John Kemp is a Reuters market analyst. The views expressed are his own
LONDON, Feb 2 – Oil prices surged 8 percent on Friday as the market digested news another 94 rigs previously drilling for oil in the United States had been idled over the previous week.
It was the largest number of rigs de-activated in a single week since at least 1987 and triggered the biggest one-day percentage increase in Brent prices since 2009.
Yet there was nothing remotely surprising about either the continued fall in the rig count – or the volatile market reaction.
The number of rigs drilling for oil has now fallen 24 percent from 1,609 to just 1,223 since early October, according to oilfield services company Baker Hughes.
But large declines had been reported in each of the previous seven weeks. Several prominent forecasters have predicted the oil-directed rig count will fall below 1,000 by the end of the first quarter.
Continental Resources, one of the largest drillers in North Dakota’s Bakken shale, promised late last year it would cut the number of rigs it employs by 30 percent by the end of the first quarter and by an average of 40 percent in 2015.
If those cuts were mirrored across the entire shale industry, which is a reasonable assumption, the rig count would fall below 1,100 by the end of March and average just 950 in 2015 as a whole.
Many market participants have ignored the falling rig count to focus on continued production increases in the short term as a reason why oil prices will fall further.
For these bearish investors, the more relevant statistic is the continued rise in production, which hit a new high of 9.213 million barrels per day in the week ending Jan. 23, according to the latest edition of the Energy Information Administration’s (EIA) Weekly Petroleum Status Report.
Goldman Sachs President Gary Cohn said in an interview with CNBC last week oil prices could go as low as $30 per barrel. Cohn’s bearishness is typical of many oil analysts and hedge funds.
The problem with this view is that it is inherently backward-looking. Current production is a lagging indicator – unlike rig counts which are a leading indicator. Focusing on current output numbers rather than rig counts is a bit like driving using the rear-view mirror to navigate the road ahead.
In practice, no one knows how much oil is being produced in the United States at the moment. Production data is collected by the states from reports filed by well operators, but there is normally a lag of several months while the reports come in, and only then are they compiled and shared with federal statisticians.
North Dakota, for example, has provisional production data for November 2014 based on returns from some but not all wells, and it is likely to be substantially revised as the last records are filed. Provisional production data for December will not be published until the middle of February and January’s numbers will not be available until mid-March.
Production data in the Weekly Petroleum Status Report are therefore estimates. Extreme care should be taken in basing an argument upon them. More accurate data based on state records is contained in the EIA’s monthly publications, but the most recent data is for November, before most of the decline in drilling.
Rig counts, on the other hand, provide some information (albeit imperfect) on what will happen to production in the months ahead.
Based on the rig counts, it is possible to argue about how much production will slow and when. But the idling of almost a quarter of all the oil-drilling rigs in the country in less than four months must have some negative impact on output in future.
FORK IN THE ROAD
In the meantime, investors are increasingly divided over the direction of crude oil prices.
In the week to Jan. 27, hedge funds and other money managers boosted their bullish bets on WTI-linked oil prices to the equivalent of 373 million barrels, the highest since July 2014.
But other hedge funds raised their bearish bets on WTI to almost 130 million barrels, the highest since November 2010, according to records published by the U.S. Commodity Futures Trading Commission.
The existence of these large short positions, when oil prices have already fallen by more than half since the middle of 2014, leaves the market very volatile in the event of unexpected bullish news, such as a larger than anticipated fall in the weekly rig count reported late on Friday.
Oil prices are unlikely to rebound to $100 any time soon, a point which has been made by Saudi Oil Minister Ali al-Naimi. But prices must recover to the level needed to sustain enough drilling to keep shale production roughly constant in the face of rapid declines on existing wells.
No one knows for certain exactly what oil price is needed to sustain replacement drilling in the major U.S. shale plays but it is almost certainly significantly above current levels.
North Dakota’s Department of Mineral Resources (DMR) has estimated the state’s producers need a wellhead price of around $55-65 per barrel to sustain current output of 1.2 million barrels per day. Current wellhead prices are just $40 per barrel.
Other experts have their own predictions for sustaining price levels — but almost all of them are above current prices.
Just as oil prices above $100 throughout much of 2012-2014 were unsustainably high, current prices below $60 are unsustainably low.
Prices could remain unsustainably low for some time, but the rapid decline in the rig count, coupled with signs of growing demand, means that a modest rebound is likely sooner rather than later.
It is possible to construct a case for remaining bearish, even with oil prices at or below $50, but the balance of risk and reward is unfavorable.
There are more reasons to think prices might rise modestly to reach $60 or even $65 over the course of the year than expect them to hit $40 or $30.
(Editing by Susan Thomas) Copyright (2015) Thomson Reuters.
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