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This Week In Energy: Can This Rally Hold?

This Week In Energy: Can This Rally Hold?

Readers probably have whiplash after the wild ride this week. On Monday, global markets crashed at frightening speeds, with oil prices spiraling out of control. China’s stock market meltdown raised fears of it spreading globally. Fresh intervention by the Chinese central bank has halted the decline for now.

Then on Thursday, global markets skyrocketed on positive economic data coming from the United States and subsiding fears of a China-induced global meltdown. In the second quarter, the U.S. economy expanded at a 3.7 percent annual rate, sharply up from the original estimate of just 2.3 percent.

That sparked a massive rally, with oil prices shooting up by more than 10 percent, the most in a single day since 2008. It wasn’t just the solid growth rate from the U.S. that caused oil prices to jump. Royal Dutch Shell (NYSE: RDS.A) also declared force majeure on its oil from Nigeria, after it was forced to close two oil pipelines. Oil theft, sabotage, and violence are rampant problems for oil producers in Nigeria. A leak struck Shell’s Trans Niger Pipeline and the company also had to conduct maintenance to avoid theft on its Nembe Creek Trunkline. The lost production was a bullish catalyst for oil, as some production was expected to be removed from global markets.

Traders also covered their short positions, which have piled up in recent weeks. With so many traders on the short side more than usual, this week’s drop had many taking profits and covering their positions. That sparked a one-time jump in oil prices, one that was inordinately large. As such, oil prices could level off instead of continuing their rally, as traders refocus back on the fundamentals of the market, which don’t necessarily look bullish. As of mid-day trading on August 28, oil prices were up by over 1 percent. Related: Sweden’s Nuclear Shutdown A Sign Of What’s To Come

As we have seen throughout this year, the downturn in oil prices is forcing major cutbacks across the industry. According to the Wall Street Journal, the number of exploration wells drilled in 2015 will hit only 1,004, a decline of 26 percent from 2014, and the lowest level in five years. Also, the cutbacks are more acute at medium-sized and small exploration companies, which lack the downstream diversification that can insulate them from the slide in oil prices.

Of course, the cutback in the number of wells drilled are logical at this point, but could set the world up for a tighter oil market in several years as new sources of supply fail to come online. Such a dynamic has played out before – the industry scaled back in the 1990s when oil prices were low, only to struggle to keep up with surging demand a decade later. Going forward, as demand steadily rises, production could level off in the 2020s as a dearth of new projects reach completion. While it may be difficult to see from our vantage point in 2015, oil prices could rise substantially in the years ahead.

As mentioned above, larger integrated oil companies have seen their downstream profits surge during the oil price downturn, offsetting losses from their upstream divisions. But the coming months could see the refining sector start to lose some steam as peak driving season comes to an end. BP’s (NYSE: BP) CEO Bob Dudley said that while downstream profits have been “very, very strong,” as we enter autumn months, downstream profits may not remain at such heights. “Actually, we see some of those correcting,” he said. Related: Did The Fed Intentionally Spark A Commodity Sell-off?

With the prospect of motorists consuming less gasoline, demand could drop, shrinking refining margins. In fact, Jeffries analysts concluded that refining margins shrank by 15 percent last week. Moreover, the supply side also looks a little negative. Refined products are building up in storage in Europe, just as crude oil stocks increased to unusually high levels. Also, Saudi Arabia is bringing new refineries online, which could increase the supply of refined products, potentially resulting in a glut that will push down prices. Total’s (NYSE: TOT) CEO said the downstream sector is in a “crisis,” and his company plans on slashing its refining capacity by one-fifth over the next two years.

OPEC, led by Saudi Arabia, will continue its current policy of pursuing market share. The group has a target level of production set at 30 million barrels per day (mb/d), although the cartel’s members are collectively producing well in excess of that level. Moreover, as each producer is suffering from shrinking revenues, they are responding by trying to ramp up production to compensate. That means without cohesion, OPEC’s collective output could continue to increase, led by gains from Iran and Iraq in particular. Related: Why Saudi Arabia Won’t Cut Oil Production

Venezuela is arguably facing the ugliest fiscal and economic crisis out of all OPEC members, and Venezuela’s leadership has called upon other members to convene an emergency meeting. Coordinated cuts are almost entirely out of the question at this point, given Saudi Arabia’s determination to maintain market share. But even if cuts were to occur, in all likelihood it would not be enough to boost oil prices to an acceptable level for countries that need oil prices in the triple digits for their budgets to breakeven. OPEC members have discussed coordinated cuts with Russia in the past, but again, that is highly unlikely. Russia – just like Venezuela, Algeria, Iraq, or any other struggling oil producer – cannot afford to cut its own production. Consequently, despite Venezuela’s call for a reevaluation of strategy, individual incentives will result in no collective action, and continued maximum production.

Speaking of Russia, western sanctions are taking their toll on a major Russian natural gas export project. Yamal LNG, a massive liquefaction and export facility under construction on the Yamal Peninsula in the Russian Arctic is facing significant delays as sanctions prevent the operators from accessing finance. The $27 billion project, led by Novatek (LON: NVTK) and Total, has been unable to tap western finance, forcing the operators to depend more heavily on loans from China. But even China, once an endless supply of capital, is becoming more cautious as its financial system faces cracks. A shortage of cash could delay the project, which has a small margin of error in terms of construction timelines as shipments are scheduled to begin in 2017. The project plans on shipping LNG along Russia’s northern coastline to China while the frigid waters are free of ice, and west to Europe during other times of the year. The possible delays highlight the very real damage that western sanctions are doing to the Russian economy.

By Evan Kelly of Oilprice.com

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