Why oil’s major rally may not last
After a punishing decline that amounted to one of the worst bear markets in decades, oil is finally showing some life. U.S. oil prices have nearly doubled off their 2016 lows, which could lure investors into believing the worst is behind it. The major driver behind the oil rally is the continuing decline in supply. Indeed, U.S. rigs are down considerably over the past year. But while the rally seems convincing, it may be premature. The decline in rigs being taken off-line has slowed down in recent weeks, and U.S. producers are beginning to bring rigs back into production. In addition, the biggest overhang on oil—OPEC’s refusal to cut production—remains.
The return to $50 oil is a huge relief to the oil industry. However, investors hoping the rally in oil prices could be the beginning of a march back toward $100 per barrel could be disappointed.
The cure for low oil prices is … low oil prices
As oil plunged toward $27 per barrel earlier this year, the economics of oil production turned. It no longer became profitable for virtually any exploration and production company to continue drilling at such low prices. Rather than continue to lose billions of dollars, the U.S. oil industry collectively responded by taking a large number of rigs off-line. This is evident from weekly oil rig counts compiled by Baker Hughes (NYSE: BHI). The North American rig count has been on a steady, uninterrupted decline as oil prices fell. The latest rig count data shows 404 rigs in operation in the U.S. last week, down 53 percent in the past one year.
At such low oil prices, a huge number of rigs were taken out of operation. This caused an economic imbalance between supply and demand. On May 25, the U.S. Energy Information Administration reported a 4.2 million-barrel drawdown in U.S. oil supply from the previous week. Since global oil demand has continued to rise at a modest pace, higher oil prices were necessary to rebalance supply and demand. This has been the cause of the huge rally in oil. West Texas Intermediate recently broke through $50 per barrel, representing an 85 percent increase in just the past three months.
The reason why this oil rally could be short-lived is that with higher prices, oil producers are once again incentivized to bring rigs back on-line. This is being borne out in the data: Baker Hughes reported no change in the weekly oil rig count for the week ended May 27, and U.S. rigs actually rose by 4 in the week ended June 3. This was only the second time this year that active U.S. rigs showed a weekly increase. Economically, this should not be a surprise. Some producers, particularly those who focus on the premier oil-producing U.S. fields like the Permian Basin where costs are low, can make money at $50 oil.
For example, Pioneer Natural Resources (NYSE: PXD) recently announced that with oil at $50, it will bring five to 10 rigs back into production. Permian is a major producer in the Permian basin in Texas. The company has increased Permian production by more than 650,000 barrels of oil equivalents per day since 2009.The rigs will be mostly located in the Spraberry/Wolfcamp area, where Pioneer is the largest producer and holds a resource potential of more than 11 billion barrels of oil equivalents.
Analysts remain negative on oil
As more oil production firms bring rigs back into operation, it could once again put supply and demand out of balance. Analysts are starting to take note of the number of companies rushing to get production back on line in an attempt to take advantage of $50 oil. Analysts at Bank of America-Merrill Lynch published a note last week, warning that continued strength in the U.S. dollar could cause another downturn in oil prices. The analysts speculated that Saudi Arabia could make the decision to unpeg its currency, which could lead Brent oil prices to fall back to $25 per barrel.
Separately, there are other reasons to believe the oil rally may be premature. Another catalyst for the rise in oil prices has been unplanned supply outages, which recently hit their highest level in five years, at 3.5 million barrels per day. The wildfires in Canada accounted for 1 million barrels of this, while supply disruption in Nigeria accounted for another 500,000 barrels taken offline, with disruptions due to social unrest accounting for most of the remainder. Why this matters is because issues like natural disasters and social unrest are often short-term in nature, and are not expected to be a recurring scenario going forward. This is why John Kilduff, partner at Again Capital, believes the oil rally will fade. In an interview with CNBC, Kilduff said, “I'm still not that constructive on it. I think some of these outages that have driven the latest leg of the price move are transitory.”
Companies to watch
The companies to watch from these developments are the oil and exploration companies that are entirely reliant on the underlying commodity price. These so-called upstream firms are unlike the integrated majors because they do not have refining operations to offset exploration and production losses.
The rally to $50 oil has been huge for companies like ConocoPhillips (NYSE: COP), and Occidental Petroleum (NYSE: OXY). Independent exploration and production companies desperately need higher oil prices.
ConocoPhillips states that its profitability expands or contracts by $100-120 million for every $1 change in Brent oil prices, and another $30-$40 million for every $1 change in WTI oil prices. As a result, investors should be aware that E&P firms like ConocoPhillips and Occidental would be particularly at risk of another leg down in oil prices.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.