Once again oil (NYSEARCA:USO) has crashed through the $50 per barrel barrier sparking concern that a new oil crash is on its way, despite OPEC having successfully implemented its historic agreement to cut production in January. As crude slides ever lower, there are signs of a new price war emerging, which will keep pressure on oil for far longer than many pundits had ever predicted.
The main reason for oil cratering in recent weeks was a far larger than expected build in what are already bloated oil inventories. This saw U.S. stockpiles rise by 8.2 million barrels, the single largest increase since 1982.
Much of this can be blamed on a significant increase in U.S. oil production, which for the first week of March reached its highest level since February 2016.
There has also been a marked uptick in drilling activity in the U.S. energy patch with the onshore rig count for the second week of March growing by nine rigs compared to a week earlier and surging to be a massive 65% higher than a year earlier.
Growing pressures could cause the OPEC deal to unravel
The reason for this has been a substantial increase in operating tempo in the U.S. shale oil industry as beaten-down shale oil producers move fast to boost output and take advantage of higher prices. This alone will keep a lid on prices for some time but probably in itself is not enough to trigger another meltdown.
Of even greater concern is conflicting signals as to whether the landmark OPEC deal to cut production is as successful as initially thought.
Saudi Arabia eased output cuts in February which caused production to grow by 263,000 barrels daily.
Then there is the issue of just how long the Saudi's will be willing to shoulder the burden of the majority of the production cuts, particularly if oil prices remain weak for a protracted period. The Kingdom is locked in a vicious battle for regional dominance and a range of proxy wars with arch enemy Iran, which means it needs considerable revenue to fund its military.
Other OPEC members are also looking to boost production to make up for shortfalls in desperately need government revenue. These include Nigeria, Libya, Iraq, Venezuela and Ecuador.
It is also difficult to tell exactly what is happening with Russia, because Putin has a very specific agenda which is focused on regional dominance as well as brinkmanship and oil revenues form a significant slice of government revenues. If Russia the world's largest oil producer decides to pull the pin on production cuts it is impossible to see OPEC agreeing to maintain production cuts.
The deal comes up for review at the May 2017 OPEC meeting and the OPEC Secretary General has stated that it is too early to tell whether the deal will remain in place after that meeting.
A key driver of the original OPEC deal was the fiscal pressures being experienced by members because of the sustained weakness of crude.
Sharply weaker oil prices were having a marked impact on the economies of petro-states, leading to significant budget cuts, social unrest and political instability.
If the U.S. shale oil industry ramps-up activity to the point where it can fill the 1.8 million barrels of daily production cut by OPEC, thereby keeping prices below US$50 per barrel, there is little rational for OPEC to maintain those production cuts. This appears likely with the majority of operators having cut costs to the point where some are profitable at US$45 per barrel and others are easily capable of breaking even.
Industry heavyweight Continental Resources Inc. (NYSE:CLR) has slashed costs to the point where it has estimated breakeven costs of $36 per barrel. Its CEO, billionaire oilman Harold Hamm, has warned that the shale oil industry could kill the oil market if it embarks on another spending binge focused on lifting production.
Compared to 2016, Continental has almost doubled its 2017 capital program to US$1.95 billion. This it claims will be cash flow neutral with West Texas Intermediate at US$55 per barrel and allow it to drill 178 net wells. Of even greater significance as far as oil prices go is that it has forecast a 6% increase in oil production when compared to 2016.
It has been suggested in some circles that U.S. oil producers could double production to 20 million barrels daily and this would certainly have a significant impact on global energy markets and oil prices.
There is a considerable incentive for shale oil producers to grow production, particularly with Trump planning to stimulate activity by loosening regulations and pushing to make the U.S. energy independent. His proposed corporate tax cuts will also help to boost the bottom-line of energy companies if implemented.
These factors combined, would certainly make shale oil companies more profitable at lower prices, thereby stimulating further production.
The final outcome could be another oil war
For the reasons discussed OPEC would find itself in a terrible bind. If it maintained the production cuts, then shale oil companies would just step in to fill the void but if it boosted production to pre-cut levels then member states would find themselves facing the same or even worse fiscal pressures as the price of crude dives. Because shale oil companies operate in a free-market and are governed by free-market imperatives, rather than government based political and financial interests they will do what it takes to survive and reward shareholders.
This means that is extremely difficult to predict what OPEC will do. The Saudi strategy aimed at wrestling back market share has clearly failed and the production cuts were an admission of that, but the Saudi's will need to react in way that allows them to at least maintain the appearance of coming from a position of strength. This makes it increasingly likely that a new price war could be on the horizon.
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