After the failure of global oil producers to set a production cap during a high-profile meeting in Doha earlier this month, doomsayers predicted that prices would crater.
How wrong they were.
At close of trade yesterday, crude oil prices had risen to their highest level since early November of 2015.
U.S. oil was up 5.3% for the week, 20.1% for the month, and 75.6% since its low for the year on February 11.
Meanwhile, Brent – the international benchmark for oil, set in London – closed up 6.6% for the week, 21.6% for the month, and 58.4% higher than its 2016 low on February 9.
The same doomsayers are now saying that these prices are unsustainable, and will fall back in short order.
The second one is both a blessing and a curse…
The Doomsayers are in it for Themselves – Not for You
I have collectively called these doomsayers calling for ever-lower oil prices Chicken Little from “The Sky is Falling” Brokerage Agency. A number of them have actually been running short positions on oil, meaning that being on TV and convincing viewers that oil prices are collapsing promises to add to their bottom line.
Now, it is true that we continue to have a significant global oversupply of oil. But this is hardly unusual. Remember: when prices were over $107 a barrel for WTI (the benchmark futures rate used in New York) in June of 2014, there was a larger surplus of oil at Cushing, OK than we have today.
Cushing is especially significant because it’s the main confluence of U.S. pipelines and the location where the WTI price is set each trading day.
So something other than just oversupply has been keeping oil prices down…
The Manipulation of Oil Prices is Almost Over
An algorithm I developed several months back has allowed us to track here in Oil & Energy Investor the actual underlying value of oil even though the contract price you see quoted has been distorted by short plays and increasingly speculative derivatives.
Normally, the result has been a “real price” – calculated each Friday – that’s higher than the contract price. In an environment where traders assumed that prices would be going down, that made sense, as artificial market manipulations drove prices down further than fundamentals justified.
Had the price been moving in the opposite direction – i.e., moving toward $100 a barrel – the price would have been artificially increased, instead.
The bottom line is this: until recently, the real price of oil has been hovering $8 to $12 above the price quoted in the market.
But that just changed…
As of this morning, the real price and the market price of oil are less than $2 apart. In other words, the recent rise in price has narrowed the room for manipulation, resulting in a more genuine reflection of the value of oil.
As WTI moves toward $47 a barrel, the lingering excess production seems to be having less of a restraining impact. There is certainly still a ceiling that will prevent prices racing to $70 or more. But the days of concerns over oil prices falling below $35 seem to be waning.
There are three reasons why…
Reason #1: Oil Supply is Already at Maximum
First, whether or not a freeze agreement is reached at the June meeting in Moscow between the world’s major oil-producing countries (another attempt at reaching the deal that failed in Doha earlier in April), analysts have come to conclude we are already at maximum global-wide production.
This is psychologically important, as it changes the expectations of traders. Any geopolitical crisis could now seriously disrupt the supply of oil. Traders are reacting by moving away from pegging prices at the expected cost of the least expensive next available barrel (as they would if they had no concern about getting that barrel).
In fact, January’s production figures (the base of the freeze proposal) are too high to be sustainable, a point already reflected in forward estimates for main non-OPEC producer Russia. There, despite rhetoric to the contrary, limitations in the country’s ability to produce and export oil are kicking in.
Second, there’s the main reason for the fall in U.S. production…
Reason #2: The U.S. Energy Debt Crisis Means Production Will Keep Falling
In the U.S., the largest producer not present at the freeze meetings, daily oil extraction levels are moving below 9 million barrels. That is largely a function of the high-risk (i.e. “junk”) bond crisis is getting worse.
Companies that need to roll over their debt now face 20% or more in annualized interest, and are instead choosing to cut their capital expenditure plans. This won’t be reverting anytime soon, and so production (which depends on that capital expenditure) will continue falling.
You see, market prices below $60 a barrel effectively cap American production, in addition to producing a wave of bankruptcies and a reduction in the number of oil companies. Yes, a significant excess of extractable reserves remains, and a number of companies could theoretically break even with oil prices in the mid-50s.
But in practice, financing (including the 20% interest on loans to oil companies) and market conditions preclude that from happening.
The lack of centralized control or state-held oil companies that can determine production levels means that the U.S. will never be at an international freeze meeting. Still, there is an effective cap on American production, without any U.S. producers having to travel anywhere.
But this final point may hold the greatest impact on restraining the downside in U.S. prices…
Reason #3: More DUCs Means Higher Oil Prices
Despite technological improvements (that have increased average per-well production by 17%) and the usage of multi-well pads, both of which reduce expenses in the field, we are now well into a major correction in American well production.
Now, there is still plenty of crude oil available for rapid extraction. We’re not looking at “peak oil” here. But we are facing a limit in the potential for profitable oil production.
As you’ve no doubt seen me mention before, the average shale/tight oil well (requiring horizontal drilling and fracking) has most of its production in the first 18 months. After that, while oil is still coming up, the flow is much, much smaller.
In normal pricing environments, well operators would use secondary and enhanced recovery techniques (such as water flooding, gas injection, or chemical additives) or even re-fracking to increase production after these first 18 months.
But in today’s cost climate, this is not affordable. Instead, companies have to “cream” the initial stage of production and employ so called drilled but uncompleted wells (DUCs) to maintain their overall extraction levels.
Whenever you see statistics for new wells, always keep in mind that many of them are DUCs – wells drilled but without casing and production strings.
These are not intended to increase aggregate production – they can’t unless they’re finished – but rather are meant to replace declining, already existing wells. An increase in the number of DUCs does not mean we are approaching some major reduction in production. But they also represent another element restraining the slide in prices.
And that’s why I’m revising my earlier oil price forecast of a $42-$45 a barrel oil price in New York and a $48-$50 a barrel in London by mid-June.
I now expect that to be the floor, not the average price.
And this is going to guarantee you some nice profit opportunities.
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