How Much Higher Can Oil Prices Go? - InvestingChannel

How Much Higher Can Oil Prices Go?

Oil prices have rallied back to the point they are almost ready to match pre-Covid levels. There are two key drivers for this miracle, which no one predicted early on as being possible in this period of time. The first is the production curbs by U.S. producers and of course, the millions of barrels of oil per day withheld by the OPEC+ cartel. The second is recovering demand, putting-so far, slight pressure on supplies, and creating a market condition known as “Backwardation.” A market condition where the future price of a commodity is higher than the present, or “spot” price. This is bullish for long term crude prices.

Another driver for the current push higher in oil prices is the expectation for continued stimulus for the U.S. economy. So far this expectation has buoyed prices over the concerns raised by Friday’s Labor report, suggesting that employment levels continue to cast a pall on the overall recovery.

One aspect of the speed at which this recovery has taken place is the meteoric rise of the share of many energy companies, with ExxonMobil, (NYSE: XOM), and ConocoPhillips, NYSE: COP) outperforming the rest of the market in the last couple of months. Shares of each are up 10% since late January, 2021.

John Kilduff, a well-known energy analyst was quoted in a recent WSJ article as saying, “The market definitely has some momentum! WTI is going to be targeting $60, too.”

What’s behind this move?

As I discussed in an OilPrice article last week, one of the keys to this support for crude, is the drawing down of inventories, both in the U.S. and globally. As noted in this article the Energy Information Agency, (EIA) reports that in the week of Jan-29th, inventories fell comfortably into the 5-year average for this time of year. This represents a decline of about 50 mm barrels in storage over this time.

This fall in inventories has happened at a faster pace than most experts thought possible and helped to create the concern about future supplies that is pushing prices higher now. We are certainly not short of oil at this point, but the shift to backwardation from contango is noteworthy for the market.

As noted above, the key forces initiating this move are production restraints by U.S. producers, currently pumping about 2.4 mm BOPD less than a year ago, and OPEC+. Last week OPEC announced a cumulative total of 2.1 billion barrels have been withheld from the market since the April 2020 Covid crisis peak.

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 down by about 5% since its peak in 2020.”

The Front-Month contract gap widens

On Friday the gap between the contract for the front-month and the one for March of 2022, widened to $5.16 per barrel. This is the biggest premium for next month contract since the start of the pandemic.

This will have the effect of pushing prices into backwardation, as we have noted so far. Some analysts worry that this effect is exacerbated by the lack of long-dated contracts by airlines and other large purchasers 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 pull oil from storage and put it on the market, as opposed to paying for continued storage.

Will oil prices go to the moon in 2021?

The two most widely used indicators for the future of U.S. production are the number of drilling rigs actively tapping new oil reservoirs, and the number of frac spreads allowing production to begin from tight shale formations.

Higher prices spur increased activity in the shale patch as noted in the graphic above. Over time, if this continues, it will have the tendency to keep pricing from rising too fast, or even possible to put a lid on their eventual peak over the short-haul.

U.S. producers have promised repeatedly that the days of growth at any cost are in the past, and their goals are to maintain current production levels or to keep the rate of decline to a profitable level. Instead of growth, producers have focused on repairing damaged balance sheets caused by massive asset write-downs over the past couple of years, and rewarding patient investors with higher dividends as margins expand. That commitment is about to get a test as the U.S. rig count approaches the 400 level.

There could be some questions about these commitments, made in the depths of the oil depression of 2020. U.S. producers have reduced their break-even levels for most wells in shale country to the mid-$30s in what’s called Tier I acreage. Those producers who are extracting oil from reservoirs in Tier I, are making money hand over fist at current prices and the return to a 400+ rig market could signal a flip-flop in their attitudes.

For the past year or so, the rate of new drilling has been below the typical 30-40% annual decline rate for shale formations. We are getting very close to a balance point, at which this decline rate will be exceeded, and new production will tend to push inventory levels higher.

We could be nearing a short term peak for WTI and Brent

Increased activity levels in the U.S. and globally will tend to slow further inventory declines. Any sign that inventories may be about to start rising will slam the brakes on higher prices, and might even push them lower in the near term. As noted in my last article, there are also other factors that will tend to keep prices in their current range.

China’s economy had been roaring back while western economies were roiling with the surge of the virus, in the grip of a new outbreak. A recent Reuters article noted-

“Tens of millions of people have been in lockdown as some northern cities undergo mass testing amid worries that undetected infections could spread quickly during the Lunar New Year holiday, which is just weeks away.”

If this effect turns out to be prolonged, oil demand in China which largely sustained the oil price from dropping into the cellar in 2020, could falter.

Iran is expected to begin testing the current U.S. economic sanctions as the Biden administration has indicated a desire to reinstate the 2015 nuclear deal. Several million barrels a day could return to the oil market in fairly short order if the appeasement of the Iranian leadership becomes U.S. negotiating policy again.

Finally, the current OPEC+ restraint is going to be more difficult to maintain as prices lurch higher. Currently, 9.7-million BOPD is being withheld, plus the “gift” from Saudi Arabia, of another 1-million BOPD. At their next meeting, March-4th, 2021 will likely focus on restoring withheld production levels, to maintain market share.

In summary here, over the next few months, the market could receive mixed signals that slow the rate of oil’s continued increases. But, as the world economic picture brightens in the second half of the year, thanks to the pandemic gradually being beaten back by immunization, we think the trajectory for oil will continue higher. Some analysts, and notably Goldman Sachs are calling for Brent at $65 by the end of 2021. With the closeness of WTI to Brent these days, that could well put the primary shale benchmark over $60 this year.

Your takeaway

The trend now is bullish for companies extracting oil and gas, as the current backwardation scenario for oil futures contracts denotes. As noted though, the oil market is a dynamic place where events can change the course of the commodity in the space of a few minutes. I think oil-related stocks remain investible for those with a time horizon longer than a few months. Investors should look carefully at high-quality companies with low costs of production for entry points to establish new positions, or add to existing ones.

By David Messler for Oilprice.com