Be Careful When Buying Into The Oil Price Hype

Includes: BNO, OIL, UCO, USO
by: Rupert Nicholson

Oil prices might improve from current levels; however, they could just as easily decline.

The 25% rig count decline is not necessarily indicative of a production decline. High production rigs (horizontal) have declined significantly less than low production (vertical) rigs.

Technological advances are making costs of production cheaper and oil easier to extract.

The oil price fall seems to be a natural correction in the market as at ~$55 a barrel demand and supply look set to meet in equilibrium.

After reading articles such as this and hearing the secretary general of OPEC state the price could go as high as $200, I started to wonder whether oil is a good investment. After all, crude oil has just had its best two weeks in 17 years. Some investors will hope that this rally is similar to the 2003 rally in the market, while others might point to 2002 and 2009 as evidence of the false signals the oil market can send.

The article I linked to above points to falling rig counts as evidence that the glut of supply might be waning. Indeed, rig counts have fallen almost 25% since the drop in prices to around 1,200. Furthermore, many rigs have been left idle with more than 5% being idle in any given week. However, what does this mean and what is an oil rig?

The author I alluded to above states "rigs are dropping at a record pace, yet domestic production is still rising. At some point these will move in tandem." From this, one might assume that production stems from the rigs, however, this rather misses the point. An oil rig drills the wells where the oil is then tapped and later extracted through oil platforms. A decline in oil rigs purely signals a decline in exploration and development of NEW oil sources. Hence, oil production might well still increase but at slower rates even while rig counts fall. The two are not necessarily correlated. In fact, due to improvements in technology, production could theoretically speed up while rig counts decline if productivity advances outpace the rate of rig decline.

Consequently, technological advances are key to the belief that rig counts might not paint the full picture. Oil rigs can be subdivided into two different categories: horizontal rigs and vertical rigs. The differing names refer to the direction of drilling by the rig. Both rigs drill downwards until the oil layer has been hit, however, a horizontal rig then turns into the layer allowing more oil to be extracted more efficiently. Vertical rigs have indeed seen a steep decline of ~40% since October, however, horizontal rigs, have declined just 15%. On top of this, much of the decline stems from less productive regions. In large oil fields such as the Permian Basin there has been almost no decline in horizontal rigs. Will this decline in rigs effect production? The simple fact is that rig counts have been falling for weeks while production has been increasing.

There are other perhaps more compelling arguments that we must examine for why the decline might be over. As we have looked at the supply side, we must also look at demand. The International Energy Agency publishes an Oil Market Report and a look at its highlights is revealing. In late 2014, many expected demand to pick up, however, now the IEA states "macroeconomic weakness continues to restrain global oil demand growth." Even at the lower oil price, the IEA expects demand to only increase by 90,000 barrels per day in 2015. Also, demand might be restricted by the disappointing U.S. growth report and the lower than expected manufacturing numbers for the 4th quarter of 2014 which were released a few days ago (for any of those interested, the WSJ has these reports under its U.S. economic events tab).

WTI Crude Oil Spot Price Chart

Source: YCharts

Source: International Energy Agency

The two graphs above are quite revealing. In the first graph, we see the oil price rally from 2004 to mid-2008 driven by Chinese demand, then the collapse following the financial crisis, and the rally from 2011 to 2012 driven by the Libyan oil crisis. This graph suggests that the recent highs of oil were due to factors brought about by the Arab spring and the concerns over oil supply from that region. This suggests the oil price could have been unreasonably inflated. The second graph is similarly important.

As we look at the period from the end of 2014 to the next few months of 2015, we can see the glut of supply and the closing of this glut. We see the speedup in oil supply toward the start of 2014 as oil prices remained over $100 a barrel. It is reasonable to assume that the subsequent slowdown in growth of supply was due to the declining oil prices, while the current growth in demand is being fueled by the global economy picking up. It seems at the current price levels, the oil market will reach an equilibrium in the coming months, and after this supply should grow marginally faster than demand (the small divergence at the far right of graph two).

So, where is oil headed? Who knows is the answer. The price could well be driven up by speculation. Having said this, it will almost certainly not hit $200 and it is quite unlikely to hit $100 (a barrel). Even if the oil price falls to $40, only a tiny percentage of overall oil production will become unprofitable. The main aim of this article is to strike a note of caution, don't buy into the hype over oil! There are good reasons the hedge fund short position in oil is the highest its been in four years.

I'm skeptical when people say that the oil price should increase on the basis that the secretary general of OPEC has said oil will reach $200. After all, he is one of the people most likely to be oil's biggest cheerleader. Its similar to Cristiano Ronaldo's agent telling you his client is worth $450mn. Oil could make you a tidy profit; however, it could well leave you in the red. I believe a fair range for oil is $35-85 (WTI crude oil) centering around a price of $55. The reason I leave room for more upside than downside is to account for speculation as I believe people like to buy into an oil price rally.

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.