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Evan Kelly

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Midweek Sector Update: Oil Price Rally Has Markets Uneasy

Oil prices have rallied nearly 30% since March, demonstrating some resilience and strength amid all sorts of conflicting projections about oil production. But now the next steps are uncertain. When oil prices were hovering in the mid-$40 per barrel range, there was very little room to drop. It was just a matter of how long it would stay at that low price point. However now, having posted strong gains in the last few weeks, there is a lot of disagreement over whether the rally will continue, if prices will stay flat where they are now, or if they will fall once again.

The bullish case goes like this: rig counts will continue to decline in the U.S., and that will soon be followed by a steady drop off in production. Spending is already way down across the board. Demand is also rising. Taken together – weaker supplies and stronger demand, prices should rebound fairly strongly and relatively soon. Related: OPEC Says US Oil Boom Will End This Year

But there is a flip side to that argument. Production levels are still elevated. Output is probably still outpacing demand by about 1.6 million barrels per day. U.S. oil inventories are at record highs and still growing, albeit at a slower rate. A backlog of wells waiting to be fracked – a fracklog – will bring a rush of new supply online when companies begin to step up completions. Meanwhile Saudi Arabia is increasing production.

There is probably some middle ground between those two scenarios, but major investors are battling it out. Hedge funds and other large investors are jumping into bullish positions, betting on a price recovery. But, as Citi analysts recently noted, the price rise over the last few weeks could actually set the stage for a more painful second half of the year. Prices didn’t stay low enough long enough to force real substantive cutbacks in production. With a bit of a rise, drillers may not end up cutting deep enough. That could prolong the glut, preventing a rebound.

And that pain keeps rolling in for some in the oil industry. Specifically, oilfield services continue to get knocked as the downturn in prices has forced a steep scaling back of drilling activity. Halliburton (NYSE: HAL) released first quarter earnings last week, where it revealed a $643 million quarterly loss. It also announced 9,000 job cuts, or about 10% of its workforce. That came on the heels of Schlumberger’s (NYSE: SLB) announcement that it was slashing 11,000 jobs. Moreover, Halliburton agreed to pay $35 billion last year in order to take over Baker Hughes (NYSE: BHI), another major oil field services firm. Baker Hughes released its own numbers for the first quarter, reporting a $589 million net loss. Baker Hughes also announced that it would eliminate 10,500 jobs, or 17% of its total workforce. Until drilling picks up, oil field services companies will continue to bear the brunt of the oil price crash. Related: The EIA Is Bizarrely Optimistic About Future US Oil Production

Amid the gloom, the biggest names in oil and gas descended on Houston this week for the annual IHS CeraWeek conference, a gathering of the top industry names in North America. While recent years have exuded a more triumphalist tone, this year’s conference was a bit more sober given the oil price crash. Some companies struck a dour note with grim predictions for the rest of the year, others were more a little more upbeat, emphasizing the fact that falling costs will help keep shale economical. ConocoPhillips reiterated that it was not second guessing U.S. shale. In fact, the company is selling off other conventional assets to focus on more shale drilling.

One thing that the conference participants all agreed upon was the need for the U.S. government to scrap its ban on oil exports. Senator Lisa Murkowski (R-AK), the top Senator on energy matters, compared the export ban to self-imposed economic sanctions. “We shouldn’t lift sanctions on Iranian oil while keeping sanctions on American oil,” she told the CeraWeek audience. “It makes no sense.” She vowed to try her best to open up the U.S. for oil exports and said that she will introduce legislation this year to do just that. Related: The Latest Media Attempts To Suppress Oil Prices

Meanwhile, the European Union is planning on releasing a multi-year investigation of Gazprom this week. The top anti-trust regulator will issue charges against Gazprom for violating competition laws as soon as April 22. The charges are the latest salvo in an ongoing saga pitting Gazprom against European energy consumers. The case against Gazprom was frozen amid the violence in Ukraine in 2014, but if the recent antitrust case against Google is any indication, it appears that the EU competition commission means business. Gazprom could settle with the EU, but that will involve changing some of its business practices, including how it dictates contract terms and what prices it sells natural gas for to Europe. The antitrust case is not the final act; it is likely merely one more scene in a long play between the EU and Russia on energy matters. Still, it will give the EU a bit more leverage against Russia moving forward.

Over in the Middle East, the conflict in Yemen may be adding a bit of a risk premium to the price of oil. The violent conflict, which pits Iranian-backed Houthi rebels against Saudi Arabia and its allies in Yemen, is showing no sign of going away just yet. Yemen is a tiny oil producer, but it sits at a strategic location where large volumes of oil are trafficked. The U.S. Navy announced that it would send warships to the Gulf of Aden to monitor the area. Worries over a potential supply disruption through the Gulf of Aden are unfounded, but the oil markets are watching that situation with concern over the conflict widening into something more regional and larger-scale. For now, oil prices are only up a bit because of the violence, but market watchers should keep an eye on the conflict.

By Evan Kelly of Oilprice.com

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