The oil market has seen a sharp rise in prices last week, but it is still below $50 per barrel. The recent developments in the oil market could suggest high volatility in prices in the near term and a potential rally in the second half of 2015. Let's review the recent developments in oil, and reexamine the Hotelling model and its view on the current low oil prices.
The US oil market is starting to adjust to the low oil environment by reducing the number of rigs. The EIA estimated that offshore drilling costs, on average, are around $51 per barrel, while onshore drilling is roughly $31 per barrel. This is a $20 gap. Considering the current price of oil is close to $50 per barrel, this is the difference between turning a profit and not.
Since offshore drilling tends to be more expansive than land drilling, one would expect a sharper fall in offshore rigs compared to onshore rigs. But this isn't the case.
At face value, however, it doesn't seem that US oil producers have focused on cutting down offshore oil rigs over onshore rigs. Based on the latest report from Baker Hughes, the number of total US rigs has dropped by 20% since the end of September - back when oil prices were above $90. This is based on a 20% drop in land rigs and 21% decline in offshore rigs. So the drop in the number of rigs was similar in both onshore and offshore.
Despite the expected slowdown in US production growth, US inventories remain high. The recent EIA report showed that US oil stockpiles have reached 1,854 million barrels - this is a relatively high level, but not far off the levels recorded in previous years.
Source of data: EIA
But this could suggest that if oil production growth were to curb down, we could see a fall in stockpiles.
On a global scale, the IEA estimates that non-OPEC countries' production growth in 2015 will be 350 thousand barrels per day compared to its December estimate. For now, the expectations are for OPEC to only marginally reduce its output to 29.8 million barrel per day - this is only 0.2 million barrel per day below OPEC's current target. If these estimates were to follow through, they could suggest a modest gain in oil prices in the second half of the year, assuming all things equal.
From the demand side, the recent US GDP report presented a lower than expected growth rate in the fourth quarter - the growth rate was 2.6%, while the expectations were at 3%. Despite this slightly lower than expected growth rate, the US economy is still expected to grow by 3.6% this year and 3.3% in 2016, which is still a higher growth rate than in recent years. This is a good indication for strong demand for oil in North America.
Conversely, in China, the leading country in importing oil, the situation isn't so good and the country continues to show slower growth. In its recent manufacturing PMI report, the index declined to 49.7 - this means the Chinese manufacturing sectors are contracting compared to previous months.
These developments are likely to keep the uncertainty about the direction of oil prices over the near term.
Another issue to consider that may, in the margins, impact oil prices in the second half of 2015 is the expected rise in US interest rates. This is based on the simple Hotelling model.
Does Hotelling matter for oil?
Whenever the prices of oil experience high volatility, as was the case in recent months or back in 2008, the good old Hotelling model tends to reappear and we ask whether the model has some insight to shed on the oil market. After all, the recent plunge in oil coincides with the descent of US Treasury yields - and according to the basic model, if you think of oil as an asset, then under certain assumptions its price should go in line with the direction of interest rates. In short, the model may offer only in the margins a bit more insight.
Chart taken from FRED
The problem is that even the chart above doesn't show a strong relation between the two except for certain periods of time like in recent weeks.
Also, the assumptions aren't too realistic and the model doesn't consider other important factors such as production costs, and quality of oil. The recent fall in real rates could be attributed to the global economic slowdown, which is a factor that tends to coincide with the price of oil.
Moreover, according to Paul Krugman: Because an oil producer's choice is between extracting oil and not - and not between storing oil and selling it - the model suggests that real interest rate may determine the difference between the price of oil and marginal cost of extracting it. But even on this front the model offers a marginal relation. If this is the case, then this gap should keep coming down by falling oil prices or by lower marginal costs.
This model could serve as a reminder that falling interest rates could play a secondary role in the price of oil. Also, if and when the FOMC were to start raising rates in the coming months, the real interest rates will slowly pick up, which could, in the margins, bring slowly up the prices of oil. But the big issues will still remain the changes in market expectations about oil supply and demand.
The oil market may experience a rise in prices in the second half of the year on account of the changes in US oil supply, lower OPEC production and, to a lesser extent, higher interest rates. But in the near term, oil prices are likely to remain at their current low levels and keep showing big price swings. For more see: A couple of notes on the oil market
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.