Only America can save the oil market.
Between Wednesday and Friday oil prices rocketed nearly 25%.
But to put this rally into perspective, oil prices are down about 70% from their June 2014 peak.
A rally was inevitable, but the long-term outlook for prices remains depressed. And the US is the only thing that can change that.
Here’s Citi’s Ed Morse:
“America can come to the rescue by reversing the supply imbalance that led to the oil crash. Lower oil prices are needed to ration supply, but non-OPEC ex-US production has been extremely resilient, and one key bearish risk is that this resilience continues. This would leave the burden on US production to bring the balance back to market near-term.”
And so despite this week’s rally, with oil at around $30 a barrel prices are significantly below where most all oil market participants thought the price would be just a few years ago.
“Unless material production declines emerge in the next 3-6 months it is hard to see much upside in crude prices,” Morse wrote in a client note Wednesday.
Morse cut his target on Brent crude — the international benchmark for prices — to $40 per barrel “to reflect new market realities.”
The 13-member oil cartel OPEC, led by Saudi Arabia, abandoned its policy of restraining production to control oil prices back in 2014, instead deciding to pump oil excessively to squeeze market share from competitors.
And so given that the current downturn has been driven by oversupply — not weak demand — someone somewhere has to restrict output.
This week at the World Economic Forum in Davos the head of the state-owned oil company Saudi Aramco, Khalid al-Falih, said $30 oil was “irrational”, a recovery is imminent, and that Saudi Arabia wouldn’t be cutting production.
According to Morse, this burden rests on US shale producers.
“This therefore leaves the largest burden of balancing global oil markets on US oil production, and the combination of stripper well declines, reduced shale production stemming from lower drilling activity and even perhaps reduced completions at sub-$30/bbl oil, should lead to material declines in 2016. In this three-way game of chicken between OPEC, shale, and non-OPEC non-shale producers, only shale has blinked so far. This is confirming its role as a key marginal producer that acts most quickly to curtail drilling activity in response to low oil prices.”
The catch is that shale producers would curtail oil as a matter of necessity, not choice.
Much of the fracking that ran up production was done with debt — not equity — made attractive by low interest rates.
In contrast, Morgan Downey,CEO of Money.net and author of “Oil 101,” told Business Insider that Saudi Arabia had up to $500 billion in cash reserves at the start of the price drop and knew that the frackers were financially vulnerable because of their high levels of debt.
For industry stalwarts, low prices have been a drag, too.
The latest report from oilfield services giant Schlumberger on Thursday was full of indications that its biggest clients are low on spending cash. The company laid off another 10,000 people in the quarter, bringing the total in this downturn to 30,000.
“The marginal high-cost producers — North American hydrafrackers — are being wiped out slowly but surely,” Morgan Downey,.
“And that will cause, of course, the recovery in oil prices over the next year or year and a half back up over 50.”
That’s not to say Saudi Arabia is in the clear.
In a recent note, RBC Capital’s Helima Croft noted that the country overshot its budget by 13% last year and recorded a wider-than-forecast deficit. The kingdom has promised several austerity measures to cope with lower oil prices for longer but Croft writes that “2016 could prove to be the year of living dangerously” for the Saudis.
And of course other OPEC producers are at risk of various political and economic crises if prices don’t recover this year.