We could see a pullback in prices if disappointment stems from either; however we would see this, in our view, as an opportunity to get long as demand recovers after maintenance, OPEC maintains its desire for prices above $50/bbl (Brent) and the U.S. enters the all-important driving season.

On February 17, the Joint OPEC-Non-OPEC Ministerial Monitoring Committee (JMMC – the committee responsible for monitoring the compliance with OPEC’s November 30th agreement) is due to provide a report to the organization’s members. This report will provide more clarity on how the agreement to reduce production targets by 1.2mbpd (plus an additional 600kbpd from non-OPEC) is progressing. Many are skeptical of the full commitment of OPEC members to the deal. If “cheating” occurs, when combined with an increase in U.S. production activity, it could derail the recent price recovery and drive prices back below $50/bbl. Further evidence of compliance should manifest itself in declining inventory levels in 1H17.

To date, OPEC claims to have implemented approximately 80% of the supply reduction (1.5mbpd of the 1.8mbpd target reduction). Iraq appears to have the most difficulty complying with the agreement, due largely to the lack of coordination (or perhaps lack of agreement) between the government and the semi-autonomous Kurdish region in the north. Current indications are that the country has implemented a little over half of their 210kbpd proposed curtailment. Even if we assume compliance through June, as specified in the agreement, it is unlikely that OPEC will continue all the cuts past that date. By then, demand will have accelerated enough to warrant the return of some supply, with perhaps Saudi Arabia restraining their seasonal uptick in production driven by higher domestic demand in the summer months.

Refiner maintenance season is set to begin in advance of the U.S. peak driving season

Each year, refiners enforce planned shutdowns of their refinery units for maintenance and upgrades. The resulting temporary decrease in demand can clearly be seen twice a year. This maintenance is typically scheduled when demand for refined products is relatively low – usually the fall and towards the end of the first calendar quarter. Normally, crude oil inventories build during these periods so higher inventories are to be expected. Given the current positioning among many investors, the headline risk of abnormal inventory builds during the upcoming maintenance season could lead to some temporary price weakness if investors use it as an excuse to book profits.

Nikko AM’s Global Oil Team expects prices to remain range-bound between $50-$60/bbl for the first half of 2017. As the impact of the recent OPEC agreement that reduced the target production levels for the cartel begins to take hold, the market should gradually experience a healthier supply/demand balance.

Why $50-60? OPEC cut production targets when oil was below $50 and it would not have done so if the group was not looking for a price above range of 2H16. At the time of the cut, the market was already beginning to balance but apparently was not doing so fast enough for the cartel. On the high side, prices above $60 would incentivize increased production activity at the higher end of the cost curve – specifically what OPEC is trying to avoid. If prices were to trade up to that level, OPEC would likely return supply to the market to discourage that.

The outlook for the second half of the year carries a bit more uncertainty. OPEC has committed to the production reductions through June. The group’s next formal meeting is scheduled for May 25th. The response of U.S. producers, the occurrence of supply disruptions, and the ongoing strength of EM demand will determine the group’s future strategy.

Although U.S. supply is returning to the market, the memories of early 2015 and the concerns associated with the balance sheet leverage of many U.S. producers are still fresh in the minds of many (especially U.S. bankers and credit rating agencies). Many U.S. E&P companies are currently spending all their free cash flow in capital expenditures, implying they would need to increase leverage to accelerate production growth to levels that would imperil the supply/demand balance. Of course, there have been significant productivity gains as well, so perhaps this isn’t as dependent upon leverage as in previous years, but nonetheless, more debt issuance would be required overall to achieve previous levels of U.S. production. Some point out that credit spreads have contracted, implying more availability of credit, but it remains to be seen how the market’s appetite has changed. This, combined with the fact that prices have not yet risen enough to make offshore production an attractive opportunity, should act as a safety valve to prevent a wave of supply additions to the market that would be harmful to prices.

The underinvestment by the industry of the past several years could cause a supply risk longer-term. The production from what is loosely defined as U.S. shale is currently approximately 4mbpd (about 4-5% of global supply), and some expectations are that it could grow to as much as 6mbpd over the next five years – the pace determined by the aforementioned willingness to provide leverage to the producers. This alone won’t be enough to offset the tightening effect on the market balance of expected demand growth of about 1% per annum (~1mbpd). This should help support prices over the medium term. The extraordinary capital budget reductions in the industry over the past several years have reduced investment by over $200 billion and have concentrated spending on shorter cycle projects. Over the long-term, these smaller onshore investments cannot produce enough supply to satisfy growing demand. This has the potential to create a supply risk beyond 2018 and could return prices to levels not seen since 2014 unless new production can be brought to market.

The U.S. is capable of assuming the role of swing producer in the short-term, but needs higher prices to ensure they can and will. Rig counts have already inflected and are on the rise. U.S. production should follow suit and offset some of the lost OPEC supply. The danger is that the U.S. producers lose discipline and increase production too much, and the market goes right back to where it started, with OPEC again stepping in to enforce supply discipline.

What has the reaction among U.S. producers been like since the agreement? Using DOE monthly figures through November, U.S. producers have already added over 300kbpd of supply to the market from the 2016 low in September. Rig additions since November imply that the current (January-end) production level could be over 9mbpd. Keep in mind that the 600kbpd increase from the lows (at an assumed 9mbpd) only offsets about 1/3 of the OPEC supply cut, so this amount of incremental supply is not enough to harm prices – yet.

Future U.S. government policy is likely to be a longer-term catalyst and could be a net positive for the industry. The Energy policy of the Trump administration appears more industry-friendly on the surface and may result in lower regulatory costs, more access to federal lands for resource extraction, and potential benefits from a lower corporate tax rate. Other aspects such as the Border Adjustment Tax plan could carry some risk for it.

The Trump administration is pursuing multiple goals of energy independence, fair trade, and a more attractive corporate business environment. Currently, the U.S. operates with a supply deficit for oil. We currently import about half the oil consumed in the country, making the implications of a border adjustment tax huge for the industry. Independent refining companies will be put in the difficult position of choosing either to pay a premium for domestic oil production (which U.S. producers would welcome) or be forced to import oil with an unattractive tax tacked on. Some of this will undoubtedly be passed along to U.S. consumers in the form of higher gasoline prices, although it seems likely profit margins for the refiners will be pressured as well.

On the corporate tax front, a lower U.S. corporate tax rate would most likely benefit the major integrated oil companies as well as the refiners, since many independent producers continue to operate at a pre-tax loss, even after the recent crude oil price recovery.

On the regulatory front, while it is still too early to pinpoint the impact of President Trump’s policies as it relates to the Energy sector, some general trends are likely to play out. First, it seems clear that the regulatory scrutiny of the Obama administration is a thing of the past. Trump has made industry-friendly appointments to key cabinet positions, which may result in less regulation going forward. This could manifest itself in a multitude of ways, but the takeaway is that there may be less regulatory interference with U.S. oil production going forward and there could be some benefit from less regulatory compliance cost. This should allow producers access to federal lands and will likely make things like pipeline approvals less difficult. Another potential benefit to the independent refining companies is a change in the Renewable Fuel Standard Program which could change the requirements for ethanol blending and will provide some relief if those companies are no longer required to purchase RINs. Finally, any industrial production acceleration from a government infrastructure stimulus program could catalyze increased demand for diesel, a product that is currently in oversupply, potentially resulting in a healthier refined product market balance.

Below are some key highlights from the plan outline the administration has posted online:

• “For too long, we’ve been held back by burdensome regulations on our energy industry. President Trump is committed to eliminating harmful and unnecessary policies such as the Climate Action Plan and the Waters of the U.S. rule.”
• “Sound energy policy begins with the recognition that we have vast untapped domestic energy reserves right here in America. The Trump Administration will embrace the shale oil and gas revolution to bring jobs and prosperity to millions of Americans. We must take advantage of the estimated $50 trillion in untapped shale, oil, and natural gas reserves, especially those on federal lands that the American people own.”
• “The Trump Administration is also committed to clean coal technology, and to reviving America’s coal industry, which has been hurting for too long.”

Already we have seen the following relevant actions from the new administration:

• President Trump signed a Presidential Memorandum inviting TransCanada to resubmit its application to build the Keystone XL pipeline
• President Trump signed a Presidential Memorandum ordering the review and approval of the Dakota Access Pipeline to be done in an expedited manner
• Energy Transfer Partners’ Rover natural gas pipeline has won Federal Energy Regulatory Commission (FERC) approval
• The U.S. Senate passed a resolution to overturn the “resource extraction rule” which requires U.S. companies to disclose taxes and other payments to foreign governments and now leaves Canadian and European natural resource companies with far more stringent reporting standards, potentially leaving them at a competitive disadvantage

Conclusions

Inflation

It seems likely that energy prices will contribute to accelerating inflation globally. The base effect alone of the prices in early 2017 versus 12 months ago should support higher levels of inflation. In 2016 for example, WTI prices averaged $41.69/bbl during the first quarter. Assuming OPEC stays true to their word, 1Q17 prices should average at least $10 (24%) higher. This impact moderates over the remainder of the year given the recovery in prices during the second quarter of 2016, but the base effect should remain supportive for higher inflation this year. In addition, the aforementioned impact from a border adjustment tax could further accelerate inflation. Assuming a 25% premium on WTI versus Brent due to the scarcity of U.S. supply (relative to demand) and the potential for a 20% tariff on imported goods, gasoline prices would most certainly be on the way higher in the U.S. This would contribute to inflation increases and could have multiplier effects on other things like wages and the costs of goods that have a significant shipping component.

Industry winners

Production activity is accelerating and this will return some pricing power to Oilfield Services companies with a U.S. onshore focus. Cost concessions over the past two years have been meaningful – in some cases as much as 25-30%. Expectations are that the increased activity will result in cost inflation of at least 5-10% this year, as service companies perform start-up maintenance on idle equipment, ramp up hiring, and attempt to recoup some of the sacrifices made during the downturn. Initially, this is manifesting itself in demand for sand (although sand prices appear stubbornly slow to react) and pressure pumping services. The latest quarterly results from companies such as Halliburton and Schlumberger revealed some guarded optimism for a better onshore pricing environment later this year. Pricing for offshore services likely remains under pressure given that the economics are less attractive to producers.

The return of pricing power could lead to higher prices at the pump as well if the producers can pass through a portion of it – further supporting the argument for accelerating inflation above. Exploration and Production companies should benefit too – the efficiency gains and production cost declines driven by the challenging environment of the past two years should help profitability growth accelerate in the current, more attractive crude oil price environment. Many of these stocks have already reacted to the rally in crude, so the importance of selection has increased. Second derivative beneficiaries could be steel producers and certain industrial firms.

Considerations for oil in 1H17

Given the nature of current positioning among investors, it seems likely that headline risk could cause a decline in prices as a result of profit-taking after the recent rally. OPEC’s commitment to maintaining prices above $50 seems clear and we would view a price below that as an opportunity to increase exposure with the expectation that U.S. supply will not continue to ramp meaningfully in that price environment and OPEC will take the necessary actions to support prices above that level

by Daniel Forgie, Senior Portfolio Manager

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OPEC Secretary General, Mohammed Barkindo, has indicated that he expects a deal to cut production to come from the OPEC meeting scheduled for the end of November. Critically, Russia will also participate at the meeting, with the implication being that Russia would also be part of any production deal. The US presidency is also a key factor, with president-elect Trump’s unfolding policies potentially influencing oil markets in their own way.

Our commodity expert in New York, Daniel Forgie, and one of our Senior Portfolio Managers in London, discuss the new policy and what may be behind the change in position.

Executive Summary

• Both Saudi Arabia and Russia appear to be shifting towards an agreement on production After running production at high levels for over a year we believe that there are now a number of factors which explain this, and which makes us more confident that an agreement will be made.

• A target of 5m b/d was originally quoted, but OPEC production has since increased substantially to 34m b/d as production in both Nigeria and Libya has recovered strongly.

• With the level of oversupply in global oil markets declining sharply in 2017, an agreement, if struck and adhered too, would firmly underpin oil Prices remain capped by US shale, though, and are unlikely to breach $60 on a sustained basis.

Saudi: Why Now?

Investors are currently speculating why Saudi Arabia may be about to agree to a deal. Rather than any single factor, it seems probable that there are a number of reasons for the change:

1. Saudi has been running production too hard for too long

In 2009, Saudi Arabia invested heavily to expand its production capacity, from just less than 11m b/d to 12.5m b/d. By ramping up production, though, its estimated spare capacity has declined to under 2m b/d. Some commentators believe that the effective capacity is actually below 12.5m b/d, which may mean the situation is even tighter.

One of the issues that Saudi has to deal with is the fact that much of its production comes from fields that have been in production for decades, with close to 50% of production coming from a single field, Ghawar, which started production in 1951.

The reason that many of these older fields have been able to operate for so much longer than first thought is due to injecting water below the oil bearing rock, raising the pressure and increasing the flow of oil from wells. Since 2011, Saudi Aramco has also been developing a CO2 injection project at Ghawar that it believes will over time increase total recovery by an additional 10-15%.

Water injection is a complicated technique and faces a number of potential complications. Water can leak into areas it is not supposed to reach, and some water will end up being pumped back out of the oil wells with the oil. This is known as the ‘water cut’, which is the percentage of water that is produced relative to the total liquid produced from an oil well. The higher the level at which production is maintained, the greater the potential problems, and higher the water cut will tend to be. A period of slower production would allow more maintenance and reduce the risks of medium term damage on these older fields.

2. Saudis are more confident that US shale oil needs higher prices than previously thought for meaningful production increases

Data from the US Energy Information Administration (EIA) shows that US shale oil production peaked in March 2015 at 5.33m b/d, and it now forecasts that by November production will have declined by over 1m b/d. Only firms operating in the Permian basin, which has the lowest costs, have been able to increase production, with other areas still in decline.

The US rig count has started to pick up as prices have risen to $50 a barrel, but US production is still declining in aggregate, even at these prices.

3. The Saudis need a higher oil price for revenue purposes

Despite an austere 2016 budget, Saudi Arabia is still expected to record a budget deficit of 326bn Riyals ($87bn), down from 367bn Riyals in 2015. This represents a budget deficit in excess of 10% of GDP, which needs to be financed partially by asset sales and partially by borrowing. This entailed Saudi Arabia bringing a record $17.5bn bond issue to market in October.

The IMF estimates that under the 2016 budget, the Kingdom’s fiscal breakeven price for oil drops to $66.7 a barrel, down from

$94.8 in 2015. With global demand and supply more in balance in 2016, a production cut should be more effective than before, and could allow prices to be sustained above $50 a barrel. This would reduce the pressure on Saudi’s deficit and, over time, continued growth in global oil demand, combined with the sharp fall in global investment, should sustain higher prices even if US shale oil production starts to grow once again.

The answer to ‘why now’ is probably due to all three of these issues rather than focused on a single one, but, it also means that a production cut at the November OPEC meeting could be more of a necessity than a choice. All three of these factors are also relevant to Russia, which has also been running at a high level of production in order to boost revenues. Russia also has a number of oil fields which have been in production for decades.

Pre-meeting talks in Vienna, however, resulted in both Iran and Iraq insisting that they be exempt from any cuts, and twelve hours of negotiations provided no agreement. Iran wants to increase its production from 3.8m b/d to 4.2m b/d which is the same level as its production before sanctions were introduced. Iraq, faced with rising military costs from its battle with Islamic State, is looking to have its production level frozen at 4.7m b/d. Even if both Saudi Arabia and Russia now want to reduce production a compromise with these two countries will be key to the final deal.

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