Wednesday, March 16, 2016

Why Shale Producers Will Never Stop Pumping

This week in crude oil, prices sit in the high $30's after three straight losing sessions are erased by a 6.14% gain in WTI price today. While the worst appears to be over, analysts still assert that an excess of supply will dominate growth in demand. Those from Citigroup blame institutional investing and bets on short-term trends for the rebound that has occurred over the past month. Data from the large investment bank shows a record number of bullish bets that hedge and pensions funds have placed on a rebounding Brent. The current market "equilibrium" feels wedged between the unrelenting force of a saturated market and strong, short-term volume behind WTI and Brent gains.

Scheduled maintenance that is expected to start soon will limit the demand for crude in upstream operations. Despite the fact that this shutdown period occurs every year, this year the seasonality trend could disrupt a critical point on the timeline of the glut. The Energy Information Administration actually reported that stockpiles grew by about 3.3 million barrels last week, a clear indicator that downside risks still remain. The market finds itself, once again, chasing its own tail after it briefly thinking it had caught it.

Volatility in the WTI price trend


As troubling as the volatility is, investors have been coping with the fluctuations by shorting after a rally, a strategy proven to be very profitable. The table above describes the kind of false hope that technically driven gains elicits from the markets. Measuring from weekly tops and bottoms over the past year and a half, one can extrapolate rebounds and retreats that represent erratic the sentiment changes exhibited by traders. Right around this time of last year, a bullish rally briefly encapsulated the market with gains of 12.9% in over two weeks, but news that production wasn't being crimped caused extremely bearish consequences. A similar resurgence occurred in late-August with hopes of ending the year at about $60 a barrel fresh on the lips of mavens everywhere. Those projections were quickly proven wrong as the second week of the new year showed prices in the $20's including a record low of 12 years.

Because of all the extreme fluctuations, oil and gas companies can't efficiently hedge against prices in the future. The exchange for commodity contracts was not meant for speculative trading. Vendors of raw materials and large-scale businesses formed the market with the goal of uniting the needs of both sides of the supply chain. Speculation in the commodities market is an enemy of businesses who hope to secure the best prices for their assets or find a bargain for materials needed as inputs. Trends that promote uncertainty, like the one described in the chart above, results in cloudy long-term market expectations making hedge trading less effective. If firms can't extrapolate a reasonably clear trend, they'll look to sell (or buy) the most recent, secure contract, the spot price. That's what we're seeing in the crude market now.

In 2015, the volatility wasn't as harmful because shale producers were cutting shale expense and increasing revenue without having to hedge for the future. For that reason, output stayed high, a trend that was underestimated from the start because analysts just assumed turning wells off was the only way to save money. In 2016, shale producers find that costs can only get cut so much; the exhaustion of technological advancement finally slowed the trimming of excess expenditures. Last Friday, the International Energy Agency forecasted a decline of 530,000 barrels a day in the U.S. for 2016. This data was part of the month-long rebound of over 20% beginning in the middle of January.  Production is just now being forced downward meaning firms will have to be successful on the commodities exchange if they want to get top dollar for their oil.

So then what's next? In the first week of March, prices appeared to have peaked again preparing for another retreat if it were to follow the recent historical pattern. A Wall Street Journal agrees that there is immediate downside risk because of the slightly higher prices. The article says that "higher prices will likely encourage shale producers to ramp up output again." Why will they go back to pumping? It surely beats the alternative of shopping in the volatile WTI  supermarket. Think about it this way. If the price of milk at Wal-Mart changed 10% every month with an accumulated change of 70% over the course of a year and a half, would anyone shop there? Probably not. The best price on the market continues to be the spot price with such diverse expectations for the future.


Included in these expectations for the future is the rise of demand for alternate energy sources like solar and wind power. An index following global representatives of that industry beat the oil exploration and production industry by over 40% against the S&P 500. The Paris agreement, signed and endorsed by President Obama, is just the first signal of waning desire to expand oil and gas capabilities in the United States. Current energy companies must discount this loss of market share when making projections over the next 10 years. Fossil fuel-based companies are beginning to realize that the end of the supply glut may be the beginning of the clean energy era. In fact, low prices now may be the only thing increasing demand for oil and gas, and thus, firms in that industry should be working to keep their products competitive. Pumping oil is not just a something that producers should do, it is a must. Analysts should stop imagining WTI and Brent prices over $60. That era ended with the fragmentation of OPEC.

Investors should stop lamenting over the death of the oil cash cows, and, instead, appreciate the price trend as their only way to survive. Relentless pumping leads to cheaper inputs for business and lower gas prices for consumers. Both support business investment and personal consumption thickening the economy in the long run. It resolves the problem of opaque expectations as a true market price emerges with no cartel looming over market participants. In order to stay competitive, unproductive wells would be ignored which leads to a slimmer, more versatile industry. Freezing output is no longer an option in this newfound free market. Pumping oil and doing it now is a requirement, and investors should expect that trend to emerge in shale producers, the most efficient drillers in the industry.

Sources: WSJ (1), WSJ (2)

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