Friday’s Oil-Price Surge: Here Is The Right Context

China, Company Strategy, Economics, Oil & Gas

By John Richardson

THE right historical context is crucial if you want to gain a real understanding of today’s oil market.

It is, for example, crucial that you put Friday’s 8% surge in oil prices into this correct context.

This involves taking the reasons given for this dramatic turnaround with a very large pinch of salt, which include the following:

  • The total number of US rigs in operation had fallen by 94 week-on-week and by 199 year-on-year,  said Baker Hughes – the US oil-fields services company . These were the steepest declines since records began in 1987.
  • The rig count at more than a dozen onshore drilling companies would drop by a total of 42% in 2015, from a total of 221 in 2014 to a total of 128,  forecast RBN Energy, the US energy consulting firm.
  • All these companies operate primarily in shale plays, and combined they are expected to spend 28% less on capital projects in 2015 than they spent in 2014, the consultancy added.

Many newspaper articles pointed out that the 8% price surge was the biggest one-day increase in nearly three years.

But an 8% increase in dollars per barrel isn’t, of course, that big a deal because prices are so much lower than they were seven months ago. For example, Brent closed at $52.99 a barrel on Friday – $3.86 higher. Last June, Brent was $115 a barrel.

On the US rig counts, here is some very important historical context:

  • Even though fewer rigs will now be doing the work, US shale-based producers are still expected to raise production in 2015 by 10%. This is expected to result in US daily output increasing to 669,000 barrels from last year’s 606,000 barrels.
  • In mid-June 2009, at the worst point of the Global Financial Crisis, the US rig count dropped to a low of 876.
  • There were 36 rigs in North Dakota in mid-2009, compared with 143 today.
  • Rig counts are unlikely to fall that far again, and even if they do, oil production will be higher because horizontal drilling and hydraulic fracking played almost no role in 2009 production. The shale revolution has resulted in a long-term turnaround in US production.

It is also worth reading very closely the US Energy Information Administration’s (EIA) latest This Week in Petroleum report, which was released on 28 January.

“Total United States commercial crude oil inventories stood at 407 million barrels as of January 23, 61 million barrels higher than the 2010-14 average and 49 million barrels higher than this time last year,” writes the EIA. This left US stockpiles at their highest level since 1982.

OECD inventories will have also reached 116 million by the end of January, similar to the build-up seen during the first quarter of 2009, said the EIA in its latest Short-Term Energy Outlook report (see the chart below).

EIA2Feb2015slideone

The rise in inventories is partly the result of traders now having a much-bigger incentive to put oil in storage.

“As supply and demand balances loosened in the second half of 2014, global inventories increased and crude oil prices for near-term delivery declined substantially more than prices for delivery further into the future,” added the EIA in its 28 January This Week in Petroleum report.

“The higher price for longer-dated contracts in a contango market provides an incentive to store crude oil for future delivery,” said the report.

“As low-cost storage capacity fills, more-expensive storage options are needed, such as floating storage (keeping crude in tankers outside of coastal refining centres). Increases in the cost of storage put downward pressure on near-term prices.”

The slide below shows how the market has switched from backwardation, where prices today are higher than they are tomorrow to contango – where the reverse applies.

EIAslide2Feb2

This is a dangerous gamble as, barring geopolitics, I can see no reason for an oil-price recovery over the next few months because:

  • As I said, US production will still be 10% higher than last year, despite the reduction in the rig count.
  • The amount of oil in storage versus the weak state of the global economy – especially the weak state of China. In December, the Paris-based International Energy Agency warned that OECD stocks could soon “bump up against storage capacity limits”.
  • See my 23 January post on crude. In short, this details how refinery turnarounds, the end to support from strong buying in China during Q4 last year and a stronger dollar will exert more downward pressure on oil.

And returning to the crucial subject of  oil production, you have to question very hard whether cutbacks in higher-cost production in general – not just in the US but also in other locations such as Canada – will be as extensive as some people think.

CNBC wrote in this article:

In recent months, a spate of money managers, including Lansdowne Partners, Avenue Capital, Carlson Capital and Blackstone’s GSO Capital unit, have been raising fresh capital to deploy in either long-short energy stock picking, credit investing, or both.

At the same time, hedge-fund investors say that finding ways to home in on the distressed oil industry has been a top priority of late.

By snapping up shares of those companies in the stock market or their debt in the bond market, investors generally are making two types of bets: That the companies will recover ground when crude rises again, generating attractive returns for those who bought shares during the downturn, or, alternately, that the companies will go bankrupt if oil remains cheap—giving their bondholders a chance to swap existing bonds for equity and, effectively, take over troubled companies with compelling assets at fire-sale valuations.

If you have swapped existing bonds for equity you are going to want to keep your newly-acquired shale-oil producer operating, almost regardless of how the oil price falls. And, of course, a “fire sale” means that you will have achieved an effective debt write-off,  This also creates the potential for a very low breakeven oil price.

As I argued in a 28 November 2014 post: What if some shale oil producers go bust? Might their debt be written off and might they then be taken over by private equity players? These new owners would then only have to cover variable costs.

This also means that OPEC, led by Saudi Arabia, will be forced to stay the course for considerably longer by not cutting back on its own production. There is no point in OPEC tightening the tap until or unless higher cost production is taken permanently out of the game.

Historical context is, as I said, crucial – more so today than a few months ago.

Why? Because now that central bank stimulus is being withdrawn, real supply and demand matter much more in oil markets. Genuine price discovery has returned to the market.

And all the indications for real supply and demand tell me that we are in for a very period of prolonged lower prices – with prices likely to fall even further in the coming months from their recent historic lows.

PREVIOUS POST

Don't Bet On A Post-Lunar New Year Rebound

30/01/2015

  By John Richardson THERE is a very risky theory that I have picked up in ...

Learn more
NEXT POST

Take Stock And Plan For the Post-New Year China

03/02/2015

By John Richardson NOBODY involved in the Asian chemicals industry is likely to ...

Learn more
More posts
China could be in complete polypropylene self-sufficiency by 2022
28/06/2020

By John Richardson SORRY to labour the point but this comes from a genuine concern for the readers o...

Read
Asian polyethylene price recovery faces multiple challenges
25/06/2020

By John Richardson THERE are reports of significant cuts in Middle East polyethylene (PE) operating ...

Read
China’s long-term ambition for paraxylene self-sufficiency seems close to being realised
21/06/2020

On Friday, I examined how China’s paraxylene (PX) net imports could fall to as little 8m tonne...

Read
China’s big declines in 2020 PX and PP imports: the impact on its major trading partners
18/06/2020

By John Richardson CHINA’S refineries and petrochemicals plants came roaring back to almost fu...

Read
Paraxylene demand collapses as higher China production threatens 6m tonne fall in imports
15/06/2020

By John Richardson DON’T SAY I didn’t tell you that a decline in stock markets would happen. The...

Read
Coronavirus will severely damage the developing world unless we take the right steps
12/06/2020

By John Richardson IT IS a fantastic achievement. “Over the last 25 years, more than a billion peo...

Read
Main Street versus Wall Street and the crisis in the developing world
10/06/2020

By John Richardson RISING equity and oil markets do not necessarily point to a V-shaped recovery. I ...

Read
Why the EU could become polyethylene self-sufficient in the post-pandemic world
08/06/2020

By John Richardson ONE OF the many unknowns about the post-pandemic world is the extent to which the...

Read

Market Intelligence

ICIS provides market intelligence that help businesses in the energy, petrochemical and fertilizer industries.

Learn more

Analytics

Across the globe, ICIS consultants provide detailed analysis and forecasting for the petrochemical, energy and fertilizer markets.

Learn more

Specialist Services

Find out more about how our specialist consulting services, events, conferences and training courses can help your teams.

Learn more

ICIS Insight

From our news service to our thought-leadership content, ICIS experts bring you the latest news and insight, when you need it.

Learn more
X

Uncover exclusive industry upates from ICIS

Interested to uncover more articles related to this topic? Explore additional news, insights and intelligence, tailored to the markets you are interested in by accessing exclusive content from ICIS.com

DISCOVER MORE