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| Brought to you by The Oxford Club | Saturday, March 12, 2016 |
We've Already Seen a Bottom in Oil Prices
 Crude has made a stunning move.
On February 11, crude traded at $26.19 per barrel. On Friday, it opened at $37.99 per barrel. That's a 45% increase.
Why the big jump in WTI in such a short time? Well, the market is finally realizing that U.S. crude production matters more than the amount of oil in storage.
Over the last several months, headlines like "Oil Storage Levels at 80-Year Highs" dominated the news. And these headlines seemed to be the only news traders paid attention to.
In reality, the amount of oil in storage at Cushing, Oklahoma, is meaningless... We could use all of that oil in a month or two.
The real concern is U.S. crude production.
And U.S. crude production, which peaked the week of January 15 at 9.235 million bpd, has been steadily decreasing ever since.
During the week ending on February 26, production dropped to 9.077 million bpd. That's a 158,000 bpd decrease in production.
Regardless of what OPEC may or may not do, oil traders are finally starting to pay attention to U.S. production levels.
And production is going to drop much further from here.
According to last week's Baker Hughes rig count report, the number of active oil rigs dropped to 392. That's 530 fewer oil rigs than the 922 that were drilling this time last year.
That's the 11th straight week of declines. It's also the lowest number of rigs drilling since 2009.
And with oil selling at current prices, the economics don't support throwing lots of capital into drilling new wells. So most E&P companies have slashed capital spending plans for 2016. That means fewer new wells.
The number of new wells being drilled is far less than the number of wells needed to keep U.S. production constant.
Production is also dropping due to the depletion rates of existing wells. Conventionally drilled vertical wells have depletion rates of 5% to 7% annually.
However, it's a different story for horizontally drilled wells and fracked wells, which make up a big portion of U.S. production.
The depletion rates for these wells can be as high as 80% in the first year. And without new wells being drilled to replace this lost production, overall production drops.
That's what we are seeing now... The beginning of a big drop in U.S. production.
If oil production continues to drop, prices will gradually firm up for WTI. However, I think there is going to be a big overshoot to the downside in U.S. production.
Oil prices will rebound faster and higher than the market thinks they will. Traders will overreact to the drop in WTI production and drive prices higher... much higher.
Even once oil prices are high enough to justify drilling again, we won't see the number of rigs increase as fast as they decreased. That's because many E&P companies are strapped for cash and have had their credit ratings slashed. This limits their ability to borrow money to finance drilling.
So drilling will start to increase, but it will increase at a slow rate. That will keep prices high for some time.
Unfortunately, the U.S. is the world's swing supplier of crude. Even though we can now export it, we can't produce it economically at these levels.
My prediction is we could see more than 6 million barrels of oil supply rapidly disappear in 2016.
Right now, the 2.2 million bpd oversupply is what's keeping prices low. But that supply continues to drop.
Enjoy low gasoline prices while you can. We've already seen the bottom.
Good investing,
Dave
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