Crude oil price and demand recovers, why U.S. production remains slow?

 Crude oil prices and petroleum demand in the U.S. have recovered pre-COVID-19 pandemic level. However, the recovery of crude oil production in the world's biggest producer is far delayed. What is the reason? 

Crude oil production in the U.S. doubled during the 2010s due to the shale revolution. It reached 13 million barrels per day level as of pre-COVID crisis end-2019. Then the global loss of demand led the output level to below 10 million bpd and the current level is about 11 million bpd. Production in end-2022 is expected to be only 1.2 million bpd higher than end-2020 despite petroleum demand is seen to grow 1.9 million bpd in the same period.

Meanwhile, current crude oil prices are at the highest level since 2014 as supported by anticipated demand recovery and a solid alliance of OPEC+ nations. This price increase has led active oil rig count to above 400 in shale-producing regions in the U.S. It is doubled from a year ago when the COVOD-19 crisis damaged seriously, but 45% lower than the same period in 2019. Usually, rig count tracks crude oil prices with a 2-3 months delay as drilling needs such readiness period. However, we know that crude oil prices had already recovered to the 2019 level in early 2021. 

Then, let's look at another factor. It was natural that rig count dropped significantly in the first half of last year due to the pandemic, but the number of active rigs has started decreasing gradually in early 2019 before that. Because, West Texas Intermediate, the benchmark crude price in the U.S. dipped from about $70 per barrel to below $60/bbl. There are some different ideas about the break-even point for crude oil production and it should vary among regions. But a survey conducted by Dallas Federal Reserve Bank shows about $30/bbl for existing wells (except for Eagle Ford where shows below $20 costs), and around $50/bbl for new wells are replied from exploration and production firms. In other areas than Permian and Eagle Ford, break-even for new shale oil wells is seen at $58/bbl.

Since the production and exploration costs are not changed significantly in the past few years, motivation for development is most likely to fade if prices decline below $60/bbl.

Capital expenditure Index by exploration and production firms started decreasing from Q4 2018 when the expected year-end crude oil price was lower than $60/bbl, then recorded zero growth for the current quarter and negative growth for the next year in Q3 2019. In 2020, a more serious situation forced many firms including large entities to file bankruptcy.

Forecast for year-end price recovered $60/bbl again in Q1 2021 and Capital expenditures became positive for both the current quarter and the next year. Although the expenditure index is even higher in Q2 2021 as the expected year-end price is higher, it is still not enough to recover from the slump in 2020. Even though, capital expenditures are likely to expand, as firms have high motivation with over $70/bbl crude oil prices unless demand fears could depress prices. 

Despite such expectations, production is not anticipated to update the historical level by accelerating the speed of recovery. The growth of crude oil output in 2021 is forecasted at only 300,000 bpd. It is because of the slow recovery of rig count as well as a sharp decrease in the number of drilled but uncompleted (DUC) wells.

DUC means the wells drilled but waiting for completion of the fracking and other works. The completion usually takes 2 months period and a lot of costs. Typically, when developing shale wells, 35% of costs are used for drilling and 65% are spent for completion.

Since late 2018 when investments slowed down due to unclear price expectations, the number of completed wells that can start production soon decreased but DUC increased in contrast. DUC is usually created to wait for favorable market conditions or to extend the leasing contract for the mining area. However, more than 8,000 DUC wells versus about 1,250 completed wells were an extraordinary situation.

As DUC wells are typically not maintained for more than 2 years, sharply increased DUC wells in late 2018 have started decreasing with high speed in late 2020. Since the number of completed wells is increasing slowly, most DUC wells are likely to be abandoned. Although the balance of wells' number may be becoming healthy, it is not a hopeful situation. Many firms are forecasting that both start production and keep waiting for the favorable market are not continually profitable solutions.

The crude oil market is fluctuating by unclear demand expectations based on contrary factors of spreading corona variants and expanding vaccination. Although price and demand may recover relatively faster, supply that needs capital expenditure can't retrieve the ordinary situation in 1-2 years.

Paradigm shift in supply/demand could boost the crude oil price

Amid many assets are losing their value globally due to the shrinking economic activities triggered by the pandemic of COVID-19, the crude oil market has shown plunge as well. Besides pessimistic forecasts for petroleum demand, collapsing a joint production cut system that has underpinned crude oil prices also accelerates panic in the market. Meanwhile, we can see the possible formation of a new order in the crude oil market.

NYMEX WTI crude oil futures front-month contract had remained in a range bound between $50/bbl and $65/bbl since the beginning of 2019 until mid-February this year. However, pessimistic sentiment triggered a free fall to below $20/bbl after late February. There are some predictions that crude oil prices could show a further decline to below $10/bbl or about $5/bbl.

The latest monthly reports by OPEC and the International Energy Agency downgraded their forecasts for global petroleum demand in 2020 by about a million barrels per day from their previous month reports. Since they previously expected world oil demand at 100.1 million bpd, the revision is only about 1%. But IEA is still amending their forecasts and global petroleum demand could dip by 2 digits, according to their current opinion.

Despite such a significant forecast for fading demand, OPEC and its alliance partners including Russia failed to extend current agreement to cut production beyond end-March. Saudi Arabia and Russia are going to start the price war with increasing supply. Although current production curbing is cutting 2.1 million bpd from the output in October 2018, boosted production could lead the market to over-supply by up to 4 million bpd after April.

Global oil output in October 2018 when OPEC+ set baseline for the existing production curb was 102.53 million bpd, while production in February 2020 was 100.26 million bpd, according to the U.S. Energy Information Administration. Production cut by OPEC+ has been mostly offset by increasing U.S. shale oil supply. Meanwhile, decreasing supply from Iran and Venezuela that are under sanction and from Libya where civil war suspends oil output has made world petroleum balance of supply and demand equation. However, the situation will be changed drastically to historic oversupply.

Production curbing by OPEC did not comply at all for long years in the history, then the organization stopped setting the production quota in December 2015. However, disorderly massive production caused sharp price decline and new joint production curbing was resumed with involving alliance partners including Russia in January 2017. High compliance with the output cut has sustained the market afterward.

Only Saudi Arabia has kept high compliance and other major producers such as Iraq and UAE have not met curbing targets. Production in Russia, the giant among non-OPEC alliance nations has not been reduced significantly as well.

Saudi's desperate change in its production policy shocked many producers. Even the U.S. that has irresponsibly enjoyed the fruits of production curb by OPEC+ is considering participating in a new joint output cut. If the U.S. tries to make Saudi to resume output limit, it is not at all persuasive as they have increased production as much as they like, against Saudi's consistent effort. However, if the U.S. proactively joins curbing, a great shift for paradigm would be seen.

When we see the historical correlation between supply and demand balances with prices, more than 2 million bpd of excessive supply usually depressed prices by $20-$30/bbl, thus more than 3 million pbd of consistent oversupply should generate further extreme price slump.

However, we are unable to say that the current crude oil market is driven by supply and demand as prices are declining ahead of the major change of supply/demand. In the fundamental factors driven market, prices typically lag to change of supply and demand balance. Therefore, the current crude oil market is drove by speculations and the situation relatively resembles a speculative market accelerated by guess over geopolitical risks.

Since it is difficult to predict how long the COVID-19 pandemic continues with what scale, how shrinking economic activities affect the global economy is unclear as well. Thus it is natural that anxious sentiment rules the market.

However, industrial activities don't have so close correlation with petroleum consumption than many people estimate. The industrial production index in the U.S., China, and Japan over the past decade only has 0.41-0.48 correlations with crude oil throughput. For the past 5 years, it decreases to 0.2-0.3 which has almost no correlation.

Crude oil processing in China in Jan-Feb only decreased by 3.8% on year despite its industrial production index fell 13.5% from a year ago. March month to date crude oil throughput in the U.S. dipped only 1.4% on year, while petroleum products delivery increased by 0.5% on year. Although crude oil demand in Japan shows 8.3% on year decrease in the first half of March, the figure includes impact by the consumption tax hike. In February when COVID-19 didn't give so significant influence in Japanese society yet, crude oil throughput fell more than 9% on year.

In conclusion, the impact on global petroleum demand by shrinking economic activities is likely to be smaller than most expects. Meanwhile, the same as cooperation on production curbing between OPEC and non-members like Russia was generated by price tumble in 2016, current price collapse could build new output curb systems that include the U.S.

Although panic in the market may persist until the rising number of COVID-19 infected people will peak out globally, then the oversold crude oil market can surge with absorbing speculative funds boosted by ongoing monetary easing.

Japanese petroleum demand has decreased to same level as 1960's

Refinery crude oil throughputs in Japan during the first half of October dropped below 2.5 million barrels per day for the first time since the late 1960's, according to data released by the Petroleum Association of Japan. 

The nation's petroleum demand basically has shown a downward tendency after peaking out in the middle of the 1990's. Even so, recent slump presents an impression that irreversible direction led by the change of social structure is accelerating the decrease regardless of the economic cycle.

The real gross domestic product in Japan indicates relatively steady growth after lowered by the global financial crisis in 2008 and the regional heavy earthquake in 2011. However, crude oil throughputs keep apparent decrease since even before the financial crisis. 

The recent breakdown for petroleum products shows that motor gasoline accounts for 31% of the total production, while 24% are gas oil outputs followed by fuel oil that is used for electric generation and industrial fuel, then petrochemical naphtha etc. Thermal power generation also uses low sulfur crude oil besides the fuel oil. Typically, 20-30% more amounts of fuel oil than crude oil are utilized for the purpose.

Regarding automobile fuels that are the majority of Japanese petroleum products, we have concerns about slowing down of domestic car sales especially for young generations. Although the number of passenger vehicles owned keeps steady growth since the beginning of this century despite the slow sales, fuel demand doesn't track the same path. Gasoline production has deepened decrease after the 2011 earthquake.  Constriction of household spending seems to be one of the major causes as well as increasing hybrid cars. Meanwhile, gas oil output is not impacted by a gradually decreasing number of tracks owned. Track utilization rate in the transportation industry looks to be rising. Industrial efficiency is improving but consumer spending is shrinking.

The petroleum industry is also pursuing efficiency. The total oil refinery capacity in Japan has been scrapped by 25% in the 2010's after utilization rates had dipped to the 70% level in the late 00's. The operational efficiency in the oil industry has improved significantly through the aggressive streamline of facilities.

What has occurred about electricity generation fuel that is the next major usage following motor fuel? There were 59 nuclear units with a total of 51 million kW of power generation capacity before the serious earthquake in March 2011. All those units ceased operations due to damage or security inspections. Then only 9 nuclear units have been approved to resume. Current total available capacity is 9.1 million kW. 22 units including those in Fukushima-1 and 2 nuclear power plants will be scrapped, and no specific restart plan has been decided for rest of units. Nuclear power accounted for 27% of the total electricity generation in Japan in 2010; however, it was merely 3% in 2017.

Electricity supply in Japan was in the severe turmoil after losing the entire nuclear power generation. There were many aged thermal power units urgently resumed from the idling status. However, such high necessities for oil-burning power was finished in 2012, and it was already backing to the normal level in 2014 despite all nuclear units were still suspended. Petroleum demand for electricity generation is declining further due to lower entire power demand, steady growth of generation with burning coal or liquefied natural gas, and resume of some nuclear units. The era that needs petroleum for electricity generation is going to end.

Japanese manufacturers have moved their factories overseas and domestic infrastructure and lifestyle are changing to that need less energy usage. Meanwhile, as the country requires importing almost all of the primary energy resources, such transition could reduce the vulnerability of its security.

China crude oil production declining with no shale oil development

Although China is one of the major countries that have shale oil reserves, about 48 billion tonnes of her proven reserves have almost not developed yet. Overall Chinese crude oil production with the downward tendency has recorded 29 consecutive months of year-on-year decrease since November 2015, according to the National Bureau of Statistics. The nation’s crude oil demand, however, increased by 13% during the same period. Thus, import dependency is growing to fill the gap between supply and demand. As the declining self-sufficiency is critical, China was unable to include crude oil in the tariff list for retaliate round of the trade war with the U.S.

In July 2018, China produced 3.75 million barrels per day of crude oil, while the General Customs data shows that imports reached 8.5 million bpd in the same period. Imported amount of crude oil was 2.3 times than domestic outputs. The import dependency is extraordinarily high for crude oil among energy supplies in China. Coal production in July was 282 million tonnes compared with 29 million tonnes of imports, and natural gas outputs were 13 billion cubic meters against 1 billion cubic meters of imports. China's coal and natural gas imports stay at about 10% level of domestic production respectively. However, monthly coal production already has peaked out at around 300 million tonnes, while only the natural gas output is still showing growth.

China is not the only country that is showing a diminution of crude oil production. The upward movement of world crude oil output in the 2010's is mostly aligned with that in the U.S. It is because of the Shale Revolution, as you know. Even if in the major shale production area, the reduction pace of production in legacy wells is expanding. So that development of new wells is the key factor to boost production. Investments in shale oil/gas development are concentrating in the specific zones like Permian Basin in the U.S. where production costs are the most competitive. It accelerates production efficiency in that areas further and depresses on traditional oil field developments in other regions. Booming shale oil productions in the Permian Basin has caused a lack of transport capacity by pipelines and output was capped as a result.

China has the world third largest shale oil proven reserves and the biggest shale gas proven reserves. However, the majority of these reserves are located in the remote places like Sichuan where developments are quite difficult. There are many issues regarding drilling and transportation. Additionally, large water usage for the Hydraulic fracturing is also an obstacle. Shale oil/gas wells said to require typically from about 10,000 tonnes to 60,000 tonnes or more of water per well depending on each depth. Although China may not need to care about environmental issues that raise counter-movements against shale oil/gas development in the U.S., spending valuable water resources to produce crude oil seems not so reasonable compared to importing crude oil.

The U.S. Energy Information Administration expects that shale oil production in the U.S will maintain growth towards 2030. Crude oil development in China may not be expanded at least until then. Since the country can't yield more coal as well, the lower energy self-supply could cause arguments. However, we are unable to forecast the future exactly. Before the Shale Revolution, the U.S. was also in similar oil production diminutions as current China. And no one knows how long demand of the fossil fuel in China will continue to enlarge. 

How China's crude oil imports are exaggerated

Accumulated domestic crude oil supply/demand balance, that deducts processing volume from the total supply of net imports and productions, reached 23.4 million metric tons in Jan-May 2018, according to the government stats. That throughout 2017 was 44.6 million mt. The monthly balance rarely shows negative figures and total accumulation since Jan 2006 attains 270 million mt.

However, China's National Bureau of Statistics said that strategic petroleum reserves in the nation are only 37.73 mt as of mid-2017. This volume was higher than a year ago by 4.48 million mt and the International Energy Agency estimated that China's SPR stood at 39.2 million mt as of end-2017.

Meanwhile, commercial crude oil inventories in China as of end-2017 were estimated at 27 million mt by Xinhua News. The latest figure as of end April 2018 was 27.4 million mt. The commercial crude oil inventories have been swung between 25 and 35 million mt during the 2010's. It is basically under the downward tendency after peaked in Sep 2014. Petroleum products inventories are also indicating a seasonal cycle and no significant upward trend is seen.

Therefore, the statistically calculated crude oil surplus is clearly larger than the actual increase in the stockpile. It is a mystery where the surplus is gone. Many people believe that Chinese stats are not reliable, but even that, the discrepancy looks too large.

Crude oil processing volumes released by the NBS are about 50 million mt recently. These figures are the sum of collected data from enterprises that have more than 5 million RMB of annual sales. Since oil refiners are unlikely to have less than US$0.8 million of annual sales, the processing volume could cover all eligible firms. Additionally, it is not realistic to estimate that those firms report much smaller production than they actually do.

Current estimated total of the strategic petroleum reserves and commercial oil inventories in China are close to 90 million mt. It equivalents to about 55 days of the nation's recent consumption volume. Although this level is still far from 90 days that is recommended by the OECD, a significant progress is seen as Chinese petroleum demand has doubled from a decade ago when its stockpile only covered less than a month of consumption.

On the other hand, China may have equipped nearly its 170 days of consumption equivalent petroleum stockpiles based on the above surplus calculation. However, we can't find their storage facilities for such large volume. Thus, it is reasonable to guess that import figures are overblown. Based on the discrepancy among estimated stockpiles, China's actual crude oil imports are likely to be below the customs reported volume by about 10%. Chinese influence in the global crude oil market should be discounted.

Chinese petroleum demand rises despite slowing down in economic data

Although recent economic data show sluggish growth of Chinese economy, petroleum demand in August was unexpectedly steady.

Apparent petroleum demand, or pure domestic demand, in China rose 3.7% on year to 9.74 million barrels per day, according to Platts' estimation. Demand in the first eight months rose 1.2% from a year ago.
Since demand fell 2.1% on year in July, quarterly growth data might be about 1% on year growth.

Platts' data do not include change of petroleum stockpile. Meanwhile, Xinhua News reported that end-August stocks of petroleum products fell 6.2% from a month ago. Especially, gas oil inventories decreased 10.3% from a month earlier.

China's domestic petroleum demand that contains the inventory movements was 10.01 million bpd, up 4.7% on year. However, it is doubtful that the figures really reflect the nation's petroleum demand.
News have reported sluggish gasoil sales in China despite the large decrease of stockpile

Crude oil processing by Chinese refineries in August rose 4.4% from a year ago, according to the National Bureau of Statistics. But refineries might have increased processing because they did not have enough crude oil storage capacity.

Higher crude oil processing produced large number of petroleum products in China. Oil companies seemed to be unwilling to keep high products inventories, since prices were softening.

Domestic official petroleum sales prices have caught up with the movements of international markets more timely after the Chinese government changed the price setting methodology last year.

Firmer petroleum demand in China is very strange. It is inconsistent with decreasing petroleum demand in other Asian countries like India and Japan as well as slump in Chinese economic data.

Fossil fuel costs for nuclear outage in Japan to be offset by decreasing crude oil imports

Japan's crude oil imports fell 19% on year to 2.74 million barrels per day in May, according to customs data. It was first time that the country's crude oil imports slipped below 3 million bpd level since 1969.

Reduction of crude oil distillation capacity and the seasonal maintenance seem to cause the sharp drop of procurement. Crude oil processing in Japan fell 3.7% and 3.3% from a year ago in April and May, then it shrunk by 15% on year during the first three weeks in June. However, there has not been reported a lack of petroleum products in the market.

Japanese oil companies consolidated their refining facilities following the Energy Efficiency Law that was enforced in 2009. They cut about 400,000 bpd of crude oil throughput capacity in 2010, then reduced further 500,000 bpd until the dead line of the consolidation that was set at end of March this year.

In Japan, petroleum demand was predicted to increase to make up for nuclear power supply outage since 2011. But actually total crude oil imports by the nation has not increased despite additional demand from the power sector.

Even demand for thermal power generation has sustained Japan's petroleum demand despite declining fuel consumption in transportation sector that is affected by fuel-efficient vehicles, it could not boost the total crude oil imports.

Meanwhile, growth of electricity demand has been usually negative in Japan after 2011 due to power saving and change of the industrial structure. Although relatively high industrial activities supported power demand in February and March this year prior to the consumption tax hike on 1st April, reaction against that depressed the growth rate to about 2% per annum of decrease in April and May.

If Japanese oil companies reduce their crude oil procurement by 400,000 bpd (about 80% of scrapped capacity since mid-2013), the nation's trade deficit could decrease by 1.6 trillion yen ($15.8 billion) per year.
On the other hand, Japanese power companies have bought additional 17 million tonnes of liquefied natural gas for thermal power generation after 2011. It roughly costs about 1.5 trillion yen ($14.8 billion) annually.

Payments for fossil fuels are considered as one of main reasons of Japan's 11.4 trillion yen ($112.4 billion) of huge trade deficits in 2013. However, additional fuel costs to make up for nuclear power outage is not exceeding 2 trillion yen, and it is likely to be offset by reduction of crude oil imports in the near term.