Where's oil headed? Ask China

U.S. oil investors tend to fixate on domestic oil markets—and particularly shales—often at the expense of the bigger global picture. In the absence of a clear consensus on the marginal cost of oil, WTI bounces around with every oil inventory and drilling rig report. Rigs and inventory down? WTI rallies. Crude stocks up? Oil prices tank.

No doubt, the U.S. is important. U.S. shales will drive the eventual rebalancing of global oil markets. The high decline rates of shale wells, and the acute exposure of independent U.S. producers to prevailing market conditions, virtually guarantee that U.S. shale production will take the brunt of market adjustments. If global oil production is to fall, U.S. shale output will lead.

But that's not the whole story.

Imaginechina | AP Images)

All in, the U.S. produces about 9 million barrels of oil per day and more than 12 million if natural gas liquids are included. However, much more is produced elsewhere outside OPEC. Non-OPEC countries, excluding the U.S., produce 44 million barrels of oil per day, nearly half the global oil supply.

As in the U.S., their oil companies are typically exposed to global oil prices and are under pressure to adjust to market conditions. In these countries, too, rig counts have fallen. True, international oil rig counts have only fallen by 20 percent, compared to 64 percent in the United States, according to Baker Hughes. But that 20 percent is projected on 44 million barrels of oil per day. The supply adjustment outside the U.S. and OPEC is potentially much greater than the shale oil adjustment over which American investors seem to obsess. And since oil is a fungible, global commodity, a barrel lost in Argentina has about the same impact as one lost in Texas or Saudi Arabia.

Nevertheless, our understanding of many of these international markets is relatively poor. Many of these countries are dominated by national oil companies whose reports are often delayed, incomplete and unreliable—if they issue public reports at all.

In some countries, though, operators do provide public information which provides us insight into events on the ground. One of these is China. Although China is usually thought of as a leading oil importer and consumer, it is also the fourth biggest producer after the U.S., Russia and Saudi Arabia. Moreover, approximately 85 percent of its oil production comes from only three companies: PetroChina, Sinopec and CNOOC. All three are listed on the New York Stock Exchange, which means that they report quarterly.

So how did these companies fare in the third quarter? Is production falling? Will China's supply correct along the lines seen in the U.S.?

As so often seems to be the case with China, the story is complicated. China's oil supply—as reflected in the Big Three's domestic oil output—fell by 2.5 percent in the first quarter of 2015 compared to record high Chinese production achieved just one quarter earlier. The decline was short lived. By second quarter, only Sinopec was showing decreasing output, with both CNOOC and PetroChina posting crude oil production gains at home. Third quarter reports show gains across the board, with Big Three oil domestic oil production eking out a new high in aggregate.

Index of China Oil Production – FOURTH QUARTER 2014 = 100
Source: PetroChina, Sinopec, CNOOC company reports

Much of the credit goes to CNOOC, China's offshore oil specialist. As in the U.S., onshore declines have been offset by offshore gains. Offshore projects typically have longer lead times and produce in larger quantities. Once a project has been approved, it will go forward even if market conditions change. Since offshore projects have long cycle times, they are relatively insensitive to short term oil price swings. Thus, production from both the U.S. Gulf of Mexico and China's Bohai Bay and parts of the China Sea has continued to advance despite the collapse of oil prices.

CNOOC's recent gains have been impressive. Its production in the Bohai Bay was up 23 percent in third quarter compared to a year earlier. Results in the East China Sea are even better, up more than 50 percent in a year. Overall, CNOOC's China third quarter oil production was up 29 percent over the same quarter last year.

On the other hand, CNOOC contributes less than one-fifth of China's total oil production. CNOOC's gains helped offset onshore declines from Sinopec and PetroChina, but were not enough to prevent the overall Chinese oil supply from slipping in the first half of the year. With the recent recovery of onshore production, however, all oars are now pulling in the same direction.

But will it last? Can China's production continue to recover in a low oil price environment?

Change in Upstream Capital Expenditures from Previous Year
Source: PetroChina, Sinopec, CNOOC company reports

All three major Chinese oil companies slammed the brakes on upstream capital expenditures in 2015. In second quarter, expenditures were down more than 30 percent across the board, and down 45 percent in the case of Sinopec. Full year CNOOC guidance suggests capital expenditures will come in 30 percent below 2014's level. Our own estimates for Sinopec suggest a similar decline. PetroChina, on the other hand, indicated in its midyear report that full year capital expenditures would fall only 12 percent. Given the pervasive weakness in oil prices recently, PetroChina would seem likely to finish the year closer to its compatriots. Either way, upstream capital expenditure is likely down at least 20 percent, and as much as 30 percent, for full year 2015.

CNOOC retains some momentum into fourth quarter, but its own guidance suggests much slower growth from 2016. By rights, at some point, sharp reductions in capital expenditures should translate into material production declines. The question is when, and how much.

It hasn't happen yet. Those who hope China will help rebalance oil markets will have to wait a while longer. China's oil production has not fallen. Indeed, the arrows point in the opposite direction.

Commentary by Steven Kopits, managing director, Princeton Energy Advisors.