February 4, 2023

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Oil climbs to a six-week high. Why it’s going much higher

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The medium term picture is bullish on demand and tighter on supply

The medium term picture is bullish on demand and tighter on supply

Tightening inventories and a willingness to look beyond the 20% demand destruction in India at the moment have boosted oil prices. WTI is up $1.24 to $64.17 after touching a six-week high of $64.32.

US inventories today were largely in-line with estimates but showed a tightening distillate market. Since then the dollar has also weakened broadly, combining to lift crude.

National Bank was out yesterday with an excellent note that makes a compelling case that a supply crunch is coming:

So, while the oil field service narrative has generally been muted under the context of upstream discipline, the Majors
are signaling the initial innings of a demand-led recovery; we suggest that global production is
potentially impaired and higher activity levels will be inevitable and could magnify the cycle through
the supply side. As an example, major market prognosticators (EIA, OPEC, etc.) suggest U.S. production
being restored towards 12.3 mmbbl/d by year-end 2022 (+12%); however, in our estimation, under the
prevailing rig count and historical rig efficiencies, the U.S. market would actually see volumes contract.
attain the suggested forecasts, spending and activity will have to be restored, and we would suggest that
U.S. oil rig counts need to average 600-650 (~2x current) to satisfy that call on supply.

This chart shows drilling relative to what’s needed to maintain current production:

WTI crude climbs above the April high

I’m a big believer in this line of thinking. It’s a classic case of the boom/bust in the oil market but it’s magnified because the usual underinvestment at the cycle bottom has been multiplied by ESG concerns and a (mistaken) belief that oil demand will imminently decline (try to square that with car sales this year!).

Oil field service companies are noting an uptick in drilling demand and are optimistic for the second half but only see activity rising modestly compared to extremely depressed levels in 2020.

“The second half of this year will see a low, doubledigit increase in international activity year-on-year,” Halliburton officials said in the Q1 earnings call.

A comment from Baker-Hughes in the earnings call:

Although the rig
count is moving higher. We believe that the commitment towards capital discipline
and maintenance mode spending remains intact among the public E&Ps.

Executives at Schlumberger laid out the case:

If you look at the recent period of under-investment, look at the
constraints in North America due to capital discipline, I believe that this will
create the condition to create a significant pull on international supply.

Oil has been consolidating in the run-up since October but it’s showing good resilience. The x-factor in the timing is when OPEC+ will return to full output. The base case has to be that they will align production with post-covid demand increases. The risk (and I believe likelihood) is that they underestimate demand and over-estimate how quickly beaten-up US producers will respond to supply. That sets up a big overshoot in oil prices, similar to what we’ve seen in so many commodities already.

Of course, supply will respond at some point but demand is generally inelastic and even a 1% imbalance can set up a spike. How high it goes is a guessing game but with all the pent up travel demand post-COVID, I see +$80/barrel coming and looking at the weekly chart, if we get to $80, there isn’t much standing in the way of a run much higher.

Oil chart daily

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