I had a hard time choosing a topic for today’s Energy Letter, so instead of choosing one, I decided to touch upon three. Notably absent is a discussion of OPEC’s decision on production quotas, which had yet to be announced when I completed this article. I will have an analysis of the decision next week, and immediate updates if needed for subscribers of The Energy Strategist.

China’s SUV Demand

One of my frequent refrains is that electric vehicles (EVs) aren’t going to make a dent in crude oil demand for a long time. If I am correct, then this creates a potential disconnect between expectations for future oil prices and the way reality will unfold. That is the kind of disconnect that presents a long-term investment opportunity. 

I base my expectation on the fact that global population is growing, developing countries are experiencing an expanding middle class, and as a result, the number of drivers around the globe is increasing. This week The Wall Street Journal published an article that highlights a critical issue. The article Gas Guzzlers Rule in China notes:

The Chinese government’s plan to replace gasoline-powered cars with a new generation of electric vehicles has hit an unexpected bump: Chinese consumers’ love affair with gas-guzzling sport-utility vehicles.

The article estimates that China will have 150 million SUVs on the road by 2025 — representing 45% of its overall fleet of light passenger vehicles. For comparison, there were only four million SUVs on China’s roads in 2010. That kind of growth helps explain why crude oil demand continues to grow, even in countries that are experiencing rapid increases in EV sales. So before EVs can reduce oil demand, they will have to make a dent in the global annual demand growth of >1 million barrels per day (BPD).  

Trump’s SPR Sales Proposal

In December 1975, Congress established the Strategic Petroleum Reserve (SPR) under the Energy Policy and Conservation Act (EPCA). The law was designed “to reduce the impact of severe energy supply interruptions” such as the OPEC oil embargo.  

But politicians have used the SPR for purely political purposes on numerous occasions. Notably, when gasoline prices are high — and especially when running for reelection — presidents have declared an “emergency” and released oil from the SPR to appease angry consumers.

Many have argued that the SPR has outlived its usefulness because U.S. demand for OPEC crude has dropped over the past decade. That’s certainly true. In 2005, the U.S. imported 10.1 million BPD of crude oil, of which 4.8 million BPD (~48%) came from OPEC. By 2016, U.S. imports had dropped to 7.9 million BPD, with 3.2 million BPD (~40%) from OPEC. U.S. energy security has improved, and because of the decline in imports the oil in the SPR will cover more days of imported supplies.

So it is not surprising that President Trump’s budget calls for selling half of the 688 million barrels of crude oil in the SPR. Trump’s plan calls for SPR sales to begin in the 2018 fiscal year, with estimated revenues totaling nearly $16.6 billion from 2018 to 2027 (presuming oil prices remain in the current range). 

Such a move is risky, but less so if U.S. crude oil production continues to grow. And if the world remains awash in oil, SPR sales may be one more headwind weighing on oil prices. 

Permian’s Midland Basin Has Lowest Breakeven Costs

The Federal Reserve Bank of Dallas is a rich source of energy-related information. I especially enjoy the monthly Energy Indicators Report, which provides a snapshot of the energy sector.

This month the Dallas Fed featured an updated slideshow that included results from a survey asking oil producers about breakeven costs in different shale plays:

The Permian Basin’s Midland area, which is in the eastern part of the Permian, had the lowest average breakeven costs for new wells at $46/bbl. Breakeven prices in the Midland Permian ranged from about $25/bbl to $65/bbl. (The largest influence on this price is how much oil and gas the oil ultimately produces). Oklahoma’s SCOOP/STACK, the Eagle Ford, and the Permian Delaware area all had average breakeven costs in the $40s. Notably absent is the Bakken, which would presumably be covered by “Other U.S. Shale.”

The Dallas Fed also asked producers about the West Texas Intermediate (WTI) price that would be needed to cover operating costs for existing wells (i.e., the “shut-in” price). In other words, this is the price that would support the continued operation of a well but would not cover the cost of drilling the well (which is conveyed by the previous graphic).

Once again, the Permian Midland had the lowest shut-in price of any area, with an average of $24/bbl, and a range down to $10/bbl. The SCOOP/STACK had a slightly higher average at $27/bbl but ranged all the way down to $8/bbl. 

One theme gaining traction in recent months is that breakeven costs have been driven down not only as a result of drilling improvements but also because drillers extracted deep concessions from drilling services companies. Now that drilling is picking back up, some of those drilling services companies are looking to increase prices. That may mean that average breakeven costs may be finished falling for now, and could creep back up this year.

If you subscribe to The Energy Strategist, then you are familiar with some of the companies poised to benefit from the new boom in the Permian Basin. If you aren’t a subscriber, maybe it’s time to give us a test drive. 

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