• Energy and Income Advisor
  • Conrads Utility Investor
  • Capitalist Times
  • Twitter
  • Seeking Alpha

Energy Stocks

Why Did Oil Prices Walk off a Cliff?

By Elliott H. Gue, on Mar. 14, 2017

The breakdown in oil prices dominated financial headlines over the past week. WTI had ranged between $50.50 and $51.50 per barrel for much of 2017 until the commodity tumbled through this floor, the psychologically important price of $50 per barrel and the 200-day moving average of $48.67 per barrel.

What happened?

Some commentators attributed the plunge to data from the Energy Information Administration estimating that US oil stockpiles had reached record levels after increasing by 8.2 million barrels.

Although this inventory build exceeded expectations, this single data point doesn’t explain the selloff in crude oil. After all, last week’s numbers marked the latest in a series inventory gains. The Energy Information Administration also reported a 6.56 million barrel per day drawdown in gasoline stockpiles and a 2.68 million barrel decline in distillates—much larger than the market had expected.

Two developments drove the big drop in oil prices: The realization that the faster-than-expected recovery in US output could offset much of OPEC’s production cut. Since late 2016, we’ve argued that US shale output, not OPEC, would be the big story for oil prices in 2017.

Several factors have helped this view to gain traction.

EIA Bloodbath

Earlier this month, Exxon Mobil Corp (NYSE: XOM) announced a strategic shift that will allocate a growing proportion of its capital expenditures to US shale and other short-cycle opportunities. Half of the energy giant’s drilling budget will go toward these opportunities in 2017.

Management also asserted that much of its acreage can generate a profit with oil prices at $40 per barrel. Although this pronouncement doesn’t necessarily come as a surprise after Exxon Mobil’s $6.6 billion acreage purchase in the Permian Basin earlier this year, the news stands out because of the company’s size and reputation. Exxon Mobil’s decision to make a big splash in the Permian Basin and accelerate drilling and completion activities underscores the quality of the resource base and low break-even costs.

IHS Markit’s (NYSE: IHS) widely watched CERAWeek conference featured presentations from a host of industry heavyweights, including Khalid al-Falih, Saudi Arabia’s energy minister.

The production response from US shale as well as upstream operators’ efficiency and productivity gains in these plays emerged as key themes during the conference. Leading US independents like EOG Resources (NYSE: EOG) and RSP Permian (NYSE: RSPP) asserted that they would grow their output by 20 to 30 percent annually over the next few years.

Harold Hamm, CEO of Continental Resources (NYSE: CLR) and a key energy advisor to President Donald Trump, warned that the industry could “kill” the recent oil price recovery by continuing to drill and complete wells with abandon.

Khalid al-Falih expressed concern about rising US shale output after months of denying the potential for a meaningful production response. The energy minister warned that US producers shouldn’t count on OPEC and Saudi Arabia to extend their production cuts for another six months to support prices and further market share gains for shale. Saudi policymakers regard rapid growth in US output as a key factor when deciding whether to extend production cuts.

Saudi Arabia has also reduced its oil output by a greater magnitude than it agreed to last November. Compliance from other countries has been mixed at best, prompting Al-Falih to warn fellow OPEC member about relying on Saudi Arabia to carry the burden.

OPEC’s assertion that US shale needed oil prices of about $60 per barrel to incentivize production growth appears to be a miscalculation; with WTI hovering around $50 per barrel in recent months, US output has increased by about 660,000 barrels per day from its lows. Oil prices would need to be below $50 per barrel to keep a lid on US production.

More important, hedge funds had amassed a record long position equivalent to 900 million barrels in WTI and Brent futures at the end of February. Speculative buying likely helped WTI to shrug off a series of massive inventory builds in January and February.

Cheered on by sell-side analysts, portfolio managers likely bet on oil prices recovering to more than $60 per barrel. But hedge funds look to make fast profits; when sentiment changes, they have no qualms about bailing out of a position rapidly.

Bearish comments from some of the top players in global oil markets and yet another inventory build—not to mention massive long bets on further upside in WTI—prompted some portfolio managers to lose patience with this trade. This wave of selling accelerated once prices broke below key levels of technical support, with hedge funds taking advantage of any rally to liquidate more of their positions.

Historically, these headlong rushes for the exit end in a panicky selloff that overshoots underlying fundamentals. The Wall Street Journal yesterday reported that Pierre Andurand’s hedge fund had lost more than $130 million this year on bullish oil bets.

Although WTI could receive a one- or two-day reprieve, oil prices could fall to $40 per barrel or lower in coming weeks. For more detailed analysis of energy prices, and which companies have already positioned themselves well for volatile pricing, subscribe to Energy & Income Advisor. EIA provides in-depth analysis and model portfolios across the energy space, perfect for investors who want to make the most of volatile times.

Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.

Ready to discover your investing potential?
Try Capitalist Times Premium Risk-Free Today