Stand Back And Think: Can This Oil-Price Rally Really Last?

Australia, Business, China, Company Strategy, Oil & Gas, Olefins, Polyolefins, US

By John Richardson

US-crude-oil-stocks-2015-02-11THE talk in oil markets right now is largely about falling US rig counts and how this has resulted in tighter supply.

But it is very important to note that this focus on the rig count is a recent phenomenon.

“People have only started paying attention to the oil rig count in the past week despite the fact they have been falling for weeks,” Gene McGillian, analyst at Tradition Energy in Stamford, Connecticut, told Reuters in this 6 February article.

“I think the people really benefiting from these market gyrations are the high frequency traders (HFT) as volumes are really up,” McGillan added.

Bullish news stories on oil have thus soared in number since late January, which has been picked up by the algorithms operated by the HTF traders. This “evidence” of a more positive outlook has prompted the HTF traders to increase their long positions in oil markets.

As the HTF traders have gone longer, and as other people have jumped on the bandwagon, oil has gone even higher, resulting in an a greater volume of stories about how crude has finally bottomed out. These stories have again been picked by the algorithms run by the HTF traders and the cycle has repeated itself.

This is fine if you are an oil trader who has already made the right bets.

But it is not so fine for either petrochemicals producers or buyers if this recovery in oil loses its momentum. Anybody who buys, say, naphtha or polyethylene resin ahead of further rises in crude that do not materialise  might well end up in a lot of trouble.

It essential, therefore, to stand back, look closely at this rig count story, and ask yourself this question: “Can this oil-price recovery really last?”

Here are some facts to consider:

  • While US companies have idled 151 rigs in five shale formations since reaching a peak of 1,157 in October, they’ll need to shut down another 200 for oil-production growth to stall, according to the US Energy Information Administration (EIA).
  • US shale-based output is still expected by the EIA to reach an all-time record high of 5.47m million barrels a day in March.
  • The US shale industry has become better at blasting crude out of deep underground layers of rock, according to productivity data tracked by the EIA in the major shale prospects including the Bakken, Eagle Ford, Niobrara, Permian and Utica. These improvements have helped overcome the natural depletion of existing wells.
  • As drillers cut costs, the less efficient equipment is idled first while the best machinery is dispatched to the most promising acreage, which boosts the amount of crude produced for every rig in the field.
  • US crude in storage remains at an 80-year high and there have been reports that foreign producers have been leasing tankers to sail around in circles with cargoes of crude waiting for the price to rise. No one, apparently, wants to be the first to cut production, preferring instead to take a “wait-and-see” approach.
  • With storage US storage tanks full to the brim, from March onwards the turnaround season at US refineries is set to begin. This will weaken demand.
  • The price when producers chicken out isn’t necessarily the average cost of production, which for 80% of new US shale oil production this year will be $50 to $69 a barrel, according to Daniel Yergin of energy consultant IHS Cambridge Energy Research Associates.
  •  Instead, the chicken-out point, as I have been arguing since last October, is the marginal cost of production, or the additional costs after the wells are drilled and the pipes are laid. This “chicken out” point is when cash flow falls to zero.
  • Last month, Wood Mackenzie, the energy consultancy, found that of 2,222 oil fields surveyed worldwide, only 1.6% would have negative cash flow at $40 a barrel. The marginal cost for efficient US shale-oil producers is about $10 to $20 a barrel in the Permian Basin in Texas and about the same for oil produced in the Persian Gulf.
  • For arguments sake, and this is a real stretch, let’s pretend that all of this is wrong and US production cuts are already very deep.  Oil prices might then continue to rise, shale production would surely increase again. The difficulty then is that the Saudi Arabians could then pump even more oil as they play their “long game” of winning back market share, leading to another retreat in the oil price.

The other key element here, worth separate mention, is obviously demand. China is slowing, along with the rest of the global economy. The Paris–based International Energy Agency recently reduced its 2015 global demand forecast for the fourth time in 12 months by 230,000 barrels a day to 93.3 million and sees supply exceeding demand this year by 400,000 barrels a day.

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