Can Oil Prices Go Above $60?

Oil prices flirted with $60 per barrel a few weeks ago, but stopped short of that key psychological threshold and quickly retreated. What will it take to break above $60?

Brent hit $59.77 per barrel on September 26, but was back to $55 per barrel a few days later. There are many reasons why oil prices are struggling to break above $60 even though OPEC continues to hold back about 1 million barrels of supply per day and tensions in the Middle East have risen sharply. For example, oil inventories are declining, but storage remains elevated. Also, fears that OPEC could flood the market next year have not entirely gone away.

There is also a short-term explanation for the recent fallback in prices. Hedge funds and other money managers built up a massive pile of bullish bets in the oil futures market, hoping to ride the wave up. But, as has happened multiple times in the past, when investors get too far ahead of the fundamentals, the rally ends up coming to a dead end. The music stops, and everyone scrambles for the exits. In other words, speculators bid up prices, but they also sow the seeds of a price correction when things get out of hand. That seems to have played out in late September.

However, another important force at work is U.S. shale. Obviously, shale output has grown quite a bit in 2017, but one theory put forward in the past year or so is that U.S. shale will trap oil prices within a relatively narrow band of $40 and $60 per barrel. Anytime oil dips below $40, shale rigs vanish and production falls. When prices flirt with $60, E&Ps scramble to accelerate drilling, buying up acreage and deploying as many rigs as possible. The result is higher output and deflated prices, pushing crude back within the $40-$60 range.

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The reason that U.S. shale is the pivotal factor, and not some other source of production, is the short lead times for new supply. An offshore project, an oil sands operation, or an oil field produced by some state-owned company will continue to produce at low prices. Those projects won’t go offline when oil goes to $30. Similarly, when oil jumps above $60 per barrel, it is not as if those kinds of projects can come online immediately – they tend to take years of planning and lots of investment.

Shale, on the other hand, responds quickly to prices. New wells can be drilled in a matter of weeks, and because production declines precipitously, the industry has to continue to drill a lot of new wells. If prices fall too low, they will hold off on new drilling, and the sharp decline rates from existing wells translate into an overall decline in output. In short, shale supply is much more elastic than other forms of oil production, stopping and starting quickly.

Because U.S. shale now makes up about 5 percent of global supply, it represents the marginal barrel in the short run. That much we knew a year or two ago, but with more data to analyze, it now appears that the industry seems to breakeven at about $50 per barrel. Thus, the shale band theory, consisting of a range between $40 to $60 per barrel, seems to be spot on.

But with the market tightening, $40 per barrel is starting to look less likely. That puts extra psychological emphasis on the $60-per-barrel threshold.

“The market is frightened by the shale oil band,” Olivier Jakob of PetroMatrix, who coined the term “shale band,” told the FT. “But it’s not just traders — we’ve seen indications from OPEC and Russian oil companies that even they think going above $60 a barrel right now would be too much and would bring on more oil from shale. They don’t want it.”

That kind of psychology is now baked into market sentiment. When oil approaches $60, oil traders become skittish, expecting prices to retreat. In order not to avoid getting burned, hedge funds and other money managers are more likely to sell off, creating a self-fulfilling slide in prices. “Their positioning is starting to create some headwinds. That risk is there,” Ole Hansen of Saxo Bank told the FT. “Most of the big moves this year have involved traders caught on the wrong side of the positions, so they may be quick to exit if we don’t see any disruptions from Iraq and they refocus on the normal seasonal slowdown in demand.”

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So, what will it take to break out of the shale band? “It’s going to be difficult to really break $60 a barrel, without some major new event,” Olivier Jakob at Petromatrix, told the FT. “And if we do break $60, it’s going to be even more difficult to sustain it.”

Still, with a return of geopolitical flashpoints in the Middle East, some surprise events are entirely possible. An unexpected outage from Libya, Nigeria, Venezuela, Iran or Iraq should not be ruled out. But until that happens, oil prices might be stuck within the shale band for a while longer.

By Nick Cunningham of Oilprice.com

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