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RPT-COLUMN-Does oil's rally put rebalancing at risk? Kemp
February 5, 2015 / 12:05 AM / 3 years ago

RPT-COLUMN-Does oil's rally put rebalancing at risk? Kemp

(Repeats Feb. 4 item. John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, Feb 4 (Reuters) - Brent crude prices rose almost 18 percent between Friday and Tuesday, despite the absence of real news, which should convince even the most ardent believers in market efficiency that oil trading is noisy and inefficient at processing new information.

The 8 percent surge late on Friday was only the third time in five years prices have jumped by three standard deviations in a single day. The March 2015 Brent futures contract gained substantially more on Monday and Tuesday. (link.reuters.com/wah93w)

The oil research team at Morgan Stanley has written that the three-day rally is putting at risk a more sustainable recovery later in the year.

“U.S. production needs to slow sharply to balance the (global) market, which requires low prices,” they wrote in a thoughtful note published on Tuesday (“Crude oil: putting recovery at risk?”).

“For a more meaningful recovery, demand needs to exceed supply to work off any inventory overhang that develops,” they concluded. Premature price increases simply hamper the rebalancing.

REAL NEWS AND NOISE

The beginning of the rally coincided with the release of data from Baker Hughes showing an unexpectedly large fall in the number of rigs drilling for oil in the United States last week.

The decline, although larger than anticipated, was not really news. The number of active rigs had been falling steadily for the previous seven weeks, so the trend was well understood.

The size of the move was wholly unrelated to the significance of the information that triggered it. Instead, the rig news sparked a classic short-covering rally, as hedge funds with significant positions betting on a further price fall found themselves losing money as oil rose, and rushed to reduce their exposure, pushing prices up even more.

“Is the falling U.S. oil rig count really driving an oil price turnaround?” analysts at Citigroup wondered in a research note of the same title published on Wednesday. Productivity gains and more careful selection of drilling targets will reduce the impact of rig cuts, they predicted.

But markets are not precision weighing machines. They are voting machines - subject to whims, crazes and manias in the short and medium term as even the greatest fundamental analysts of all admitted in their landmark work (“Security Analysis”, 1934, Benjamin Graham and David Dodd).

Fundamentals always reassert themselves eventually, but it can be a long time coming, as generations of fundamentally driven investors have discovered.

Crude had become heavily oversold in the expectation prices would continue the steady downtrend of the previous 17 weeks. Once that assumption was invalidated, market participants and prices reacted sharply.

There is no mystery about why oil fell so far and so fast between June 2014 and late January 2015, or why the decline terminated so abruptly. Price formation in bubbles and crashes has been thoroughly examined by Didier Sornette at the Swiss Federal Institute of Technology (“Why stock markets crash: critical events in complex financial systems”, 2003).

There is much more disagreement about where prices will settle for the rest of the year. For oil market bears, futures must remain below $50 a barrel and perhaps even $40, to force a much larger and sustained drop in U.S. drilling.

RIGS VERSUS PRODUCTION

Citigroup notes the largest activity declines so far have been among smaller, older, less sophisticated rigs that drill vertical or slanted wells, rather than the most modern and powerful rigs with horizontal capability.

In the Big Three shale formations (Bakken, Eagle Ford and Permian), which account for almost all of the increase in U.S. oil production since 2010, 199 rigs have been idled since early October.

About 170 other rigs have been idled in conventional oilfields or more marginal plays that have added relatively little to production growth in recent years.

By employing the remaining, larger and more modern rigs on the best and surest drilling prospects, and withdrawing from more marginal and speculative well sites, production could be maintained or even continue to grow, according to Citi.

The bears are almost certainly correct. The decline in production from new wells is likely to be much smaller than the drop in the rig count owing to efficiency improvements and more selective drilling.

Based on an analysis of drilling productivity in the Big Three shale basins, Citi estimates U.S. production could still grow by another 700,000 to 900,000 barrels per day despite a 40 percent reduction in rigs.

Nonetheless, in my view, the decline in the rig count is too large not to have a substantial impact. The number of rigs active in North Dakota, for example, has fallen from more than 190 in September and October 2014 to just 142 on Wednesday, says the Department of Mineral Resources (DMR), which regulates drilling in the state.

In a presentation to state budget-setters last month, the DMR estimated a fleet of 140 active rigs would be needed just to sustain output at the current level of 1.2 million barrels per day, given decline rates on old wells.

The number of active rigs has now been reduced to this threshold level. If the DMR is correct, output should flatten over the next few months.

PRICES RISK ADJUSTMENT

But even after the rally, the price U.S. shale oil producers receive at the wellhead remains below breakeven levels in all but the most attractive parts of the Big Three shale plays.

For example, wellhead prices in North Dakota are only around $45 per barrel, based on an average of WTI futures prices ($53) and posted prices ($37).

With wellhead prices at $45, the DMR projects that state production will decline by around 100,000 barrels per day by the start of July.

State oil producers need wellhead prices of around $55 per barrel to sustain output, which implies WTI prices of perhaps $60 or more.

The recent rally in Brent and WTI futures is unlikely yet to put the rebalancing at risk. Output is still likely to fall in the second half of the year.

Underscoring the depth of the adjustment already under way, National Oilwell Varco, the largest supplier of drilling equipment in the United States, reported that fourth-quarter orders in its rig technology equipment division were down 90 percent compared with a year earlier.

“Customers are delaying purchases of both capital and consumables wherever possible, seeking to conserve cash in the face of market uncertainty,” the company’s chief executive said on a post-earnings call.

As long as wellhead prices remain below breakeven levels, drilling will continue to slow, and output will remain on course to peak around the middle of the year and then start to decline. (Editing by Dale Hudson)

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