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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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U.S. Production Is Falling, Why Isn’t Oil Recovering Faster?

Why aren’t oil prices rising faster? The recent recovery in oil prices has largely stalled out and investors looking at historical figures could be forgiven for not understanding why prices cannot move higher for now.

Oil is stuck in neutral despite the fact that even after prices started to crash, many investors once saw $60 as a remarkably cheap threshold. Today, prices remain firmly below that level, and investors will probably have to wait for more positive data before getting close to that level.

The problem is not production or a glut of oil. U.S. oil output is falling slowly but steadily over time. At this point, the U.S. is producing about 8.4 million barrels per day, which is the lowest level since roughly May of 2014. Oil production displays a high degree of serial autocorrelation over time, meaning that production tends to continue in trends. Actions taken to boost or cut production tend to pay off over time giving production levels a high degree of inertia. As a result, it’s likely that U.S. production will keep falling for the next few months at least.

The Baker Hughes rig count has fallen dramatically versus year ago levels. While rig counts have probably bottomed and may even bounce a bit, it is unlikely that counts will rise sharply any time soon despite the modest increase reported recently.

Part of the reason that oil prices have not responded more quickly to U.S. production cuts is Iran. Iran has been ramping up production at almost the same rate that the U.S. has been cutting production. This won’t continue. Realistically, Iran is at the end of its rope in terms of ability to ramp up production. All of the low hanging fruit has been plucked and to materially increase production from here, the country needs billions upon billions in foreign capital investment – a prospect that looks unlikely and at a minimum will take several quarters of negotiations.

At current prices, most oil companies are in no hurry to dump money into risky capital investments, and the vast majority of companies are rightly more concerned with maintaining the stability and safety of their balance sheets. Related: Iran Aims To Double Oil Exports, These Are The Hurdles

The other issue for oil prices is that inventories remain high. Oil inventories are significantly elevated in the U.S. thanks to production here along with rebounding Canadian and Russian production. Inventory is so inflated that numerous additional storage containers have been built in places like Cushing to take advantage of the need for storage. Ocean transport and even oil tanker cars are also being used to hold the sea of crude.

While U.S. production is down 12 percent versus its June 2015 peak, it will take time to work through crude inventories. Inventories stand at roughly 524.4 million barrels, which is the highest level in at least a decade. The increase in imports of crude to the U.S. has helped buoy that especially since the U.S. economy is about the only major economy that is functioning even close to potential output. Moreover, some analysts are worried about the slow rise in the Baker Hughes rig count number, which has risen for 5 of the last 6 weeks. Against this backdrop it probably not surprising that a lot of major institutional investors have backed off of bullish oil bets.

Add all of this up, and investors should not be surprised that oil prices may be stuck in neutral for the time being. This situation provides an opportunity to look at which U.S. oil firms are capable of generating profits at current prices. Those are the stocks that investors should look to own.

By Michael McDonald of Oilprice.com

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  • Tradezero on July 18 2016 said:
    Investment in the field of oil is falling , since everyone wants to maintain their company in an equilibrium. https://goo.gl/bdmGER

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