Oil Rally Is A Double-Edged Sword

March 22nd, 2016 by

bloody-swordNet longs on oil futures are at an eight-month high, as money managers and hedge funds increase bets that the current oil rally will continue. News of lower production in the US and a drop in exports from two OPEC members is helping build bullish sentiment.

However, this oil rally may be planting the seeds of its own destruction. As West Texas Intermediate works to build support at $40 a barrel and Brent holds above $41, more oil producers are able to turn a profit. This has a very good chance of reversing the fall in production that has sparked the present oil rally.

Fueled by Rumors and Speculation

A notable factor in the gain in crude prices has been the vague announcements from Russian and OPEC oil ministers of a grand meeting to address the global oil glut. Even the most optimistic expectations forecast only a production freeze instead of a cut. This means 1.5 million to 2 million barrels a day will still be added to current stockpiles.

Still, oil has gained 50% since the first meeting between Saudi Arabia, Russia, Venezuela, and Qatar in February, to discuss a production freeze. Throughout the negotiations, which have been pushed back to April, each participant has made it clear that they will not agree to production limits unless everyone does.

Trust Is Lower Than Oil Prices

Behind all the talk of coming together to support oil prices, OPEC is leery of trusting Russia to hold up their end of the bargain. As crude prices collapsed in the wake of the Global Financial Crisis of 2008, Russia came together with OPEC and agreed to reduce production to support prices. However, Russia increased production to steal market share from OPEC members.

Saudi Oil productionThis wasn’t the only time that Saudi Arabia had been played for a sucker. In 1980, as North Sea oil flooded the market, OPEC agreed to cut production to defend oil prices. Saudi Arabia cut production by 75%, from 10 million barrels/day to 2.5 million, plunging the kingdom deep into debt. However, their “friends” in OPEC rushed to fill the gap, increasing production as much as possible.  In 1985, the Saudis struck back, turning on the spigot and flooding the oil market.

The push by the Saudis in November 2014 for OPEC to flood the global oil market and force competitors out of business shows that the kingdom has learned its lesson of the futility of defending oil prices through production cuts.

Bombs And Drawdowns

Part of the recent oil rally has been the drop in production in Iraq and Nigeria. Both nations have been affected by terrorist attacks on oil pipelines.

burning-oil-industryIn addition, Iraq has shut off oil pipelines running north to Kurdish-held northern Iraq, in an attempt to bring them back to the “national unity” negotiating table.

All told, 850,000 barrels of oil a day was lost between the two nations in January and February, helping at least a little in nibbling away at the global oil glut.

On the opposite side of the world, the oil industry got a bit of good news last week when it was reported that record-high crude stockpiles at the central storage in Cushing, Oklahoma actually fell for the first time since January. 570,574 more barrels of oil left than arrived in Cushing, for a total of 69.05 million barrels in storage.

Shale DUCs in a Row

$40 oil means some US shale drillers have been thrown a lifeline. News that some companies are activating DUC (Drilled, UnCompleted) wells to replace depleted wells (shale wells produce for only five years on average) means that US oil stockpiles will fall more slowly than first thought. Even so, production is forecast to fall for the next two years if oil stays below $40 a barrel.

oil-well-worker$45 oil will see more wells being brought online than are running dry, as more drillers rush to take advantage of the oil rally. It only takes a couple of weeks to bring a DUC to production, which means that US shale companies will be the new “swing producers” in the global oil market. This also means that shale will rapidly cap oil prices, once they reach a certain point. This could be viewed as a “turnabout is fair play” move by the US petroleum industry against OPEC.

Another development is the increasing amount of US crude being exported to Europe, traditionally an OPEC market. The discount on West Texas Intermediate compared to Brent means that European refineries can increase profits by switching to American oil. This is taking the fight into OPEC’s back yard, as far as global market share of oil is concerned. While the US will remain a minor player in the oil export market, it will still bring some relief to the strain on American storage facilities.

Perhaps the biggest factor in low oil prices is that OPEC never wants to see $100 oil again. They’ve learned the hard way over the last few years that high oil prices invite a flood of competitors pumping higher-expense oil.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product