Most analysts seem to have their mind made up as to where oil prices are headed over the next 12-24 months—up, and in many cases, significantly. Jeffrey Ubben of ValueAct Capital sees oil moving to US$100 over the next several years, and Canadian banks RBC and TD Bank see oil averaging US$40.28 and US$47.00 this year, respectively.
Oil prices rallied about 60% in a little over a month (from the bottom on February 11 to the recent high on March 18), and the rally is supported to an extent by improving fundamentals. U.S. crude production has fallen from 9.6 million barrels per day (the high) to last week’s 9.038 million barrels per day, the lowest level since November 2014.
This is a sign that higher-cost U.S. production is finally coming offline thanks to lower oil prices. Unfortunately, the current rally is also being driven by sentiment as traders pile in on news of an OPEC supply cut coming soon. This has lead major investors to cover their short positions and, as a result, the current rally has exceeded what makes sense based on actual market fundamentals.
The current rally is very similar to the one that occurred last year at this time (oil rallied over 40% on optimism that a bottom was near), but fundamentals brought the rally to an end. While oil may be heading up over the long term, there is good reason to believe it is headed back down for another leg first.
An OPEC supply cut would not fix the oversupply
Oil prices are weak because there is currently a daily global oversupply of between 1.5 and two million barrels per day. Prices have rallied partially because OPEC and other producers have agreed to meet next month to talk about freezing production. Major producers Saudi Arabia and Russia are expected to be in attendance.
The major issue is that many analysts, including the International Energy Agency, have stated that such an agreement would do little to nothing to help fix the current oversupply. This means that any increase in prices based on such a rally is doomed to fail.
Why is the IEA so pessimistic? The major reason is that almost none of the producers at the meeting are actually capable of increasing production, which would make a freeze meaningless. The only country able to meaningfully increase production this year is Iran, and to a very small extent, Saudi Arabia.
Saudi Arabia is currently producing near maximum capacity after increasing production heavily last year; analysts are estimating that it could possibly hike production by 100,000 barrels per day in 2016 at most.
Most importantly, Iran, the only country actually adding production in 2016 (it’s expected to add about 500,000 barrels per day) is not expected to be part of the OPEC meetings. Without Iran taking part in any agreement, any OPEC agreement is a non-event and does nothing to correct the current oversupply.
Crude is still being added to stockpiles
Even though U.S. production is falling, the 1.5 to two million barrel per day oversupply still exists, and, as a result, oil is constantly being added to stockpiles. Just last week the U.S. government reported a huge stockpile build of 9.4 million barrels, which was three times analyst expectations.
This adds to U.S. stockpiles that were at a record high of 523 million barrels. These levels are currently a massive 160 million barrels above the average for the past five years, and as long as crude is being added to stockpiles rather than drawn, it is impossible for any rally to last.
To make matters worse, the current rally could encourage new production from the U.S. to come online, and combined, these factors could lead to prices falling over the next few months.
Fortunately, this is an opportunity for investors who missed the first rally. Names such as Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) that have access to highly economic drilling locations (in Baytex’s case, the Eagle Ford and Lloydminster—some of the most economic plays in North America) will do very well as oil prices rise over the mid to long term, and a pullback in oil prices will create a unique buying opportunity.
