to drive sentiment and prices in the foreseeable future.
Investors have not given up on shale producers yet
The current pandemic has done enormous damage to every part of the global economy and oil producers are no exception. Some went bankrupt, some had to file for Chapter 11 in the US and others were forced to lay off workers and cut capital expenditure significantly. The economic downturn and the consequent demand destruction could not have come at a worse time for oil producers and especially for US shale companies. Even before the virus outbreak investors had been demanding return on their investment and had refused to pour more money into shale sector. The health crisis has only magnified the problems.
Recent estimates and revisions on US oil production are telling and are a good reflection of the difficult situation shale producers have found themselves in the recent past. US oil production for this year and next has been revised down from 13.30 mbpd and 13.71 mbpd in January to 11.38 mbpd and 11.08 mbpd this month. Shale output that was 9.15 mbpd in March tanked to 6.75 mbpd two months later. Output from the prolific Permian Basin declined from 4.88 mbpd to 3.71 mbpd between March and May, according to the EIA.
The price crash in March and April forced oil producers, majors and independents, to write down assets and to deepen spending cuts in their efforts to shore up their balance sheets. The CEO of one of the US independents said in July that the incumbent generation of oil traders will not see US production reaching 13 mbpd again. And it is not just producers that have suffered. Oil service companies, the likes of Schlumberger, Halliburton, or Baker Hughes, have also started to shift their focus away from the US and look for opportunities somewhere else.
The pandemic did indeed land an almost unbearable punch to the US shale sector. It would, however, be premature to write the eulogy of the industry. Firstly, the EIA, in its monthly Drilling Productivity Report sees a substantial uptick in shale production. The latest one, published in the middle of last month, shows a sizable growth in shale output since the bottom of 6.75 mbpd was reached in May. LTO production is expected to have recovered to 7.55 mbpd this month. Whilst it is still well below the high seen last November the recent trend can be viewed as encouraging.
Secondly, investors also see renewed potential in the sector. It is laid bare by the fact that shale producers’ share prices have maintained their relatively close relationship to oil prices. The shares of one of the most reliable players in the Permian Basin, Pioneer Natural Resources, for example, have faithfully followed the price movements of front-month WTI. As global demand destruction took hold and the price war between Russia and Saudi Arabia broke out in March its share price fell below $60 from $160 at the beginning of the year. As the US benchmark bottomed out so did Pioneer’s share price and started its upward journey in the second quarter of the year and popped back above $100 in August. Correlation between its share price and WTI has been a respectable 86% year-to-date.
Barring any negative development caused by the pandemic next year’s supply-demand balance is expected to be tight, especially if the OPEC+ alliance lives up to expectations and sticks with its output agreement. This will logically lead to global inventory depletion and higher prices, which, in turn, will make shale producers an attractive investment. The likely revival of the industry will be led by growing demand and stronger oil prices.