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Ain't got that swing

Tight oil is not the new market balancer but, alongside storage, will help smooth out the market’s troughs and peaks

In America, 2016 was rife with challenges for oil and gas companies. But the year also saw the first cargo of liquefied natural gas leave American soil in decades and revealed the resilience of the Permian. And, of course, it was also a year that threw up a political shock, with the election of Donald Trump.

In the oil industry, hopes are rising that 2017 will bring a return to something like normality.

Several months of relatively stable prices have calmed fears. This decreased volatility has also given Opec a steady platform to try for a deal. The late November meeting will, at the very least, put the group on the threshold of an agreement; one that could buoy markets, but also signal Opec's return to its former market-balancing role.

Politically, 2017 will be about America's new president, and the first 100 days of the administration. Trump's victory means barriers to fracking will likely dissolve. So too might any on climate policy, including the problem of methane emissions.

For the industry, another test is coming for the oil patch. The time spent with oil prices hovering between $40 and $50 a barrel will prove to be an anomaly. That range will most likely be buffeted in the near term by an Opec deal, by still-burgeoning oil supplies, or the much-anticipated return to a market balance after 10-plus quarters of oversupply.

US shale gas and then shale oil have now been tested and retested by low prices. The resilience of American gas drillers to falling prices was first attributed to their ability to switch to oil, while keeping up gas production.

While that was at least partly the case for natural gas, the resilience in oil production was found in drillers' desperation to keep their livelihood. Deep cost cutting was accompanied by new techniques that still have more room to reduce cycle times and cut costs. LNG exports, fueled by still-robust natural gas production, are now contributing to the global oversupply of that fuel.

But the resilience of tight oil producers has done something else: it has proved wrong the widespread assumption of the past few years that shale would be the world's new swing supplier, or oil-market balancer. Several implications stem from that fact.

There was never anything special about tight oil in this assumption about swing supply. Given enough time and pressure from a price change, many elements have the potential to be the market balancer, including shale.

Keep gasoline prices very low for a long period, for example, and eventually extra demand will be sufficient to balance the market, an effect already made clear in China and the US.

But a true market balancer must pass two tests - and for now, America's oil sector has overcome neither. The first is that the size of the potential response to the price change must be big enough. (Historically, the market has examined remaining Opec spare capacity to measure that capacity and its sufficiency.)

The second is the ability and willingness to be the first mover when an imbalance occurs. In both cases, the data are clear: American shale oil fails both tests.

Start with its raw size. Shale oil accounts for about 4.5m barrels a day, or less than 5% of total global supply. This small base was able to disrupt the market in 2014 with a startling 1.4m b/d of production growth - but that was under ideal circumstances of price (high), technology advancement (rapid) and years of momentum. In 2017, assuming Opec returns at least a partial agreement, I expect shale production to resume its output growth, rising to 4.8m b/d, helping overall American production to increase again too.

So shale oil is coming back. But in a time of global shortage, it will have neither the volume nor the speed to plug the gap. So it fails that test of sole market balancer too.

American shale's inadequacy in this first category is debatable, of course, and 2017 might see my conclusion itself put to the test. But US shale's failure of the second test - its ability and willingness to reduce production, first, in times of oversupply - is clear. A whole six months passed from the Opec November 2014 meeting, when prices really started to nosedive, before shale output even stopped growing.

In fact, even while the price was plummeting and the global oversupply became headline news, tight oil output added 400,000 b/d before the slump in investment finally caught up with it. Since an output peak in 2015, production has fallen nearly 1m b/d, or by about 50,000 b/d a month. The global oversupply during that period, though, was sometimes greater than 2m b/d. So shale's decline in that period was helpful to balances, but hardly comprehensive in swiftly balancing the market.

Shale wasn't the only culprit here. Offsetting the decline further were long-lead-time assets in the Gulf of Mexico (GoM), that started pumping after the price had already begun its descent. Production growth there even accelerated as prices declined, with both 2014 and 2015 returning incremental growth of about 150,000 b/d. But these assets are now largely on stream, and that growth level is unlikely to be repeated. In 2016, about 40,000 b/d will have been added. Some more will arrive next year. Even with Trump's support next year, the pipeline of projects will gradually dry up. While shale has proven to be an inadequate swing supplier or market balancer - too slow and meager in its downward production response to qualify, and too small to increase production sufficiently in times of market tightness - it does, though, have another role.

It can bridge the gap between Opec-style market balancing and the long-lead projects like the deep water and oil sands. This bridge could, in future, be sufficient to allow for a truly free global market to develop in oil.

Even if shale output were to sprout globally, its growth would probably be too slow to prevent huge price swings (and might even encourage them). This would place pressure on both producers and consumers of all sizes, who would need to manage long-term strategic volatility.

This is a different kind of volatility from the typical 30- and 60- day-implied volatility or the oil Vix option (an instrument to trade price volatility). Strategic volatility is the term I use for a long swing in price that can treble or halve the price over the course of months even years - and is much more critical for producers than traders.

So if shale can't do the swing job and Opec isn't necessarily ready to take up the mantle again, where will the market get its balancer?

The answer is storage another significant strategic and market advantage for America. Stockpiles are now well above their level before the price collapse, pretty much worldwide. The same is true in the US - but it has also added to its inventory capacity: another 80m barrels has come on line since 2014. On top of that, the Louisiana Offshore Oil Port is offering options to store crude in its facilities, giving another valuable data point to determine the depth of any oversupply. The view that storage levels need to return to normal before the market rebalances may be correct. But what we understand as "normal" is going to be very different.

Storage can meet the two tests for a swing supplier. It's big enough (the US now has 10 more days of full cover than it did before the price crash) and it is the first to move. That's obvious from its rapid rise recently. It holds another advantage too: it's relatively transparent.

Unlike Opec's spare capacity, or shale, which is too many for most analysts to assess its responsiveness accurately, storage capacities for about 70% of the world's storage data are available in plain sight. The market can see, with a few clicks of a mouse and some calculator work, how long a stockpile will last. So don't expect American shale in 2017 to assume Opec's mantle as the market's swing supplier.

But do watch for it to keep disrupting the market, introducing a new element of shorter-cycle oil. It will play an increasingly important role in global markets, and a significant one in storage. Those are major shifts in global oil - but they aren't the ones everyone expected.

This article is part of Outlook 2017, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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