In the five weeks since February 11, the price of WTI crude oil on the CME/NYMEX spiked 50%, up from $26/bbl to $40/bbl (see black dashed circle in Figure #1). For hedge funds that took long positions in February, it was an awesome trade. And for beleaguered producers, it was certainly a bit of good news. But there are no celebrations in the streets of Houston and Oklahoma City. The fact that $40/bbl should be considered "good news" is sobering: Eighteen months ago, that price level would have been seen as a catastrophe for the producing community. In fact, it still is. In today's blog we examine the factors that help push prices above $40/bbl and what it will take to really get US production growing again.
Yes, $40/bbl crude oil will help the balance sheets of most oil and gas producers. A handful of rigs might be put back to work. But let’s put things in perspective. Since October 2014, the price of crude is down 60%, over 1,200 rigs drilling for crude (75%) have been idled (see Figure #1), and thousands of oil industry workers are looking for jobs. Producer CAPEX budgets have been slashed, and the reality is that a price of $40/bbl will do little to change the meager investment plans that most producers laid out in their Q1 earnings calls. At $40/bbl, producer returns for drilling most shale wells are under water. Consequently, new drilling has slowed to a crawl. A few companies have declared bankruptcy, and more are on the way.
F1: WTI Crude price and oil rig count
Source: Baker Hughes and CME Data from Morningstar, RBN Energy
In the midst of this carnage, the market has started – ever so slowly – to correct itself. Production volumes are declining. Even though the US Energy Information Administration reports that US crude oil production remains above 9 million barrels per day, it is down about 600 thousand barrels per day from its peak this time last year, and will likely drop at least another 750 thousand barrels per day by year end.
The big question, of course, is whether this decline in production, and all the other factors that impact global crude oil supply and demand, have already started to balance the market. Could that explain the 50% spike in crude oil prices over the past five weeks? Is the bottom of the crude oil price crash in the rearview mirror? And are we looking at a meaningful price recovery over the next few months?
Well, it is possible. But it depends on what we consider meaningful. And it also depends on what we deem to be a recovery.
First, let's consider why prices have spiked up to $40/bbl. While it is possible that supply and demand have moved into balance, it is more likely that technical factors and market psychology have been responsible for much of the increase. There were few fundamental factors pushing the price of oil down to $26/bbl in the first place. Instead, it was the combination of a preponderance of bearish news (Iran production increases post-sanctions, lower demand from a weak Chinese economy, high US oil inventories) accelerated by financial players piling on short trades, driving the market lower. When the news cycle shifted to a glimmer of hope (OPEC/Russia meetings on some kind of production freeze, the promise of higher demand as the US shifts to driving season and summer gasoline blends), the shorts cashed out, and the crude oil price responded accordingly. Whether these factors have solely been responsible for the recent price increases, or whether real changes in the supply/demand balance have also been at work, won’t be known for weeks to come.
But if this is truly the start of an upward trend in crude oil prices, what should we consider meaningful? A price of $40/bbl is not it. At $40/bbl and with today's drilling and completion costs, there are only a few spots in the major shale plays where it makes economic sense to drill and produce more oil. Those companies smart (or lucky) enough to have potential drilling locations in the sweet spots (locations where the most prolific wells can be drilled) can still drill and still make money. But across all the shale plays in the US, there are only about a dozen oil-dominant counties where those economics work. Everywhere else, producer returns for drilling and completing an oil well are in the red.
Thus to be meaningful, the price for crude oil must increase to a level where the economics for a larger number of potential wells are in the black. Furthermore, that price must be confirmed by the forward price of crude (the futures curve) and producers must believe that it will stay at that level for some time and, hopefully, continue to increase. If those conditions are met, it is likely we will see a meaningful response from many producers at a price above $55/bbl. Even though this is far below the $100/bbl price of the shale heydays, many producers can make this number work now because their service providers (drilling crews, frack crews, etc.) have reduced costs by 25-40%, the producers have become much more efficient in their operations, and many more drilling locations are economic at a price level of $55/bbl. Of course, for producers to jump back into the oil patch at that price requires bringing back a lot of workers no longer employed in the industry. And capital must be available to finance the drilling of wells. Determining how these two factors (hiring and finance) will impact the oil patch is a big question for the industry today. Particularly for the hiring issue, the longer prices stay down, the greater the problem becomes.
The other question we need to consider is – what do we deem to be a recovery? Certainly, the producing community would like prices to get back to the good ole days of eighteen months ago - $100/bbl, and then stay at that level for the next few decades. That is pretty unlikely. In fact, what is much more likely is that shale has fundamentally changed the oil market such that the word recovery is no longer relevant to the conversation. That is because oil prices are now range bound, locked into a bracket which is capped at the high end, and with a floor at the low end.
For an explanation of this phenomenon, consider the following scenario: (a) The crude price ramps back up to a sustained level of $55/bbl; (b) many US producers can demonstrate attractive returns at this price and are able to hedge their price forward for two or three years; (c) those hedged producers raise new capital (mostly from private equity and sovereign funds, not banks) to drill the wells; (d) rigs and crews get pulled back into the oil patch; (e) production starts to increase again, (f) the oil market gets oversupplied again, (g) prices go back down again. Thus in this scenario the $55/bbl threshold price for recovery became a price ceiling. While prices might move above that level for a time, it will only be a temporary respite from low prices. Over-production will simply push prices right back down to a floor price.
What floor? We know the answer to that question. Down to the level where producers stop most drilling and production starts to decline again. Based on recent experience, that floor price appears to be some number below $35/bbl. Again, the price may go below that number for a time. But it will only be temporary.
Here’s the bottom line. The crude oil market is undergoing a structural shift, into a world where prices will cycle in a range between a floor and a ceiling. So the answer to the question posed in the title to this piece "Are We There Yet?”" is, in the famous words of Gertrude Stein, “there is no there there.” A stable, recovered price is not a world we are likely to see again. When prices fall, producers will cut back production. When prices rebound, producers will start drilling again, pushing prices right back down. US producers know where the oil is. The only reason why more wells are not being drilled today is because the economics don't support the investment. Eventually, higher prices will mean a resumption of investment and drilling. Consequently, production will fluctuate up and down with price, and price will fluctuate down and up with production. Companies that learn to thrive in this range-bound crude oil world will succeed. Over the long term, the rest won’t make it.