It's been a good few weeks for black gold. From a low of $26.05, it finished this past week at almost $40, with corresponding increases in U.S. Oil (NYSEARCA:USO). Cheering the rise on has been a steady procession of seemingly bullish news out of Russia, the Middle East, and here in America's own back yard. The question now is the same as its been for most of the past eighteen months. Is this a real bottom, or just a temporary reprieve?
There is one, and only one, way that meaningful stability will come to the oil market, and it is not hard to guess: supply and demand have to come back into balance. And that is nowhere close to happening yet. Most of this "news" supporting oil prices the last few weeks isn't news, either because everyone already knew about it or, sometimes, because it didn't even actually happen. The one thing that is news, the Federal Reserve's dovish turn, is almost certainly a short term blip. Investors should not buy into this rally, which I submit won't last.
The Fed's Dovish Turn
The one legitimately bullish factor for oil that wasn't there last month is the extent of the Federal Reserve's budding opposition to further rate increases. Their most recent announcement that they are holding off on further rate increases for now sent oil sent oil sharply higher. A weaker dollar, as we all know, supports oil prices by making it easier for other countries to purchase the commodity.
Although the Fed does have a mandate to look after both employment and inflation, and therefore would technically be within its rights to let inflation run for a little while to prevent overseas turmoil from affecting the American jobs market, its unrealistic, in my view, to expect that it would seriously jeopardize the hard-won credibility on inflation-fighting that Paul Volcker had to wrestle away from the market after the oil panics. No, no, the old ones, back in the 70s.
That means that the Fed's restraint on rates can really only last as long as inflation remains comfortably below its 2% ceiling. And it probably won't much longer. The most recent reports have core CPI at 2.3%, already above the mark. PCE, which the Fed prefers, is only at 1.7%, but it will probably soon hit high enough that the Fed will have to move. At that point the dollar will firm up and the pressure on oil will return.
This "Freeze" Isn't Even Chilly.
It's interesting, though, that the oil rally was already over two weeks old when the Fed announced its decision. It seems to have had its initial genesis, rather, in the same place it seems all oil rallies do: Saudi Arabia.
This time it was supposed to be different, the Saudis thought. Shale production in America was supposed to take the brunt of the production cuts and collapse, leaving Saudi Arabia to have its cake of high prices and eat high production levels, too, after a brief period of flooding the markets with oil. The short-term pain for geopolitical rivals like Iran and Russia was a nice bonus, but it was also supposed to be a short one. Instead, its gone on for eighteen months. A quarter of KSA's currency reserves are up in smoke and the kingdom still faces a deficit in the double-digits of GDP. That's why, with both of them hurting so badly, Russia and the Kingdom actually cooperated and announced a production freeze last month, which corresponds to the beginning of oil's bounce to within a few days.
The market has been doing this for a while now, bouncing on mere talk, which is always cheap, even for cash-strapped oil producers. Those other rallies all fizzled, and I submit this one will too. The problem is the same as with all the others: for all the talk, nothing's actually happened. Russia and Saudi Arabia were never going to increase production. And with the market already oversupplied by 2 mbpd, a freeze doesn't help anyway. What is needed is for someone to actually cut. Russia and Saudi Arabia, two of the world's top three producers, are only going to freeze, at high levels, what's more.
Shale Can't Do It Alone
And even now, the Saudi strategy has not really succeeded. Much has been made in recent months about the decline of U.S. shale production, but despite a drop of close to 80% in the drilling rig count, shale production is only down 7%. To the extent that shale really is shrinking, which is undeniable, that is already priced into the market, since its been clear for months. Nor is the drop forecast to be nearly enough to wipe out the surplus. OPEC foresees the "collapse" of shale will bring production in the U.S. down by 420,000 barrels. Even the EIA's larger 700,000 barrel estimate represents less than half of the surplus in global production.
True, the decline in shale production is actually somewhat steeper than that, but it has been somewhat offset by rising production in the Gulf of Mexico, from projects that were begun before prices crashed and were too far gone not to finish. This means that things for oil are actually even worse than they look. As shale producers have cut the rig count by three-quarters they have been abandoning more and more marginal plays to focus on core, sweet areas with lower costs per barrel. The more of the old, higher-priced shale is already out of the system, the less shale production has left to fall.
"Missing" Production Isn't Vanishing
Some oil bulls have latched onto the recent conflicting IEA reports for further optimism. According to reports, IEA has an 800,000 barrel a day gap in its data between what it said total world oil production summed to last year and the barrels it can actually count around the world. If that oil really were missing, and the EIA's more pessimistic estimates about American production turned out to be right, then the world surplus would be almost eliminated.
The problem is that a vanishing world surplus should be easing storage pressure, and that isn't happening. True, the inventory report two weeks ago came in with a surprisingly low build in crude stocks, but only because the draw on gasoline stocks also came in surprisingly low. Had gasoline come in as expected the draw on crude reserves would have been a minuscule 600,000 barrels, less than six figures a day of production. You'd have to go back to the week before that to find an inventory report that came in substantially below projections in aggregate. And all this became moot this past week, when the most recent inventory report showed an aggregate build of 6.9 million barrels, nearly a million barrels a day and more than the entire missing production in the IEA report.
That's two weeks of either minimal or no draws on record high storage levels. Some have noted that a rise in imports accounts for about 70% of that build-up this week, and that's fair enough. But even 300,000 barrels a day still being added to storage when prices are crashing and tanks are filled to the brim seems to me a very bearish signal. The IEA's missing barrels may be missing, but they haven't vanished. More likely than "ghost" production is that the IEA simply doesn't have as good a picture of reserve build up in some less developed countries. Someone is storing oil and forgot to tell the oil accountants.
Shale oil is not collapsing enough to balance this market. Really it isn't even collapsing at all, just consolidating a little.
China will help a little, but not much; its output is forecast to fall 5 percent this year, but the government made sure it would not fall any more when it put a $40 floor under the domestic price of oil. Meanwhile, the economic news out of China remains bad, so whatever China does to help on the supply side will probably be cancelled out by its shortfalls on the demand side.
Iran is still aiming to dump a million barrels of fresh production onto the market. Even if they fall short of that, as many expect, any additional production right now is likely to keep pressure on prices. And Iran has already announced that they don't want to join any production freeze, and the same goes for Libya, another country that could conceivably dump seven figures worth of daily oil, or close to it, onto the market if the new cease-fire holds.
Iraq's production is setting new records, and as the only OPEC member that was exempt from production quotas even before OPEC formally abandoned them late last year, was never a good candidate to look to for cuts. The war against ISIS is far from won, but it seems unlikely that they will advance far enough into the country to substantially damage production.
In short, there is no "ghost production," shale isn't declining nearly fast enough, and Russia and Saudi Arabia aren't actually doing anything to balance the market. Iran, Libya, and Iraq are either irrelevant to this discussion or are actually going to make things worse. The Fed support of oil, such as it is, seems highly likely to be very short-lived, as does this oil rally. Anyone who has been nursing losses in Exxon (NYSE:XOM) or Chevron (NYSE:CVX) or other oil stocks should look at this as perhaps their last opportunity to recover at least some of their losses, and sell such holdings.
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.