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OFFON

Jordan
Dufee

Analyst
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The US challenges OPEC for oil supremacy

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03/13/2019 | 11:54am EDT

OPEC's policy of limiting production, including partners such as Russia, seems to be bearing fruit. If we only consider the evolution of crude oil prices since the beginning of the year, which have risen by 22% and 24% respectively for European and American references, this is even a great success for the cartel and its legitimacy. Nevertheless, this inflation in oil prices is not to the taste of the White House, which sees it as a loss of purchasing power for American consumers.

Donald Trump is not happy with OPEC... but paradoxically, the rise in oil prices benefits a whole section of the American oil industry. This seriously complicates OPEC's efforts to achieve a sustainable market balance.

 
Evolution of American oil production - source: EIA

The shale boom has only just begun

Proof of this is that, by reaching a rate of 12.1 million barrels per day (mbd), American producers have never extracted so much oil, refuting the redundant ideas of a future collapse of American shales under the constraints of its technical and economic challenges. More concretely, the shale industry is undergoing a profound transformation, with small and medium-sized companies giving way to powerful majors such as Shell, Exxon Mobil and Chevron. With them, technological progress is taking place in giant steps and is accompanied by production prospects that are beyond comprehension. To support this statement, it is necessary to review the guidance provided by Chevron and Exxon Mobil during the last few investor days.

To make it short, the two giants plan to triple their shale oil production in 2018 over the next five years. In the Permian Basin alone, straddling Texas and New Mexico, Exxon has revised its production forecast from 600,000 barrels per day to 1 million in 2024, while Chevron has increased it from 650,000 to over 900,000 barrels per day in 2023. (See graph below).
 
 
Chevron's production evolution in the Permian Basin - Source: Chevron Investor Presentation
 
 
 
Evolution of Exxon Mobil's production in the Permian basin - source: Exxon Mobil investor presentation.

Permian productions far exceed the 2017 and 2018 forecasts for both Chevron and Exxon Mobil. Future extraction rates remain strong.

These prospects may seem at first sight fanciful, even foolish, if we do not take into account the continuous progress made in engineering and oil exploration, which drastically reduce production costs. On the basis of Chevron's data, we are talking about a decrease of around 40% between 2015 and 2018, boosting the thesis that "shale oil" requires a high price per barrel to be profitable. At least that's what Michael Wirth, CEO of Chevron, suggests, saying that shale yields are the highest in the company's portfolio. Similarly, Exxon Mobil argues that its Permian operations would generate an average return of more than 10%, even with a barrel of crude oil at USD 35. Beyond the communication exercise, these oil giants justify increasing their spending on shale oil, which, due to high depletion rates, requires continuous investment.

But what to do with all this oil?

One could rightly say that the rise of US oil serves the desire for energy self-sufficiency, legitimate for the world's leading economy. However, this amounts to completely ignoring the specificities of the oil markets in terms of quality. Oils derived from shale hydrocarbons are extremely light and low in sulphur (API > 31.1° for a sulphur content < 0.5%). The problem arises downstream of the supply chain, when refiners have to make their "product mix" to produce finished products, ranging from bitumen to diesel.

Without going into detail, these very light oils must be cut with heavier crude references to keep refineries running at full capacity. In other words, the United States must and will always have to import oil of a heavier quality, like that of its Canadian neighbor, from the oil sands. In this context, it is wrong to think that the United States remains entirely autonomous in terms of energy.
 
Classification of the different origins of oil by API and sulphur content - source: EIA

The right question is rather to ask "what to do with all this light oil", which the United States will have on its hands. At the risk of saturating the American market and feeding national stocks, the United States is stepping up its export efforts.
 
 
Historical evolution of US crude oil exports - source: EIA

A historical perspective makes it easier to understand the revolution that the rise of shale oil represents for the American economy, which is tending to become a net exporter of petroleum products. In addition to the progress made in acquiring high-capacity oil terminals (and the resulting setbacks, with delays in new infrastructures such as pipelines), every effort is being made to gain international market share.

A future American supremacy on the oil markets?

The United States has a wide range of weapons, the most formidable of which are probably US sanctions and lobbying. Overall, within the commodity chains, geopolitical and industrial interests are closely linked.

As such, US sanctions aimed at suffocating Iranian crude oil exports are destroying supply. Import contracts are being jeopardized, leading many countries to diversify their sources of supply. India, 75% of whose crude oil imports come from OPEC member countries, including Iran, has signed an annual contract with the United States under bilateral agreements. Similarly, many states, such as South Korea, grant a freight discount for imports of crude oil not originating in the Middle East, making US oil more competitive.

Although it is extremely difficult to quantify the substitution of Iranian oil by American oil, due to the confidentiality of supply contracts, the ability of the United States to gain market share from OPEC cannot be ignored.

Another way to sell light oil is to change the rules of the international trade game. Failing to destroy the supply of a competing country, the idea remains here to gradually replace certain uses of heavy oil with light oil. Probably the most striking example remains the International Maritime Organization's (IMO) decision to reduce the maximum sulphur content of fuel oil from 3.5% to 0.5% as of January 1, 2020. Understand here that we are going on a crusade against heavy fuel oil, in the name of a fight that is intended to be ecological, but which still arranges the financial interests of the American majors who must sell their future stocks of very light crude oil well.
 
Consumption by fuel type of international maritime transport - source: EIA

A profound change is taking shape in maritime trade, which will consume a significant share of light oil from 2020 onwards.

The environmental footprint of marine fuel oil has been known for decades, but the regulation for light oil is only about to come into force now, in the era of American shale oil, a happy coincidence. Unless the active lobbying of oil groups that sit more or less on the IMO through non-governmental organizations such as the Oil Companies International Marine Forum have had their say?

What about OPEC?

Although the historical cartel retains some legitimacy in regulating oil prices, with its policy of oil quotas, OPEC is taking the risk of losing market share.

The Organization learned the lessons of an open price war with the United States in 2014, which proved to be more destructive for members heavily dependent on hydrocarbons than American shale producers. The instruction thus seems clear: it is a question of maintaining budgetary balances by supporting oil prices. Communication is therefore carefully planned, as would a central bank, in order to anchor price expectations upwards.

This policy has one limit, not the least of which is to test the ability of OPEC members, but also of its partners, to lose market share internationally. Not all members have the same resistance to cash out these potential "shortfalls"; this will sooner or later lead, as with any agreement on commodity markets, to non-compliance with the agreements. 

Unknown variables

Driven mainly by the demographics of emerging countries and the emergence of a global middle class, oil consumption is set to increase in the coming years. Nevertheless, the pace of this growth raises questions from specialized agencies such as the International Energy Agency (IEA), which regularly discusses the consequences of a slowdown in global growth on crude oil demand. More concretely, fears focus on the economic slowdown in China, a country that has accounted for more than half of the growth in oil demand over the past decade.

The second unknown highlighted by the IEA concerns longer-term investment expenditures in global productive systems. The latter are obviously a function of the investment capacities of oil companies but also of the financing conditions, which are intended to be increasingly strict in the context of an increase in bond rates. Some observers do not hesitate to sound the alarm about a future structural market imbalance, which could not satisfy too much demand if nothing is done to stimulate investment. It is obviously too early to talk about an oil shock, especially if the miracle of shale oil is realized, by thwarting all forecasts once again.

Jordan Dufee
© MarketScreener.com 2019
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