Although oil has been trading manically over the past two months, the daily chop masks a broader consolidation around $60 per barrel in Brent. This is quite a turnaround from January’s lows. The rally has occurred despite near-term supply exceeding demand, resulting in persistent inventory builds year-to-date.
The proximate reasons for the modest price recovery are threefold:
- Sharp declines in North American rig count reflecting capital expenditure (capex) retrenchment by exploration and production companies, and that bringing focus to the changing trajectory of production
- Company reports of delayed well completions to preserve cash and defer production to when prices are higher, leading to higher production decline rates and speeding up the expected adjustment process
- Nascent signs of demand picking up in the U.S. and elsewhere
The bottom line is that prices work. Both supply and demand are responding, which should eventually allow for prices to modestly firm.
While we see signs that supply and demand could come back into equilibrium later this year, uncertainty remains over the new ultimate “equilibrium” price. With the resilience of shale oil untested, the price at which U.S. production grows sufficient to meet global requirements – but not too much as to overwhelm balances like in 2013 and 2014 – is a bit of a moving target. Falling costs associated with declines in capex and a growing backlog of drilled but uncompleted wells suggest rigs and production will quickly respond at a lower price than before.
The wild card is always geopolitics. A stepwise or comprehensive agreement with Iran would present a downside to prices. On the other hand, Nigeria’s political climate has been deteriorating ahead of the presidential election. And the strain of low oil prices on producers like Iraq and Venezuela could result in destabilizing outcomes and lower production.