Oil Prices: Collapse Now, Spike Later

Oil prices closed out the week sharply down, wiping out all the gains posted since the start of the year.

Surging U.S. shale production, along with broader financial turmoil, has clearly put an end to the bullish mood in the oil market. U.S. shale struck several blows against oil prices this week.

First, the EIA dramatically overhauled its forecasts, predicting U.S. oil production would hit 11 million barrels per day (mb/d) this year, rather than late next year. Then, on Wednesday, it revealed estimates that put U.S. oil production at 10.25 mb/d for the week ending on February 2, a staggering 330,000 bpd increase from a week earlier. Those weekly estimates are subject to revision when more data becomes available, but if those figures hold, it would point to a significant ramp up in drilling activity and new supply coming online.

As a result, it seems that, in the short run at least, U.S. shale has killed off the oil price rally, which saw WTI move from $50 per barrel in October to the mid-$60s per barrel by January. Brent saw a similar jump from the mid-$50s to $70.

But we’re now potentially moving into the next phase of this cycle, an all-too-familiar correction after prices have seemingly climbed too far.

This time around the downward swing could be aided by a rebound in the strength of the dollar. Typically, a weakening dollar pushes up oil prices, and the rapid run up in prices over the last few months occurred not coincidentally at a time when the dollar posted a steep decline. But the greenback has clawed back gains, particularly over the last week, with expectations of rising interest rates. Related: The Oil Bubble Has Burst. What Now?

"The dollar index got down to 86 [cents], crude got to $66," John Kilduff, founding partner of Again Capital, told CNBC. "[The] dollar index is now back over 90, crude's back down around $61, ready to break and I think fall back down into the mid-$50s here fairly rapidly."

Dollar Index (DXY). Source: Bloomberg

However, the tightening in the oil market has not been a mirage. Inventories are closing in on the five-year average. Goldman Sachs argues that inventories are probably already back at average levels, but it will take time before we know for sure because of data is published on a lag. “The rebalancing of the oil market has likely been achieved, six months sooner than we had expected,” Goldman Sachs said in a recent note, predicting Brent will hit $82 per barrel within six months.

It may seem a bit of a contradiction — on the one hand, the oil market seems poised for a price correction amid rising supplies, financial turmoil and overzealous positioning from hedge funds in the futures market. On the other hand, inventories are back close to average levels and some argue that OPEC could overshoot and tighten the market too much. Who to believe? Related: What’s Behind The Energy Stock Selloff?

In the short run, the bears are back as U.S. shale output is skyrocketing. There will likely be a short-term liquidation of bullish bets from hedge funds and other money managers, after building up a net-long positioning that became overstretched. That could add to the losses for WTI and Brent.

But a price correction doesn’t mean that the market will settle in at lower prices for the long haul. Demand is rising and OPEC will likely maintain high levels of compliance with its production limits.

Moreover, the severe cutbacks in upstream spending that began when oil prices initially collapsed in 2014 have yet to really be felt in terms of supply. Large-scale projects that received FIDs before the market downturn were carried through to completion, allowing new supply to come onto the market even as the industry made sharp spending cutbacks. But that pipeline of projects is now on the verge of drying up, which raises questions about the availability of supply next year and beyond.

“From next year onwards, we literally halve the number of projects and decline rates are picking up,” Amrita Sen, chief oil analyst at Energy Aspects, said on Bloomberg TV. “I do think there is a potential for spike … We’ve seen a huge amount of shale production growth, 1.5 million barrels per day, year-on-year in Q417, and still we are drawing stocks everywhere. That just shows you that we aren’t adding enough supplies elsewhere and demand growth is very high.”

Sen says the market won’t go back to the days of $100-plus, but “it could be a spike up to $90-plus in 2019. Yeah, absolutely we can.”

By Nick Cunningham, Oilprice.com

More Top Reads From Oilprice.com:

• Oil Prices Tank As U.S. Drillers Add Massive Number Of Rigs
• LNG: Glut Today, Shortage Tomorrow
• What’s Behind The Energy Stock Selloff?