Oil prices have returned to the point where they are almost ready to match pre-Covid levels. There are two main drivers for this miracle, which no one has foreseen as possible in this period of time. The first are the production restrictions of American producers and, of course, the millions of barrels of oil per day held by the OPEC + cartel. The second is to recover the demand, placing, until now, a slight pressure on the supply and creating a market condition known as “Backwardation”. A market condition where the future price of a commodity is higher than the present or “spot” price. This is high for long-term oil prices.
Another factor for the current rise in oil prices is the expectation of continuous stimulus to the US economy. So far this expectation has driven prices on concerns raised by Friday work report, suggesting that employment levels continue to hamper the overall recovery.
One aspect of the speed with which this recovery has occurred is the meteoric increase in the participation of many energy companies, with ExxonMobil (NYSE: XOM) and ConocoPhillips, NYSE: COP) outperforming the rest of the market in the past two months. Everyone’s shares have risen 10% since the end of January 2021.
John Kilduff, a well-known energy analyst, was quoted in a recent WSJ Article saying, “The market definitely has some momentum! WTI will also target US $ 60 ”.
What is behind this movement?
As I discussed in a OilPrice Article Last week, one of the keys to this support for oil, is the reduction of inventories, both in the USA and worldwide. As noted in this article, the Energy Information Agency (EIA) reports that in the week of January 29º, stocks fell comfortably at an average of 5 years for this time of year. This represents a decline of about 50 mm in storage barrels over that time.
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This drop in inventories occurred at a faster rate than most experts thought possible and helped to create concern about future supplies that are pushing prices higher now. We are certainly not short of oil at the moment, but the shift towards the retreat of contango is notable for the market.
As noted above, the main forces that initiated this movement are production restrictions by US producers, currently pumping about 2.4 mm BOPD less than a year ago, and OPEC +. Last week, OPEC announced a cumulative total 2.1 billion barrels were retained since the peak of the April 2020 crisis at Covid.
Another well-known energy analyst, Martin Rats of Morgan Stanley, was quoted by the WSJ as saying: “the amount of crude oil and petroleum products stored worldwide has dropped by about 5% since its peak in 2020”.
The first month’s contract gap widens
On Friday, the difference between the previous month’s contract and that of March 2022, increased to $ 5.16 a barrel. This is the biggest award for next month’s contract since the pandemic began.
This will have the effect of pushing prices backwards, as we have seen so far. Some analysts fear that this effect will be exacerbated by the lack of long-term contracts by airlines and other large buyers to protect their exposure to rising commodity prices.
Most think the current high still has legs, as the setback scenario gives traders an incentive to take oil out of storage and put it on the market, rather than paying for continuous storage.
Will oil prices go to the moon in 2021?
The two most widely used indicators for the future of United States production are the number of drilling rigs actively exploring new oil reservoirs and the number of fracturing spreads allowing production to start from compact shale formations.
PrimaryVision data, graph by author
Higher prices encourage increased activity in the shale area, as noted in the chart above. Over time, if this continues, it will tend to prevent prices from rising too fast, or even to put a limit on its eventual peak in the short term.
American producers have repeatedly promised that days of growth at any cost are in the past, and their goals are to maintain current production levels or keep the rate of decline at a profitable level. Instead of growth, producers have focused on repairing damaged balance sheets caused by massive asset reductions over the past two years, and rewarding patient investors with higher dividends as margins expand. That commitment is about to pass a test, as the US platform count approaches 400 level.
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There may be some questions about these commitments, made in the depths of the 2020 oil depression. US producers have lowered their equilibrium levels for most wells in the shale country to about $ 30 in the so-called level I area. Producers extracting oil from Tier I reservoirs are making a lot of money at current prices and the return to a market of more than 400 platforms may signal a change in their attitudes.
During the past year or so, the rate of new drilling has been below the typical annual decline rate of 30-40% for shale formations. We are getting very close to a breakeven point, at which this rate of decline will be exceeded and new production will tend to raise inventory levels.
We may be approaching a short-term peak for WTI and Brent
Rising activity levels in the US and globally will tend to slow further stock declines. Any sign that inventories may be about to start rising will curb higher prices and may even push them down in the short term. As noted in my last article, there are also other factors that tend to keep prices in their current range.
China’s economy was recovering while Western economies were shaking with the rise of the virus, in the clutches of a new outbreak. A recent Reuters article noted
“Tens of millions of people are under arrest while some northern cities are undergoing mass tests amid fears that undetected infections may spread quickly during the Lunar New Year holiday, which is just a few weeks away.”
If this effect is prolonged, the demand for oil in China, which has largely supported the price of oil falling in the cellar in 2020, could falter.
Iran should start testing current US economic sanctions, as The Biden administration has indicated a desire to re-establish the 2015 nuclear deal. Several million barrels a day could return to the oil market in a relatively short time if the appeasement of the Iranian leadership becomes the US’s negotiating policy again.
Finally, the current OPEC + constraint will be more difficult to maintain as prices rise. Currently, 9.7 million BOPDs are being retained, in addition to Saudi Arabia’s “gift”, of another 1 million BOPDs. At its next meeting, March 4º, 2021 will likely focus on restoring retained production levels to maintain market share.
In short, in the coming months, the market may receive mixed signals that reduce the rate of continuous oil increase. But, as the world economic scenario brightens up in the second half of the year, thanks to the pandemic being gradually overcome by immunization, we believe that the oil trajectory will continue on an upward trend. Some analysts, especially Goldman Sachs, are asking for Brent at $ 65 in late 2021. With WTI’s proximity to Brent today, that could put the primary shale benchmark at more than $ 60 this year.
Your takeaway
The trend is now upward for oil and gas extraction companies, as shown by the current setback scenario for future oil contracts. As noted, the oil market is a dynamic place where events can change the course of the commodity within minutes. I think oil-related stocks continue to be invested for those with a time horizon longer than a few months. Investors should look carefully at high quality companies with low production costs as entry points to establish new positions, or add to existing ones.
By David Messler for Oilprice.com
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