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The Consequences Of $50 Oil

Roughnecks US Shale

On Thursday Brent crude rose above $50 while the WTI rose to $49.85. The rise in prices came after the EIA reported a dramatic fall in U.S. inventories. The weekly drop of 4.2 million barrels, far more than the 2 million that was expected, triggered a sharp rise in a market which had been growing increasingly bullish, sending the Brent price above $50 on Thursday morning. It is the first time in seven months that the price has reached this level.

It’s a recovery that came much more quickly than analysts expected. Since reaching a low of $27 in January, both Brent and WTI have risen by nearly 80 percent, an impressive achievement considering the general slump in commodities. Concerns from the Energy Information Agency (EIA) that the world would “drown in over-supply” in 2016 have been allayed.

The new price reflects disruptions in world production. Wildfires in Canada have affected imports to the U.S., while persistent violence in Nigeria has caused that country’s exports to fall from 2.2 million bpd to less than 1.4 million bpd according to the Nigerian oil minister. Canadian crude is the single largest U.S. oil import, and the sudden fall in Canadian production was bound to have an impact on U.S. inventories. There is also the increasingly chaotic situation in Venezuela, a major Western hemisphere producer which has been hammered by economic crises brought about by the slump in prices. These disruptions, combined with falling production elsewhere, have accelerated the upward trend in prices, indicating that the market could be close to levelling off near a $50 baseline. Related: Depreciating Dollar Sees Crude Climb To 7-Month High

That’s good news for investors, many of whom have been anxiously watching the ongoing rally, waiting for a sure sign that things were getting back to normal. Predictions that prices would reach $50-60 by the summer before levelling off have proved persistent since the price cratered below $30 in January, and early this week an analysis from Citigroup estimated a stable price would be reached later this year.

Still, there are many indicators that this is a temporary situation: a variety of factors may combine to send the price back down. While output from Canada and Nigeria fall due to disruptions, barriers to Libya and Iranian production are slowly being lifted. Last week Libya announced a compromise between its warring east and west factions, allowing for exports from its oil port al-Hariga to resume. This will bring as much as 300,000 bpd back on-line and may signal a resurgence in Libyan output after a five-year hiatus.

OPEC’s greatest success story this year has been Iran, which in the five months since sanctions were lifted has increased its production by a wide margin, pumping 3.6 million bpd in April and exporting over 2 million bpd. Another attempt to freeze production may come when OPEC meets again in June at its headquarters in Vienna, but most analysts aren’t holding their breath. After the failure at Doha in April, there are growing doubts about OPEC’s ability to function as an effective cartel. Saudi Arabia will likely continue to produce at high levels to compete with Iran, which will further impede prices. Related: Clinton Chasing Votes With Fracking U-Turn

For prices to recover completely, there will have to be a strong recovery in global demand. Earlier fears that the world’s thirst for oil was in the midst of a long-term decline have been partially put to rest by rising demand in emerging markets, most notably India, the world’s fastest-growing energy market. EIA estimates of world energy demand were revised upwards for 2016 and 2017, and consumers in the U.S. have taken advantage of low fuel prices, further pressuring the upward trend in prices. But that demand could taper off when the era of historic low prices comes to an end.

High prices will, of course, compel new production in high cost areas. The gradual decline in U.S. production may be partially arrested if the price hovers over $50 for long enough. Shale production, which has proven surprisingly resilient considering the enormous pressure placed on shale producers, could tick back up, triggering an eventual fall from $50 in the weeks or months ahead. Then again, some analysts have pegged the break-even for U.S. shale at a higher level, anywhere from $100 to $75 to maintain profitability. This indicates that the decline in the shale sector will continue, along with the sweeping bankruptcies that have plagued the U.S. oil patch since last year.

If U.S. shale stays competitive, it could trigger another round of production increases from Saudi Arabia, which is determined to do its utmost to hold on to market share even as it boasts of long-term plans to build an “oil-less” economy by 2030. The Saudi bottom line has been ravaged by years of low prices, generating huge budget deficits and debts to contractors (which the Saudi government will attempt to cover through IOUs). Nevertheless, Saudi Arabia remains uniquely positioned to weather such storms; should the price fall again, it is better-placed to retain market share than the high-cost producers in the U.S. and elsewhere.

By Gregory Brew for Oilprice.com

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