After months of weakness in oil prices, a number of recent events provide cause for cautious optimism that a rebound is in the works.
For the week ended March 27, U.S. domestic oil production fell by 36,000 barrels per day, snapping an eight-week streak of increases. Since 2010, U.S. production has increased by 70 per cent, but fallen on a weekly basis 37 per cent of the time. As such, it is far too early to assert that U.S. shale companies, the proximate cause of the global supply glut, are in the midst of curtailing production to bring the market back into balance.
The path to a new equilibrium in oil prices will no doubt have its fair share of casualties. Some smaller producers are being forced to drill unprofitable wells to generate cash to meet current obligations, and a few countries, including Venezuela and Russia, are also in "forced production" mode.
The recent round of weakness in the U.S. dollar, however, offers far more reason to expect a near-term support for commodity prices. A prolonged stretch of soft economic data has prompted the Federal Reserve to signal that it is in no hurry to lift rates from zero, and financial markets to push back their expectations for the first hike into the fourth quarter of 2015. The strength of the greenback accentuated the downside for oil prices as the supply glut became evident in 2014, and this headwind looks to have ebbed, at least for the time being.
"If you can tell me where the dollar's going, I'll tell you where crude oil's going – the other way," said Stephen Schork, editor of The Schork Report.
Nonetheless, the West Texas intermediate futures curve is currently pricing in a "low for longer" oil environment, with crude envisaged around $65 (U.S.) per barrel in five years.
"I think we'll be in the $75 per barrel territory within 18 to 36 months, and a lot of people aren't prepared for that," said Andrew Barber, chief market strategist at Eagleview Capital. "The perception of slack demand is overblown; there's healthy demand in the U.S. and Europe, as well as the developing world – albeit, not as great as it was two years ago."
Credit Suisse research analysts Jan Stuart and Johannes Van Der Tuin also gave a nod to the underappreciated pickup in demand in a recent note to clients.
"This year is starting off with accelerating oil demand growth – in contrast to last year," they wrote. "Data for the quarter are evidently not complete, but for a string of large consumers, including China, Japan, South Korea, India, February numbers are in, and exceed our forecasts (as well as those of the consensus)."
The precipitous decline in rig counts in the United States, as seen in weekly figures provided by Baker Hughes, has been somewhat of a mirage. Fewer rigs have not engendered a corresponding decline in production. This scenario has been, thus far, similar to what transpired for natural gas since 2008: Rig counts have been decimated, but production has risen by more than 30 per cent.
"Rapid technological improvements, including drillers now starting to re-frack already fracked oil wells, are reasons to believe that growth in global demand for crude must be a key driver of a meaningful rebound in prices, not sharply lower US supply," writes CIBC World Markets economist Nick Exarhos.
However, the focus on storage builds at Cushing, Okla., may also prove to be a head-fake for the markets. The United States is entering a period in which refinery demand picks up steam and inventories typically get drawn down in anticipation of the summer driving season.
The crack spread, that is, the difference between the price of crude oil and refined products like gasoline and heating oil, increased significantly in February and remained above its five-year average at the end of March. As such, refiners have additional incentive to boost output.
In recognition of the margin expansion for refiners and firming global demand, state-owned Saudi Arabian Oil Co. raised its selling prices to Asian customers for the second straight month.
However, in the event that storage capacity does evaporate and refiners have supplied enough product to the market, the two biggest reasons for buying spot crude will have faded and another round of pressure on oil prices looms.
"I would expect to see another flush in prices, potentially even a break of $40 per barrel in the summer months," Mr. Schork said.
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