USO: The Curious Case Of... WTI

| About: The United (USO)
This article is now exclusive for PRO subscribers.


Oil production "freeze" yields no real-time results - why you should not be surprised.

Today's environment is negative for oil prices - but will it stay that way?

Broad, non-directional assessment of macro events that are having impacts on the oil industry.

Ever since I signed up to receive alerts on the United States Oil ETF (NYSEARCA:USO), I have read a multitude of various articles, which, for the most part, can be broken down into two categories: the "I have no idea, but I think oil is going higher" hopeful speculations and "the gloom and doom: oil is going to $20 and lower" repetition of facts well known today. I will do my best to not steer in either of those directions and simply present food for your investing thought through my analysis and interpretation of information available in the news.

Full disclosure upfront: I am long USO LEAP calls and stocks of a few oil-related corporations. So essentially I am a bit biased, so apologies in advance if you see me steer towards the bullish camp.

The Micro View

We are oversupplied. We are overproducing, making the world even more oversupplied. While the EIA expects 2016 crude daily production to decline slightly from 9.4 mb/d to 8.7 mb/d, the OPEC is forecasting an increase for the U.S. and Canada. Although the 2016 capital expenditure budget cuts that companies announce left and right are likely to play a role in reducing production down the road, extracting oil from the already drilled wells remains very cheap.

It's still cost-effective down to prices of $10 per barrel to maintain many existing wells across the United States, which is why drillers have not shut in production. But producers face a significantly higher bar when it comes to authorizing new production, because the cost of drilling and finishing a well accounts for the lion's share of lifetime costs.

And given that the rapid decline in oil rigs (down 60% in the past year) vastly outpaces decline in production, it is probably exactly what is happening in the market today. The "glut" problem will not get solved by addressing supply alone.

Demand remains weak. China is experiencing its slowest growth in 25 years. Europe is dragging its feet, and Emerging Markets are not doing much better either. If anything, demand for oil may actually get weaker in 2016.

In this environment, it is very tough to say why oil should suddenly appreciate in price. And I would have to agree that any rally in oil should be sold into as long as this supply-demand relationship holds. The problem is, as always, in "timing the market" - you will most likely learn of the turning tide only after it passes you by.

To see why it may turn, we need to turn to the macro picture.

The "Freeze" On Oil Production

Since the market learned that Saudi and Russian ministers are to meet in Doha, crude embarked on a small rally. When the news of production freeze came out, the oil market sold off. Then, we had comments from the Iranian officials that the freeze was "illogical", followed by statements of "support" for the freeze. And all this while crude oil prices just continued to oscillate between $28.50 and $31 per barrel.

It seems that while the market wants to make something of these actions, it's not sure which direction to take. Part of it I think is attributed to the uncertainty about whether all parties will hold to their commitments. But assuming they do, will it really work? In fact, let's assume that a cut was agreed to, would that really help stabilize the oil supply?

I have a good reason to believe it would not. The major problem with that agreement, one of the major producers was not invited. And thus, not obligated. The United States shale producers can and will continue to pump as long as they can make any profit.

By now, it's probably obvious that while some smaller E&P operators in the US are on the brink of Chapter 11, quite a few can still operate at these prices. Freezing the production will not help improve supply, but can help possibly to put a floor on price deterioration.

A cut would probably be worse for Saudi Arabia and Russia - they would just be freely giving up market share to shale producers who would eagerly fill in the gap.

The Macro Picture

It seems the market is disoriented. The results of the meeting in Doha most likely will not lead anywhere. But the one thing that needs to be taken away is that big oil-producing nations are starting to move - the current environment is not comfortable for them.

Back in 2014, Saudi Arabia was willing to let prices decline to protect its market share. It was willing to flood the market to destroy competition, specifically the U.S. shale industry. But today, a glimpse of higher production is scary enough to hold an emergency meeting.

Speculative, but I think Saudi Arabia's officials did not expect the shale production to be so resilient. And they did not expect the oil price to drop so low either. And now, the $700 billion in reserves is likely shrinking far too fast to their liking. Same situation with Russia, albeit its reserves are much smaller, and it is also "enjoying" the sanctions for its "misbehavior".

Yet, shale production is still not dead. And in this war of survival, I think the "market makers" (e.g. government-backed oil producers) are starting to "blink". Current environment is not welcome for them - production has not declined as expected, but the price did. And the longer this condition holds, the shorter the time span oil-based government budgets can sustain increasing deficits.

The two options at this intersection are either to boost production even further to drive prices lower or "hope" that it will work bankrupting private corporations. A very risky bet, and if it doesn't work, the nations will likely face delinquency on their own obligations.

The other safer bet is to back off. To put a freeze, and if it doesn't help, agree to implement cuts. All to lower the effective production volumes and prop up the commodity price. Unfortunately, I think these countries are late to the party. In 2014, the OPEC opened the "Pandora's Box" when it refused to support oil prices. And today, I think the actions to limit production will not help stabilize the supply side of the market.

Don't Mess With The U.S.

Being a big oil-dependent producer nation has its benefits and shortfalls. On one hand, being big allows controlling and impacting prices. On the other, heavy dependency on oil is detrimental in a downturn and size impacts flexibility: the bigger you are, the slower you are to move.

At $100 oil, everything was glamorous for producers with very high margins. When the prices started to decline, everybody faced a common problem - cutting the "fat" and slimming down.

The "Pandora's Box" is in the fact that slimming down Saudi and Russian budgets is much harder than cutting expenses from corporate balance sheets. They can't lay off their population or sell property assets. And they can't easily restructure their operations to weather the storm.

As bold as it sounds, I feel that the U.S. companies will be much quicker to adapt and become profitable at $30 oil than the oil-producing nations adapt their budget expenses to balance out in this same environment.

As such, I do not believe oil will go much higher in any foreseeable term. Even if OPEC does cut production, the U.S. producers will fill in the gap at any sign of oil price increase.

CapEx cuts will have their say if prices and production increase, exhausting existing wells as a result. But even the new wells are likely to be drilled at a lower cost.

"There are some companies out there that have figured out a way to cut their drilling costs by 50 percent," Robertson said. "While a few months ago, their break-even point may have been one (price), now it's different."

Bottom Line

I would feel foolish trying to speculate where we are headed with oil prices in the long run. In the short term, I'm inclined to side with the bears that it "will get worse before it gets better." But I don't want to time the market as I feel the snap back will be fast and furious. If it ever comes. And I'm not expecting it to be that big either.

I do believe that these moves by Saudi Arabia and Russia, two low-cost major oil producers, to curb further price declines put a floor on oil pricing. But having a floor does not imply we are going to bounce and run to the upside - just that we probably won't go all too much lower. And if the freeze doesn't put in stability in place, we will see these same players reassemble to find alternative options.

I'm quite confident we will still see bankruptcies among the shale producers. But I really hope that we don't see governments going out of business, as additional instability in the global economy may have adverse impacts on the markets overall and subsequently on oil demand.

Disclosure: I am/we are long USO, MRO, VNR, RIG.

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.