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Introduction

With oil closing near $46 a barrel in New York last week, OPEC appears to have finally lost control of the oil market narrative with traders appearing to have given up on an early re-balancing of the crude market.

Prices are now flat and calendar spreads are plunging to the lowest level since OPEC signed a six-month deal to curb production in November 2016. Meanwhile, shale drillers are pressing ahead with their longest expansion since 2011.

US Rigs and Shale – can’t rise forever

US rig count continues to climb, adding another 9 rigs in the last week of April, putting the oil rig count just shy of 700, or up 120 percent from its low point a year ago. Aside from just a handful of exceptions, the rig count has grown almost entirely uninterrupted, week after week, for the past 12 months, even during bouts of lower prices.

Oil rig counts are rising but so are costs and the reality of the limitations of shale may start to become painfully obvious. While the number of active  oil rigs increases so does, the cost of those wells, which increased by 7 percent between November and March according to the Bureau of Labor Statistics. That is the first significant increase in drilling costs in three years and with the rapid increase in drilling rigs, oil service and labor costs will go higher.

Shale break even prices
Shale break even prices

Unsurprisingly, the increased rig count has led to a sharp resurgence in U.S. oil production. The most recent estimate from the EIA puts total U.S. production at 9.3 million barrels per day, up 700,000 bpd from September 2016. Some of those additions came from long-planned offshore projects that came online in recent months, so it has not come entirely from U.S. shale. But that suggests even stronger production gains could be forthcoming, since the shale industry is only now getting going. Estimates vary, but by and large, there is a consensus that U.S. shale will add hundreds of thousands of additional barrels per day to the market this year.

Bulls, Taureau, Stier

Then there are unexpected gains from elsewhere around the world. Libya, which was exempt from OPEC’s share of planned cuts because of its internal conflict, has doubled its production since September to 700,000b/d, according to the latest reports.

More ominously, Libya is aiming to ratchet up production to as much as 1.2 mb/d by the end of the year and whilst that goal could prove to be fanciful, it highlights the fact that Libya could be as much of an upside risk as a downside one.

Collapse in the oil contango
Collapse in the oil contango

Futures Market

The return of bearishness is borne out by the latest trading trends in the futures market. Hedge funds and other money managers continue to pare back their bets on crude futures, reducing net-long positions for the third week in a row. According to data cited by Bloomberg, major investors cut their bullish bets by 21 percent at the end of April. Speculative movements in the futures market don’t dictate everything, but they are good indicators of market sentiment. The recent net-long reduction suggests that investor confidence is on the wane.

Outlook for OPEC

The fact that the oil glut persists despite what should be bullish trends – high OPEC compliance, growing demand, and the initial signs of falling inventories – suggests that lower prices could be forthcoming.

The fist week of May saw around $ 7 million worth of   options changed hands that will pay off if West Texas Intermediate falls beneath $39 a  barrel by mid-July. WTI, which hovered around $46, hasn’t traded below $39 since April 2016.

Large Bet on $39 Oil
Large Bet on $39 Oil

For the next couple of quarters, there seems to be nothing to indicate a strengthening market is close to hand and OPEC are almost certain to continue their cuts during their May meeting. Can the case be made for bulls on the horizon?

U.S. production is up 327,000 barrels a day from last year and that is a small part of OPEC’s 1.2 million barrels per day cut and does not even cover the 558,000 barrels per day non-OPEC cut. On top of that, as drilling costs rise, the break even on shale may slow the amount of projects and may make some banks think twice about extending money to drillers that are pumping more oil but losing money on every barrel.

Looking ahead we should start to see large draw down in U.S. supply as the impact from traders dumping oil from floating storage and sales from the Strategic Petroleum Reserve start to subside. At that point, the market may wake up to the fact that we are entering a global supply deficit for the first time in over a decade and questions must arise around shale’s ability to fill that void.

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References
  1. http://oilprice.com/Energy/Oil-Prices/The-Return-Of-Bearishness-In-Oil-Markets.html
  2. https://www.bloomberg.com/news/articles/2017-05-05/suddenly-oil-below-40-a-barrel-doesn-t-seem-so-far-fetched
  3. http://www.worldoil.com/news/2017/2/28/rystad-examines-what-to-expect-from-us-shale-break-even-prices-in-2017
  4. http://blog.pricegroup.com/2017/05/01/shale-cost-is-rising-the-energy-report-050117/
  5. IEA backs Oil
  6. https://www.ft.com/content/06b4d614-c2b4-11e6-81c2-f57d90f6741a

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