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Oil Prices Retreat On Rising OPEC Output In May

Oil prices reversed earlier gains…

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Gloomy Outlook Sees Hedge Funds Turns Bearish On Oil

Hedge funds slashed their bets…

Why Oil Won’t Rally Above $60 In The Near Term

Drilling rig

Last week the IEA warned that rising non-OPEC production could put an end to the OPEC-fueled price rally that began in late November after the cartel’s agreement to cut production. With oil production bouncing back in the shale patch and a handful of other large-scale offshore projects set to come online, global output could prove resilient despite OPEC’s best efforts.

That raises the prospects of a new trading zone for crude oil, trapped within a narrow band between $50 and $60 per barrel. OPEC’s cuts of 1.2 million barrels per day, plus the non-OPEC reductions of almost 600,000 bpd, will put a floor beneath crude at $50. The cuts ensure that the market will not be excessively oversupplied going forward, perhaps blocking another potential downturn in oil prices. On the other hand, the swift rebound in shale drilling could put a cap on prices, killing off any chance of a sustained price rally. Anytime prices try to rise beyond the $50s per barrel, more shale production will come online and push prices back down.

There are plenty of signs that suggest that both of these forces are playing out. OPEC officials are striking an optimistic tone in regards to compliance with the promised cuts. Over the weekend, Saudi energy minister Khalid al-Falih said that OPEC and non-OPEC countries have already complied with 1.5 million barrels per day of cuts since November, although those figures are still preliminary. The figures that al-Falih provided to the media did not include an overall collective output figure, nor did they include rising production from Libya and Nigeria, countries exempted from the Nov. 30 deal. So they should be taken with a grain of salt. Related: Brazil’s Massive Oil Upside Explained In One Chart

Still, al-Falih said that compliance with the deal has been “fantastic.” Meanwhile, Qatar’s oil minister Mohammed al-Sada brushed off threats from rising U.S. shale. “Even with increasing shale drilling, we still see a rebalancing of the market,” he said.

But the shale industry appears to be putting a cap on the rally. As oil prices climbed back above $50 per barrel following the OPEC deal, the increases in the rig count began to accelerate. There have been 235 oil rigs added back to the shale patch since hitting a low point in May 2016, with nearly a third of those having been deployed since the OPEC deal was announced less than two months ago. Last week alone saw 29 oil rigs added, which is the largest single-week increase in nearly four years. At the same time, U.S. oil production is up 400,000 bpd since the end of last summer.

As a result, we could see oil prices trading within a narrow price band as a result of the opposing forces of OPEC and U.S. shale. This “shale band” theory has been floating around for almost two years at this point, but there is a growing consensus that such a narrow trading range is emerging. “There are of course a lot of dreams out there about much higher prices ahead, but for now a market consensus seems to be forming around these two supply forces: OPEC cuts at $50/b versus U.S. shale supply boost at $60/b.” Bjarne Schieldrop, chief commodities analyst at SEB, the leading Nordic corporate bank, said in a statement. Related: Why Russia Beat Saudi Arabia As China’s No.1 Oil Supplier

Since the OPEC deal was announced in late November, oil has indeed traded within this range. At least twice, prices started to move towards the mid- to upper-$50s per barrel, only to get pushed back down again by news about rising rig counts and higher oil production figures. Similarly, when WTI starts to test the lower bound at $50, news about OPEC compliance keeps benchmark prices from breaking below that threshold.

(Click to enlarge)

The effect could also lead to less volatility, despite the IEA’s recent warning to the contrary. If OPEC and U.S. shale squeeze prices into a $50 to $60 per barrel range, there would be less of a chance of the astounding weeks-long price rallies and crashes that the markets became accustomed to since 2014. Daily price movements can still be significant, but it was not a rarity to see 5 percent swings in a single day as recently as a year ago.

Of course, the shale band is not an ironclad theory by any means, nor is it permanent. There are plenty of factors that could trash the credibility of this hypothesis, namely, poor OPEC compliance, weak oil demand, higher-than-expected shale production, and stubbornly high crude oil inventories, which could all work together to push prices lower. Likewise high OPEC compliance, strong demand, a faster drawdown in stockpiles and disappointing figures from U.S. shale could spark a rally above $60 per barrel. Time will tell.

By Nick Cunningham of Oilprice.com

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