Oil Prices Are Unlikely To Increase From Here

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Includes: BNO, CLR, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI, WLL
by: Jonathan Weber

Summary

OPEC countries and Russia can't agree on meaningful production cuts.

Iraq is the latest OPEC country to announce record production levels.

Shale oil companies are getting increasingly comfortable with oil prices in the $40 to $50 range.

This will mean that supply will grow if oil reaches that high, which will then mean that oil prices will not grow much beyond that point.

Oil prices (NYSEARCA:OIL) are up a lot since they bottomed in the mid twenties in February, but I believe there are a couple of points preventing them from rising much from the current level.

The global supply-demand gap, which led to the decline in oil prices in the first place, is not solved yet, the world's producers continue to pump more oil than the world demands. This has led to a huge build up in reserves globally, and with storage levels at record highs, this puts additional pressure on oil prices: Price increases would lead to huge selling activity of those companies which bought and stored oil at lower prices (this would prevent oil prices from rising much), and at the same time, demand for oil could drop further once storage capacity is maxed out.

There are, however, other reasons that work against oil price increases as well:

The first is the apparent unwillingness of major OPEC and non-OPEC producers to cut their production rates. Russia as well as OPEC countries have increased their production rates over the last year, which led to a post Soviet times record production rate in Russia earlier this year, and with Iraq we now have the second biggest OPEC producer pumping at record levels as well.

Bloomberg reports that Iraqi oil production reached 4.55 million barrels in March, which reflects an increase of 0.09 million barrels a day over February's production level of 4.46 million. A 0.09 million barrels a day increase over a month doesn't sound like a lot, but when we calculate what would happen if Iraq chose to increase its production at that pace for a year, we get to a production increase of 1.08 million barrels a day - an output increase that would pressure global oil markets substantially.

The fact that Iraq can increase its output by 2.0% month over month, and that the country apparently feels no need to cut its production level (or keep it at the level seen in previous months), but rather chooses to increase its production levels to record highs in the midst of a global oversupply situation, shows that the country does not seem to be interested in bringing oil prices up.

As most major producers seem to believe that all others should cut production, but not themselves, the outlook for the coming OPEC-Russia meeting is rather dim. Past meetings did not result in any meaningful production cuts that would be necessary to restore the global supply-demand gap.

The next headwind oil prices face is not political, but rather of a technological/commercial nature: The oil price decline has led to a lot of pressure on smaller oil companies to cut their production costs, and the resulting efficiency gains, streamlining of operations, focus on the best shale plays, technological improvements and other cost cutting measures have made a lot of smaller players what no one believed they could be: Low-cost producers.

A couple of years ago, when oil prices stood at $100 and above, everyone knew that shale players were the marginal high-cost producers, and that major oil companies and (OPEC and a few non-OPEC) countries would remain the low-cost producers. But we see now that cost-cutting efforts have allowed some shale players to get into a position where they are not dependent on $100 oil anymore, not even to oil prices close to that level: Continental Resources (NYSE:CLR) CFO Hart has stated that the company would amp capital expenditures as soon as oil prices reach the mid-$40 region, and that production levels could be increased by 10% in 2017. Increasing production levels by at least ten percent if oil prices reach the mid $40s region doesn't sound like a pressured high-cost producer, but rather like a low-cost producer with aggressive expansion plans. Obviously, such acting will not allow for oil prices rallying much beyond $40 to $50, since higher production output by shale companies will lead to higher global supply levels, which will in turn mean that oil prices will not climb much further. Whiting Petroleum's (NYSE:WLL) CEO has also stated that the company would start completing new wells if oil prices reach the mid $40s level, which, in turn, would mean production growth again.

The huge efficiency gains shale players have seen over the last years mean that oil prices will have a hard time reaching above the $50 per barrel levels, as a lot of these companies are willing to increase production at these prices, which means additional supply and widening of the global supply-demand gap. Other oil producers would have to cut their production substantially to balance the additional shale oil supply, and at least the major OPEC countries and Russia don't seem to be too interested in making such moves.

Takeaway

Iraq has been the latest major oil producer to announce record levels of oil production, which underlines the unwillingness of OPEC and non-OPEC players to cooperate and cut (or at least freeze) production levels.

With a lot of smaller shale oil companies cutting their costs substantially, the world could see a lot of additional supply growth from these former high-cost producers once oil prices reach $40 to $50, which means that price increases beyond that point are not very likely for the foreseeable future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.