09.08 The Current Oil Environment: Sabotage, Corruption and the Energy Information Administration

Back in 2104, as oil prices were touching $110 per barrel, there were headlines everywhere predicting an ISIS attack on Baghdad.

The fall of Baghdad has not occurred, but ISIS did take Ramadi. In terms of distance and safety, it would be as if ISIS took Fort Worth and you lived in Dallas. Meanwhile, other countries in the Middle East have fallen into chaos. Syria, Yemen and Libya have fallen into the category of failed states. However, only Libya had substantial oil exports, the fall of Yemen and Syria have had little effect on oil exports. Since May and the fall of Ramadi to ISIS, oil prices retreated from over $60 to below $40.

Despite regional instability, oil exports from OPEC have continued to flow near record highs for much of the summer. Surprisingly, a large part of that increase has come from Iraq, which has been producing close to 4 million barrels per day. Saudi Arabia increased their production to 10.3 million barrels per day, but they also increased internal consumption by at least that amount for new refineries and electricity demand.

In 2015, there has been little concern over oil supplies. Media reports have repeatedly stated that supplies are growing in many countries, especially the United States. The steady drum beat of an oil glut may be about to change.

Many oil bears have been quoting  production data and forecasts  from the Energy Information Administration (EIA) of growing U.S. production despite a massive drop in rig count. The rational for the strength in oil production were improvements in drilling and completion techniques and companies targeting their best reserves. The EIA now predicts that oil production will drop by 7% by September from its peak earlier this year by 360,000 barrels per day. Part of the confusion has been that many people assumed that the earlier EIA data were actual production numbers when in fact, they were  forecasts based on models. Over time, the EIA adjusts the data after they get production data from the states; however, the actual EIA numbers actually lag the state data by 4 to 6 months.

The EIA is revising the forecasting models by incorporating more actual production numbers from the actual producers. The EIA’s numbers had been adding 50,000 barrels per day per month, which worked well when rigs were fairly constant in 2014, not so well in 2015 when rig count in major shale basins dropped by 58%. The EIA believes its new methodology will be more current with actual and no longer lag many months behind.

The U.S. is not the only country seeing its oil production peak. The stress brought to oil infrastructure, security and activity levels by low prices is beginning to take its toll. Nigeria and Iraq have both experienced major production disruptions due to the sabotage of pipelines by ISIS and local insurgents. Both countries have seen their budgets stressed to the breaking points by ISIS, Boko Haram, low oil prices and in the case of Nigeria, $20 billion in Government corruption and fraud.

Nigeria is not the only country to see its oil industry disrupted by massive corruption. Brazil’s Petrobras has experienced corruption accusations of unprecedented proportions his year. They now forecast a reduction of future production growth of over 1 million barrels per day due to a 40% reduction in budget cuts. Russia saw its oil production drop by 50,000 barrels per day in July, and Canada shut in over 200,000 barrels per day due to an explosion and fire at one of their projects.

Oil prices have experienced a stunning rally in recent days off of their lows around $38 per barrel. Where prices go from here is anyone’s guess. However, the assumption that supplies will not be impacted by record budget cuts in the U.S. and every part of the world outside of a small part of the Middle East and instability caused by the stress induced by low oil prices to countries and companies will appear to be misplaced. Production reductions caused by much lower investment, sabotage, a reduced workforce and regional instability are beginning to take their toll.

Steve Titcomb, Investment Advisor, Echelon Investment Management