Oil prices have rallied back to the point that they are almost ready to rival pre-Covid levels. There are two main drivers for this miracle, none of which early predicted would be possible during this period. The first is the production restriction by US manufacturers and, of course, the millions of barrels of oil per day that the OPEC + cartel withholds. The second is to restore demand, so far putting pressure on supply and creating a market condition known as ‘Backwardation’. A market condition where the future price of a commodity is higher than the current or ‘spot price’. This is optimistic for long-term crude oil prices.
Another driver for the current rise in oil prices is expected continuous incentive for the US economy. So far, this expectation has boosted prices above the concerns of Friday’s Labor Report, suggesting that employment levels continue to cast a shadow on the overall recovery.
One aspect of the speed at which this recovery has taken place is the rapid rise in the share of many energy companies, with ExxonMobil, (NYSE: XOM) and ConocoPhillips, NYSE: COP) surpassing the rest of the market in the last pair. months. The shares of each are up 10% since the end of January 2021.
John Kilduff, a well-known energy analyst, was recently quoted WSJ article as if to say: “The market is definitely gaining momentum! WTI will also target $ 60. “
What is behind this move?
As I discussed in one OilPrice article Last week, one of the keys to this crude oil support was stockpiling both in the US and globally. As noted in this article, the Energy Information Agency (EIA) reports that in the week of 29 Jan.th, stocks fell comfortably in the 5-year average for this time of year. This represents a decrease of approximately 50 mm drums in storage during this time.
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This decline in inventories has happened at a faster pace than most experts thought possible and helped create concerns about future deliveries that are now pushing prices higher. We are certainly not short of oil at this point, but the shift to backwardation from contango is remarkable for the market.
As noted above, the main forces driving this move are the production constraints by US manufacturers, currently pumping about 2.4mm BOPD less than a year ago, and OPEC +. OPEC announced a cumulative total last week of 2.1 billion barrels have been withheld of the market since the peak of the Covid crisis in April 2020.
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 around the world has fallen by about 5% since its peak in 2020.”
Front-Month’s contract gap is widening
On Friday, the gap between the contract for the first month and that for March 2022 widened to $ 5.16 per barrel. This is the highest premium for next month’s contract since the start of the pandemic.
This will cause prices to decline, as we have noted so far. Some analysts are concerned that this effect is amplified by the lack of long-term contracts by airlines and other major buyers to hedge their exposure to rising commodity prices.
Most think the current rally still has legs, as the backwardation scenario gives traders an incentive to take oil out of storage and market it, rather than pay for continued storage.
Will oil prices go to the moon in 2021?
The two most commonly used indicators for the future of US manufacturing are the number of oil rigs actively tapping new oil reservoirs and the number of frac spreads allowing production to begin from dense shale formations.
Data from PrimaryVision, diagram by author
Higher prices encourage more activity in the shale area, as shown in the image above. Over time, if this persists, it will tend to keep prices from rising too quickly, or even possibly suppress their final short-term high.
Producers in the US have repeatedly promised that the days of growth at all costs are in the past, and their goal is to maintain the current level of production or keep the pace of decline at a profitable level. Rather than growth, producers have focused on repairing damaged balance sheets caused by massive asset write-offs in recent years, and reward patient investors with higher dividends as margins increase. That pledge is about to be tested as the U.S. rig count approaches 400 levels.
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There may be some questions about these pledges, made during the lows of the 2020 oil depression. US producers cut their break-even levels for most shale land resources to the mid-1930s in the so-called Tier I area. The producers extracting oil from Tier I reservoirs are making money by hand at current prices, and the return to a market of over 400 rigs could turn their attitudes.
In the past year, the number of new wells has been below the typical annual decline of 30-40% for shale formations. We are getting very close to a balance point where this decline rate will be exceeded and new business will tend to push inventory levels up.
We can approach a peak for WTI and Brent in the short term
Increased activity levels in the US and worldwide will slow further inventory declines. Any sign that stocks are on the verge of rising will slow the brakes on higher prices and even lower them in the short term. As noted in my last article, there are also other factors that keep prices within their current range.
The Chinese economy was roaring as the Western economies were stirring the wave of the virus, in the throes of a new outbreak. A recent Reuters article noted:
“Tens of millions of people are trapped as some cities in the north are under mass testing for fear that undetected infections could spread quickly during the Lunar New Year holiday, which is just weeks away.”
If this effect turns out to be long-lasting, oil demand in China will come, which will largely keep oil prices stable fall into the basement in 2020, could falter.
Iran is expected to begin testing current US economic sanctions like the The administration of Biden has indicated a wish to restore the 2015 nuclear deal. Several million barrels per day could return to the oil market in a fairly short period of time if the reconciliation of the Iranian leadership becomes the US bargaining policy again.
Finally, the current OPEC + restriction will be more difficult to enforce as prices rise. Currently 9.7 million BOPD is withheld, plus Saudi Arabia’s “gift” of another 1 million BOPD. At their next meeting, March 4th2021 is likely to focus on restoring withheld production levels to maintain market share.
In summary, the market may receive mixed signals in the coming months that will slow the pace of continued oil gains. But as the global economic picture improves in the second half of the year, thanks to the pandemic gradually being pushed back by immunization, we think the trajectory for oil will remain higher. Some analysts, and Goldman Sachs in particular, are asking for Brent for $ 65 by the end of 2021. With WTI now close to Brent, that could put the primary shale benchmark at $ 60 this year.
Your takeaway
The trend is now optimistic for companies that extract oil and gas, as the current backwardation scenario for oil futures contracts indicates. However, as noted, the oil market is a dynamic place where events can change the price of the commodity in minutes. I think oil-related stocks can stay invested for people with a time horizon longer than a few months. Investors should look carefully at high quality companies with low entry point production costs to acquire new positions or to supplement existing positions.
By David Messler for Oilprice.com
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