Following months in freefall, oil prices recently bounced off their January lows. But experience suggests there are more ups and downs to come.
Oil’s swift, sharp slide from mid-June to late January was one of the most spectacular moves in its history. Investors had been lulled into a false sense of security with respect to the oil market, given several years of stable, relatively high quotations.
But in 2014 a series of reductions in worldwide petroleum demand growth projections, combined with an impressive climb in U.S. shale bed production, contributed to the shift in view that oil supplies were now plentiful.
Then OPEC’s decision late last year to allow the market to find its own level, rather than reduce production to support prices, accelerated the downturn. By the end of January 2015, oil prices had fallen 60% from their mid-June peak.
Companies in the energy sector are used to volatility, and don’t change their overall spending plans unless a shift is considered lasting and material. Months of nearly relentless selling pressure did just that, though, and many producers adjusted to the new normal by reining in their drilling initiatives substantially.
But even though many companies announced sizable reductions to capital expenditures in late 2014, the market didn’t stabilize right away, since it was still reeling from OPEC’s decision to allow prices to float.
It was only after even more drillers decided to abstain from going all out, and said so in early February—around the time that corporate earnings season was in high gear, that oil prices showed signs of putting in a floor. At the same time, not coincidentally, a noticeable downturn in the U.S. rig count had occurred.
The market’s newfound volatility aside, we give credit where credit is due, in that U.S drillers were able to turn around a situation wherein, not that long ago, it was assumed domestic wells would produce less and less. Good old-fashioned American ingenuity brought forth the technological advances that changed the course of industry history. Specifically, the combination of horizontal drilling and hydraulic well fracturing opened up the shale rock formations that were always known to contain oil, but were never able to be tapped for commercial gain. The trouble is that drillers are now a victim of their own success, creating too much of a good thing with their oil production gains now seen as surplus.
It is also clear that the bounce from late January to early February in oil prices is only a step in the dynamic pricing process and not necessarily a permanent reversal of the down trend. The spending reductions announced and the sharp drop in the rig count provided oil traders with sufficient reason to bid up quotations 20% from their recent bottom.
But U.S. shale oil production continues to rise in a success story that is hitting its first bump in the road. Current domestic production of around 9.1 million barrels a day marks an impressive jump from around 5.4 million barrels in early 2010. Last year saw a 1.2 million barrel-a-day rise alone, with most of the advance arising from the development of shale fields. According to recent report from the Energy Information Agency, the Department of Energy’s forecasting division, U.S. production will continue to rise through 2016, with about a 600,000 barrel-a-day gain this year and a 200,000 b/d rise next year. The declining rate of growth is owing to the slowdown in investment now occurring, of course. But still-rising output suggest market sentiment could sour again in the near term if demand fails to keep up, or if production from venues outside the United States advances.
Over time, though, there is little reason not to believe that, as the saying goes, “The cure for low prices is low prices” (and vice versa). That is because low quotations boost consumption and lead to decreased investment in new wells. What remains unclear is the time frame over which the eventual comeback will take place. Prices may be choppy for months, until clear signs of better supply and demand fundamentals take hold. Note: Periodic disruption to supplies from oil-producing nations in the Middle East and North Africa are likely to continue to enhance market volatility.
For investors, the bottom line is that there is still a large measure of uncertainty with the oil market, which is still adjusting to the recent precipitous drop in quotations. That suggests a long-term view and a focus on quality stocks may be wise. Shares of Exxon Mobil (XOM) and Schlumberger (SLB) fit the bill on those counts.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.
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