Oil prices have also drifted higher in recent weeks because of ongoing noise about a deal among major producers to freeze output at January 2016 levels and data points suggesting that US onshore oil production has started to decline.
Short covering has played an important role in this recovery rally. The latest data from the Commodity Futures Trading Commission shows that hedge funds covered 12.7 million barrels worth of short positions in West Texas Intermediate (WTI) future and added less than 700,000 barrels to their long positions. Overall, hedge funds’ aggregate reported bets against WTI futures remain elevated at 176 million barrels, suggesting we could see another 25 million barrels of profit taking before oil prices break decisively lower.
Recently published data from the Energy Information Administration shows that in December 2015, US oil output declined on a year-over-year basis–the first time since 2011. We expect US onshore oil production to continue to fall in 2016, offset by growing volumes from deepwater projects coming onstream in the Gulf of Mexico.
Our outlook calls for US oil production to decline by 500,000 to 1 million barrels per day next year, but this contraction won’t occur in time to ameliorate the current inventory overhang. Oil stored in Cushing, Oklahoma, has reached about 90 percent of nameplate capacity. If you back out the space needed for blending and other ancillary operations, storage at this oil hub is maxed out.
The Gulf Coast has about 110 million barrels of storage capacity, but the market has entered the part of the year when inventories build rapidly; moving crude oil to the South merely shifts the oversupply from one region to another.
Finally, the proposed freeze in oil production is a non-event.
Russian oil production stands at 10.88 million barrels per day, a record level for the post-Soviet era. The country’s oil output growth is expected to slow in the first half of 2016 because of declining drilling activity. In other words, this production freeze doesn’t amount to much of a concession from Russia, either.
We also doubt Iran would agree to freeze its output when the West recently eased restrictions on the country’s exports. Iran might consider maintaining its output at the levels that prevailed prior to the prohibitions on exports—which would imply another 500,000 to 1 million barrels per day in incremental production over the next six to 12 months.
Civil unrest has weighed on Libyan oil production in recent months; given the importance of oil revenue to the country, we doubt decision makers would agree to freeze output at reduced levels.
If Saudi Arabia were to freeze production at January levels instead of ramping up output in advance of the summer demand spike (a big if), global oil production would decline by about 500,000 to 750,000 barrels per day next summer. This move wouldn’t relieve the glut in global oil inventories that will continue to build over the next two months.
Our near-term outlook for crude oil remains unchanged. WTI prices will need to fall to between $20 and $25 per barrel over the next few months to prompt US onshore producers to shut-in production and prevent oil inventories from overwhelming capacity in key trading hubs.
The Bloomberg Global Tankers Index has given up almost 20 percent of its value since mid-October 2015 after a strong run earlier in the year. Despite this recent bout of weakness, shares of tanker companies have outperformed their peers in dry-bulk and container shipping over a similar time frame.
Although legitimate concerns have emerged about projected growth in the global tanker fleet over the next two years, much of the recent downside likely reflects profit-taking in a weak market and sympathy selling with oil prices and other shipping industries that face major headwinds.
Trading at 0.65 times book value, tanker stocks haven’t been this cheap since early 2013—even though industry fundamentals have improved significantly from three years ago. In our view, this disparity creates a good opportunity for investors to build positions in tanker companies.
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Elliott and Roger on Sep. 30, 2020
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