A bit over a month ago, I was concerned about Chesapeake's (NYSE:CHK) exposure to commodity prices, and I believed that investors should protect themselves through futures. At the time, oil (NYSEARCA:USO) was trading at $50/bbl. There were a lot of oil bulls back then, and there are still a lot today. But with more bad news for oil coming out week after week, the market seems to have realized that the future for crude isn't very bright. Now that oil has indeed fallen to $40/bbl, what now?
I've always been bearish on oil (read Oil Can't Go Higher), which is quite ironic considering that two large positions in the V20 Portfolio are positively correlated with oil, but I digress. I don't think oil's fall to $40/bbl should be surprising at all. While the market has been focusing on the consistent crude inventory draw (except last week, when it increased by 1.7 MMbbl), no one seems to care that domestic production has been rising and imports have not slowed down (read Oil's Outlook Deteriorated).
Last week, we also saw oil rig counts rise for five weeks in a row. These are all negative developments for oil, and as long as these factors persist, oil will remain under pressure. The good news is that with oil now down to $40/bbl, I believe that rig additions will slow. However, that doesn't rule out the possibility of oil slipping to $30/bbl thanks to international producers, though I think that oil will still quickly bounce back in such a scenario.
Counting the week ended June 3rd, the number of oil rigs have risen in 8 out of the 9 weeks. The beginning of this streak corresponded with a rapidly appreciating oil, whose price rose from $27/bbl in February to $50/bbl in June. Today, the opposite is happening. I believe that this will cause producers to hold off on adding more rigs, which will send a positive signal to the market. The shorter-dated futures do not trade at a significant premium; hence, producers won't add more rigs based on a hedging strategy.
However, this will not alleviate future pressure, as longer-dated futures still look enticing. The August 2017 contract is currently trading at $5.74/bbl higher than the spot price at $45.82/bbl. As I mentioned in this article (read Oil Stocks Are In For A Rough Ride), many producers will be happy to add more rigs at $45/bbl. Should the current price of long-term futures hold, producers will become more willing to add rigs as time goes on, since the long-term contracts will eventually become short-term contracts.
So rig additions could slow, a positive for oil, but that won't stop international producers, who will continue to pump at record rates. Saudi Aramco has lowered its Arab Light crude price in a bid to compete with Iran, that has been producing more and more since the sanction was lifted. As international producers increase production, we must see an offsetting decrease in domestic production for price to stabilize.
But since production is inelastic in the very short term, producers will continue to pump as long as they can break-even on cash operating costs. We've seen this happen earlier this year when oil dipped below $30/bbl, and there is no reason this won't happen again. However, I believe that such a scenario would further accelerate the aforementioned decrease in capital spending (e.g. less rigs), which should drive the price back up eventually.
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