The sudden wave of cautious optimism surrounding the direction of oil prices can be boiled down to the decline in U.S. oil production, a trend that is starting to pick up pace. While U.S. oil producers managed to stave off significant production declines in 2015, drillers are finally starting to capitulate with oil prices in the mid-$30s per barrel and below.
The effects are starting to show up in the data. The EIA reported weekly estimates showing that U.S. production has now dropped below 9.1 million barrels per day (mb/d). That is a departure from the past few months – the U.S. saw little to no decline in output in the fourth quarter, as weekly figures pointed to a resilient rate of production that hovered between 9.1 and 9.2 mb/d. That trend continued into the early part of 2016 even though prices crashed below $30 per barrel.
However, by the end of January, the EIA believes that U.S. oil production finally started to see output fall. Between January and the end of February, the U.S. lost over 150,000 barrels per day in production. The EIA’s weekly figures are not as accurate as their retrospective monthly estimates, but since the monthly figures are published with several months of a lag, it could be a few more months before we get a more accurate picture of how fast output is falling.
The rig count also continues to fall, suggesting that production declines are more or less locked in for the next few months at least. The oil rig count dropped below 400 for the week ending on March 4. Drilling activity has ground to a halt, and with capital budgets stretched or broken, the industry won’t be able to bring enough new sources of supply online to offset mounting legacy production.
The announcements from U.S. shale companies back up the data emerging from the EIA. In recent weeks more than a dozen U.S. shale companies announced that they expected their production to decline in 2016, a list that continues to grow. For example, Continental Resources, an iconic driller in the Bakken, has pretty much given up on completing wells in North Dakota this year. The company’s output could fall by 10 percent this year as a result. More and more companies are following suit.
Taken together, it appears as if the market is finally starting to balance, even if the process may protracted and painful for E&P companies. Growing optimism about the direction has pushed oil prices up by 30 percent in less than a month. WTI jumped above $36 per barrel on March 7, the highest price since early January. Brent is closing in on $40 per barrel.
Oil speculators are becoming more bullish on oil prices. Hedge funds are rapidly liquidating their short bets, as fears of sub-$20 oil have all but vanished for now. According to data from the CFTC, net-short positions fell by 15 percent for the week ending on March 1. “We might see the real bottom being behind us,” Ed Morse, head of global commodity research at Citigroup Inc., said on Bloomberg TV on March 4.
In addition, although a lot of questions remain, OPEC representatives are planning on meeting with Russia’s energy minister between March 20 and April 1 to follow up on their production “freeze” agreement. An outright cut to production remains a long-shot, especially since Saudi Arabia’s oil minister Ali al-Naimi all but ruled it out at the IHS CERAWeek conference in Houston in late February. It is hard to imagine OPEC and Russia shifting course from the production freeze, but any agreement to take additional action represents an upside risk to oil prices.
Given the mounting evidence, it seems that the oil price rally is finally here, then? Maybe. But it is also possible that bullish sentiment is starting to outstrip the fundamentals, even if the fundamentals are trending in the right direction. U.S. production declines are still proceeding modestly, a pace that is not quick enough to soak up the 1.5 mb/d or so of excess supply anytime soon.
Moreover, oil storage levels are still rising in the United States, hitting a new record last week of 518 million barrels. Until inventories are drawn down substantially, oil prices will run into a ceiling every time they try to rally.
The worst of the oil bust may be over, and oil prices dropping to $20 per barrel seems increasingly unlikely. But with prices up more than 30 percent in just a few weeks and the world still suffering from oversupply, is there really any more room for price gains in the short-term?