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Midweek Sector Update: Not Everyone Is Convinced By The Current Oil Price Rally

Midweek Sector Update: Not Everyone Is Convinced By The Current Oil Price Rally

The rally in oil prices – jumping by around 10 percent in a week – took a breather at the start of this week, as the markets began to digest what happens next. WTI dropped back to $47 per barrel from $50, and Brent traded just below $50 per barrel, down from about $52 last week. Prior to the rally, there was a growing consensus that crude had hit bottom, and a rally was around the corner. Now that oil has bounced off of its recent lows, there is quite a bit of disagreement over the sustainability of the rally. For oil bulls, U.S. oil production will continue to contract at the same time that demand continues to rise. Just last week, the rig count plummeted to fresh multiyear lows, with oil rigs dropping by 9 to 605. The deeper cut to the number of rigs plying for oil and gas indicates that steeper declines in production are coming down the pike.

Still, bearish calls for oil prices persist. Deutsche Bank warns that the rally in energy stocks could be overdone. Citigroup’s Ed Morse says the bust in oil markets isn’t over yet. “I think we are not at the bottom because we are still seeing consistent cost deflation,” Morse said at a conference in Peru over the weekend. Royal Dutch Shell’s (NYSE: RDS.A) CEO Ben van Beurden does see a rebound, however. “I see the first mixed signs for a recovery in oil prices,” van Beurden recently said. UBS sees the same, predicting that oil prices will rise to around $70 per barrel within the next year. The projections are all over the map, to say the least. Related: China To Continue Expanding Its Influence In The Oil And Gas Sector

To muddy the picture further, the IEA released its monthly report for October, which didn’t include much of a change from the previous month. The Paris-based energy agency still expects oil markets to be oversupplied in 2016 as demand growth slows from a five-year high of 1.8 million barrels per day in 2015 to a more pedestrian 1.2 million barrels per day in 2016. At the same time, it appears increasingly likely that Iran will be able to bring new supplies online next year. So, softening demand along with new sources of supply add up to a market that will take some more time to balance out.

For its part, OPEC published its monthly report on October 12, which showed gains in production from the cartel of about 109,000 barrels per day in September compared to August. The gains came mainly from Iraq, which added 80,000 barrels per day in output. Nigeria, Angola, and the UAE also added production, while Saudi Arabia pared back production by 48,000 barrels per day. The data illustrates how each member is working hard to increase its own output in order to make up for the shortfall in revenues from low oil prices. The data also put a damper on oil prices, as OPEC production is acting as a counterweight to the contraction in North America.

At the same time, OPEC members are also struggling terribly. No country is worse off that Venezuela, which is almost entirely dependent on crude for its export revenues. Venezuela is set to propose a new strategy for OPEC, calling for the group to reinstitute a price band that has not been seen since 2005. Back then, OPEC targeted a band of $22 to $28 per barrel, but abandoned the policy once oil prices surged above the upper limit. The price band, under Venezuela’s new proposal, would consist of the oil cartel seeking to keep oil prices above a floor price of $70 per barrel, which would later rise to $100 per barrel. Venezuelan officials will release the proposal when they meet with OPEC officials on October 21. As with prior pleas from Venezuela, OPEC is unlikely to pursue such a strategy as long as its most powerful member (and the country that will have to do the overwhelming amount of cutting), Saudi Arabia, decides that it wants to pursue market share. Related: Tanker Companies Profiting From Low Oil Prices

The credit redetermination period in the U.S. for shale drillers is being closely watched to see if a cut in lending will force indebted shale drillers out of the market. But there are reasons to believe that the evaluations will not necessarily be as monumental as many had believed (or hoped). Firstly, if Oasis Petroleum (NYSE: OAS) is anything to go by, the cut in lending may not be as draconian as first thought. The company, which is burning cash at today’s prices, saw its credit facility only cut from $1.7 billion to $1.525 billion.

Moreover, more than two-thirds of U.S. oil and gas production comes from companies that do not use the reserve-based lending structure for their financing, according to Bloomberg, meaning there is only a small slice of U.S. output that is vulnerable to lending cut offs. And for those that are in fact subject to pending cuts in credit, their facilities would need to be slashed by more than half for them to be in serious danger of going out of business. The results aren’t entirely in yet, but Oasis Petroleum’s outcome suggests that the credit redetermination period may not turn out to be the pivotal event for balancing the oil market that everyone had previously expected. Related: This State Just Became The World's Greatest Renewables Market

Still, oil and gas companies in the U.S. are seeing their hedging positions expire. And some are taking advantage of last week’s rally in oil prices to lock in hedges at $50 per barrel. Hedging activity spiked for December 2016 delivery, hitting a weekly high, according to Reuters. The movements suggests a few things. Firstly, oil companies are a lot more pessimistic than they were this past spring, when the rally to $60 per barrel did not spark a flurry of hedging for the future. In other words, while companies thought prices would rebound higher than $60 per barrel earlier this year, and thus decided not to lock in future production, now they are happy to lock in at $50 per barrel. At the same time, the hedging activity indicates that some in the industry are positioning themselves to survive at $50 per barrel, which could keep supplies online for quite a while, stifling a recovery. 

By Evan Kelly of Oilprice.com

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