Much has been made of the recent confidence tumble in America’s Permian Basin, the low cost and prodigious shale play that straddles Texas and New Mexico. It began when Pioneer Natural Resources announced its second-quarter financial results – reporting net income of US$233 million, compared to a net loss of US$268 million the same quarter last year. But the positive results weren’t what investors focused on – it was expected, given the recovery in crude prices this year. Instead, they zoomed in on Pioneer’s decision to slash US$100 million from its 2017 capital budget, as well as anomalies within its production data – an unexpected drop in oil production that was somewhat offset by higher natural gas output (though from new wells, unusually), accompanied by higher costs. Pioneer’s stock took a tumble, down by 16% at one point, and it dragged all other Permian-related stocks with it – spooking investors that held shares of EOG Resources and RSP. Editorials and analytical notes were written furiously, warning that enthusiasm in the Permian was waning.
Meanwhile, the weekly rig count data released by Baker Hughes-GE fell by one the week Pioneer released its results. Within the topline number, active rigs in the Permian basin were flat week on week, having been the main source of rig count growth over the past year together with the Eagle Ford basin. The week after, active rig counts fell by 5, with the Permian and Eagle Ford losing 2 and 3 sites, respectively. On a macro scale, the market would cheer this as a sign that US oil production is finding a new plateau at the current level of crude prices, stuck around US$50/b. On a micro level, it is causing some jitters among Permian producers – many of whom have trimmed their spending targets for 2017 and 2018, including heavyweights Diamondback Energy and Devon Energy, in anticipation of a slowdown.
Are we about to see a collapse in the Permian? Absolutely not. After a period of rapid growth in early 2017, in response to crude prices jumping on the OPEC supply freeze pact, the Permian is merely hitting a wall of marginal gains. Permian producers raised production rapidly earlier this year, anticipating that prices would maintain at US$60/b, thereby unleashing supply that moderated prices again. With the outlook now pointing towards prices stubbornly sticking to the US$50/b level, producers are now adjusting their approach. The Petroleum Economist reports that "oil bulls and OPEC ministers who are looking for cracks in the shale recovery due to recent announcements by Anadarko, Hess and Whiting Petroleum are cutting their 2017 budgets, will be disappointed. It may just be too soon claim any victory that US shale is shutting down. EIA reports that DUCs (Drilled but Uncompleted Wells) have nearly doubled from this time last year to around 2,250. If oil remains at sub-$50, companies could start pulling rigs, and start shifting to cheaper and quicker options of completing their DUCs. This will power production growth for at least several months."
Growth in the Permian will continue through 2017 and 2018, but at a slower pace. The Permian region is projected to represent about 30 percent of total U.S. crude oil production in the coming year. Wood Mackenzie is predicting the Permain output will rise by 300,000 b/d by the end of 2017, pushing past the 2.7 mmb/d level. Meanwhile, supermajors ExxonMobil and Chevron are both increasing their presence in the Permian attracted by lower costs – the average wellhead breakeven presence in the Permian hovers around US$35/b – aiming to raise production there by 20% and 35%, respectively, from low bases. Meanwhile, Falcon Seaboard Resources just announced a US$145 million Permian fund.
Interest in the Permian isn’t waning. The ride is just slowing down, because the industry in the Permian has moved past the short, sweet period when prices rise faster than costs, and is now adjusting to that. And even the furore around Pioneer is misplaced; the company has said that the unexpected drop in oil production was short term and would be fixed in the next quarter. Pumping more natural gas isn’t a huge problem either – Permian player Parsley boosted its gas production forecast for the year in fact – since it diversifies output and total resources are still expanding. Now, in fact, might be a good time to cherry pick Permian stocks – the valuations remain good, while the stock prices have taken a beating. With OPEC, mainly Saudi Arabia attempt manoeuvring again to support prices, the Permian basin phenomenon is far from over.
P.S. for continuity of investments in the energy industry, making the right choices are key for future success. Read more about Scenario planning and the so what question a recent blog post by Henk Krijnen. Henk Krijnen will be in Kuala Lumpur this October 2017, presenting a very timely "Masterclass on Scenario Planning for Decision Making in the Energy Industry". Find out more https://goo.gl/tauq5x. If you are too busy during this period, check out our training series on “Training to Navigate Uncertainty in Oil & Gas”
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Supply chains are currently in crisis. They have been for a long time now, ever since the start of the Covid-19 pandemic reshaped the way the world works. Stressed shipping networks and operational blockages – coupled with China’s insistence on a Covid-zero policy – means that cargo tanker rates are at an all-time high and that there just aren’t enough of them. McDonalds and KFCs in Asia are running out of French fries to sell, not because there aren’t enough potatoes in Idaho, but because there aren’t enough ships to deliver them to Japan or to Singapore from Los Angeles. The war in Ukraine has placed a particular emphasis on food supply chains by disrupting global wheat and sunflower oil supply chains and kicking off distressingly high levels of food price inflation across North Africa, the Middle East and Asia. It was against this backdrop that Indonesia announced a complete ban on palm oil exports. That nuclear option shocked the markets, set off a potential new supply chain crisis and has particular implications on future of crude oil pricing and biofuels in Asia.
A brief recap. Like most of Asia, Indonesia has been grappling with food price inflation as consequence of Covid-19. Like most of Asia, Indonesia has been attempting to control this through a combination of shielding its most vulnerable citizens through continued subsidies while attempting to optimise supply chains. Like most of Asia, Indonesia hasn’t been to control the market at all, because uncoordinated attempts across a wide spectrum of countries to achieve a similar level of individual protectionism is self-defeating.
Cooking oil is a major product of sensitive importance in Indonesia, and one that it is self-sufficient in as a result of its status as the world’s largest palm oil producer. So large is Indonesia in that regard that its excess palm oil production has been directed to increasingly higher biodiesel mandates, with a B40 mandate – diesel containing 40% of palm material – originally schedule for full implementation this year. But as palm oil prices started rising to all-time highs at the beginning of January, cooking oil started becoming scarcer in Indonesia. The government blamed hoarding and – wary of the Ramadan period and domestic unrest – implemented a Domestic Market Obligation on palm oil refineries, directing them to devote 20% of projected exports for domestic use. Increasingly stricter terms for the DMO continued over February and March, only for an abrupt U-turn in mid-March that removed the DMO completely. But as the war in Ukraine drove prices even further, Indonesia shocked the market by announcing an total ban on palm oil exports in late April. Chaotically, the ban was first clarified to be palm olein only (straight refining cooking oil), but then flip-flopped into a total ban of crude palm oil as well. Markets went haywire, prices jumped to historical highs and Indonesia’s trading partners reacted with alarm.
Joko Widodo has said that the ban will be indefinite until domestic cooking oil prices ‘moderate’. With the global situation as it is, ‘moderate’ is unlikely to be achieved until the end of 2022 at least, if ‘moderate’ is taken to be the previous level of palm oil prices – roughly half of current pricing. Logistically, Indonesia cannot hold out on the ban for more than two months. Only a third of Indonesia’s monthly palm oil production is consumed domestically; the rest is exported. An indefinite ban means that not only fill storage tanks up beyond capacity and estates forced to let fruit rot, but Indonesia will be missing out on crucial revenue from its crude palm oil export tax. Which is used to fund its biodiesel subsidies.
And that’s where the implications on oil come in. Indonesia’s ham-fisted attempt at protectionism has dire implications on biofuels policies in Asia. Palm oil prices within Indonesia might sink as long as surplus volumes can’t make it beyond the borders, but international palm oil prices will remain high as consuming countries pivot to producers like Malaysia, Thailand, Papua New Guinea, West Africa and Latin America. That in turn, threatens the biodiesel mandates in Thailand and Malaysia. The Thai government has already expressed concern over palm-led food price inflation and associated pressure on its (subsidised) biodiesel programme, launching efforts to mitigate the worst effects. Malaysia – which has a more direct approach to subsidised fuels – is also feeling the pinch. Thailand’s move to B10 and Malaysia’s move to B20 is now in jeopardy; in fact, Thailand has regressed its national mandate from B7 to B5. And the reason is that the differential between the bio- and the diesel portion of the biodiesel is now so disparate that subsidy regimes break down. It would be far cheaper – for the government, the tax-payers and consumers – to use straight diesel instead of biodiesel, as evidenced by Thailand’s reversal in mandates.
That, in turn, has implications on crude pricing. While OPEC+ is stubbornly sticking to its gentle approach to managing global crude supply, the stunning rebound in Asian demand has already kept the consumption side tight to match that supply. Crude prices above US$100/b are a recipe for demand destruction, and Asian economies have been preparing for this by looking at alternatives; biofuels for example. In the past four years, Indonesia has converted some of its oil refineries into biodiesel plants; in China, stricter crude import quotas are paving the way for China to clamp down on its status of a fuels exporter in favour of self-sustainability. But what happens when crude prices are high, but the prices of alternatives are higher? That is the case for palm oil now, where the gasoil-palm spread is now triple the previous average.
Part of this situation is due to market dynamics. Part of it is due to geopolitical effects. But part of it is also due to Indonesia’s knee-jerk reaction. Supply disruption at the level of a blanket ban is always seismic and kicks off a chain of unintended consequences; see the OPEC oil shocks of the 70s. Indonesia’s palm oil export ban is almost at that level. ‘Indefinite’ is a vague term and offers no consolation to markets looking for direction. Damage will be done, even if the ban lasts a month. But the longer it lasts – Indonesian general elections are due in February 2024 – the more serious the consequences could be. And the more the oil and refining industry in Asia will have to think about their preconceived notions of the future of oil in the region.
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