Oil Price Rally Built On Very Fragile Ground

China, Company Strategy, Economics, Naphtha & other feedstocks, Oil & Gas

oil1

By John Richardson

OIL prices rallied yesterday on an unexpected fall in inventories at Cushing in the US to 61.7 million barrels for the week ending 24 April (see the above chart). This was a decline of 514,000 barrels over the previous week, which compared with forecasts of an increase of 400,000 barrels.

So does mean that supply is finally responding to lower prices, resulting in a “New Normal” of crude trading in a pretty stable range of $50-70 a barrel, or perhaps even higher?

No. As a Singapore oil trader who I spoke to this morning put it: “Whoopee, Cushing has declined, but this is only partly because US refinery operating rates picked up a little.

“And the other reason that Cushing storage fell was that it was almost at maximum capacity. In other words, it hadn’t much further to go except down.

“You must also put this decline in to the context of oil inventories across the whole of the US. According to the latest Energy Information Administration report, total US crude stocks are still at their highest level in more than 80 years,” he said (see the chart below).

Oil2

“US oil production also rose by 7,000 barrels last week, and it now at its highest level for several decades,” the trader continued.

American shale-oil production is now at around 4 million barrels a day, up from 1.2 million barrels a day last year.

So why did yesterday see West Texas Intermediate hit $58.58 a barrel, its highest price since 11 December 2014?

Perhaps because of financial speculation. Data shows that in the case of Brent, hedge funds have placed huge bets on higher prices by taking out futures options worth 265 million barrels of oil – yet another all-time high. Commodity markets often move on sentiment, and the sentiment amongst the speculators seems very bullish at the moment.

But as the Singapore trader pointed out, there is plenty of data out there to suggest that this price rally has been built on very fragile ground.

And here are six more important points to consider:

  1. Oil producers have hedged more than 500 million barrels of Brent in order to protect against further price declines. Their ability to so do might well have been helped by the extra liquidity in futures markets provided by the hedge funds. So this means that the producers can now afford to stomach much-lower H2 prices in physical markets because they have locked-in higher prices on futures markets. This could result in oil production remaining high in the second half of this year, even if physical prices do suffer another sharp downward correction.
  2. The view of the oil producers is opposite to that of the hedge funds. ExxonMobil CEO Rex Tillerson, for example, said last week that there would be no quick rebound to higher prices. Exxon is the largest shale producer in the US. Last week also saw the CEO of ConocoPhillips, John Watson, say that he was worried that there were too many US untapped shale-oil awaiting completion. This is the “fracklog” I discussed last month. So recent stronger pricing might be quickly reversed by these wells being brought on-stream.
  3. US shale producers are expected to see their costs fall by 45% this year, and by up to 70% by the end of next year, according to the UK’s Daily Telegraph. Hess, for example, has announced it has already “driven down drilling costs by 50%, and we can see another 30% ahead.” This underlines my point that the US has huge incentives, both economic and political, to continue working very hard to reduce shale-oil production costs.
  4. Oil companies in general, not just shale oil companies,  are treating lower prices as an opportunity to trim costs – and thus lower their production costs. They are finding these savings in  rig rates, the cost of equipment, well completions and other oil services.
  5. Almost all countries can still economically produce oil at $15 a barrel, according to a new IMF and Rystard Energy Study. Only Canada/Australia with costs of $20 a barrel, Brazil at $30 a barrel and the UK at $40 a barrel needed higher prices, added the study. “Lower oil prices are expected to have a smaller impact on production of shale oil in the United States than on deepwater and oil sand production, especially in Brazil, Canada, and the United Kingdom,” wrote the IMF.
  6. Saudi Arabia is playing the long game in order to try and win back market share, and so is unlikely to cut production. There used to be a lot of talk of Saudi Arabia needing oil at around $90 a barrel to balance its budget. But this overlooked the fact that Saudi Arabia has plenty of foreign reserves to enable to withstand prices at much-lower levels for several year. And, anyway, Saudi Arabia remembers the bitter lesson of the 1980s, when its production cutbacks failed to prevent oil prices from falling – because other countries maintained or increased their output.
  7. US dollar strength. A stronger dollar means that recent price declines are having less of a beneficial impact on other countries because they have, of course, seen their local currencies weaken against the Greenback. This has reduced the demand for oil.

And there is an eighth factor worth separate mention, as it is the most important factor of all, which is this: Demand. Apart from the impact of a stronger dollar on oil consumption, the global economy continues to struggle, largely because of events in China.

So as I again think about the hard-pressed chemicals company planning offices out there, here is some concluding advice: Please, please build in a scenario of a sharp retreat in oil prices in the second half of this year.

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