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The Problem With This Oil Rally

By Ellen R. Wald, Ph.D.CommoditiesMar 15, 2016 06:31AM ET
www.investing.com/analysis/oil%E2%80%99s-ups-and-downs-200121623
The Problem With This Oil Rally
By Ellen R. Wald, Ph.D.   |  Mar 15, 2016 06:31AM ET
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The price of oil rose sharply last week to nearly $40 a barrel, presumably based on two pieces of information: falling rig counts in the United States and the announcement that major international oil exporters Saudi Arabia, Russia, and Venezuela would freeze oil production if other oil producing countries agreed to the same. The rally seemed genuine enough that even the IEA stated in its March monthly oil reports that, “there are signs that prices might have bottomed out.”

The problem with this oil rally (which already proved transient) is that the forces that drove oil up to $40 are not really indicative of a change in the oversupplied market.

Oil rig count in the United States has been dropping steadily in 2016, while oil production has remained steady. Rig counts are released weekly but do not provide a good indication of oil production in the United States, because the rate of production from rigs already in use has climbed steadily. Oil storage facilities present a much more accurate indicator of the amount of crude oil in the U.S. These storage facilities are so fully stocked that overflow is being stored in railcars. The significance of this cannot be understated – there is so much pumped oil in the United States that there is nowhere to put it. Even ending the oil export ban has not helped because the global market is nearly as over supplied as the U.S. market, and U.S. oil is struggling to find outlets internationally.

When it comes to the so-called “production freeze,” the truth is that the market should have known better. Talk of an agreement to hold oil production at current levels has been floating around since the beginning of 2016, and every time Russia, Saudi Arabia, Venezuela, Iraq, Qatar, the UAE, Oman and others meet secretly in some combination the same theme emerges. It goes like this: the big producers will only agree to a freeze (not a cut) if everyone else – including wild-card Iran – agrees as well.

Meanwhile, Iran has stated unequivocally that it will not freeze crude oil production, at least until its export numbers return to pre-sanctions levels. How long this may take is unclear, particularly because Iran is clearly struggling with old and inoperative equipment. In this respect, however, we can take Iran at its word. The country’s stated intentions and its interests are clearly aligned when it comes to oil production. Regardless of the low price that oil may fetch, any sale is better than no sale. The same holds true for all of the big producers, which is why any firm and final commitment to a production freeze is highly unlikely to succeed in the current market.

Another sign that any semblance of international cooperation for a production freeze will fail is the news that the Italian oil company, ENI (MI:ENI), recently started to produce oil from the world’s northernmost offshore oil platform. Production from this source has been a long time coming – the project is two years overdue – and ENI will almost certainly want to pump and sell as much as possible to offset $6 billion the company already invested in this Arctic platform. ENI is a major international oil company, but the company is not big enough to hold off on production from such a large investment. Such is the nature of the oil industry – only the strongest players can afford to actually cut production.

Even though the charts and graphs have indicated a sustained upward trend in crude oil prices over the past month, the situation on the ground – or rather, in the tankers, railcars, and pipelines – has not changed much at all. The only ways the supply glut will truly ease is through increased demand (which is what OPEC predicts according to its latest monthly market report) or decreased supply (which is what may happen as smaller companies face bankruptcy and sales and larger companies cut expensive exploration and production projects).

Until then, everything else – coordinated supply cuts or freezes, falling rig counts, and Venezuelan pressure on OPEC – is just speculation.

The Problem With This Oil Rally
 
The Problem With This Oil Rally

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Agathon Maximus
Agathon Maximus Mar 18, 2016 6:03PM ET
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The global debt ponzi is unwinding, driven by CBs and buybacks. The unwind to revaluation will succeed in spewing losses mainly onto the unsuspecting, the public, through debt instruments, derivatives and hypothecation. ..We are now in the Coverup Act part of the play. The temporary bounce. When the subplots and manipulations run in hyperdrive. ..Same as 2008... different antagonist forces, same result essentially.
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mike calderone
mike calderone Mar 17, 2016 11:31PM ET
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The world economy was on the brink of collapse. I truly believe this rally is being manipulated by the participants who have actually come to some sort of agreement and will not announce it until they have taken all their long positions in the commodity and the emerging markets as well. I am certain in the last G20 meeting the heads of the central banks plotted a course to stability ( short term at least) ..I expect the rally to continue for at least another 10.00 and the world economies that count on oil begin to stabilize. This is why we have seen a parabolic rally in emerging markets for the last 8 weeks or so. The world is in a very fragile position and there is no way on earth the central banks are going to through in the towel anytime soon. Stable oil prices will lead to higher equity prices and a generally balanced currency between all the major players and just like that the global crises has been avoided. At least in the short term (Lol).
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Scott Kidney
Scott Kidney Mar 17, 2016 11:40AM ET
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. . A 10% drop in US oil production will make the equation balance. (assuming no increase in demand! HA!). with the level of rig activity where it is now, that should happen in less than 2 years.. . Wait until production is lower than consumption.. Once that level tips, prices will rise, how high? Well until its high enough to be profitable to drill in the U.S. Most plays make money around $50/bbl, but its expensive to pick up and drop rigs.....breakeven prices may differ.. . ENI's production in the arctic is less than a drop in the bucket compared to the worlds daily flow of oil, and even Irans increase in production is pretty insignificant, accounting for 5% of the top 10 producers. Im also suprised that no-one is talking about Canada, they are a bigger producer then Iran, and have dropped projects left and right, they are set to see a production decline also. . . . . . . .
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Joe Bucks
Joe_Bucks Mar 16, 2016 1:35PM ET
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Crude Oil Chart: 37.84 by Joe Bucks
25 minutes before the FED!!! Janet will deliver! Long USD! Long oil as well? What do you say?
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Ghoda Sandrokottos
Ghoda Sandrokottos Mar 16, 2016 2:34AM ET
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Ellen; what a master piece! Very nicely written. I was bullish on oil. Now I have chosen to sit on side lines.
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George Steven
George Steven Mar 15, 2016 10:02PM ET
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Good article. I never realized this with the rig counts. ..I think Russia plays the game quite well to "talk up" oil prices..We could see oil back to 26 and the SP back to 1850 with demand fears and an unresolved supply glut..
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Srinath Gunaratne
Srinath Gunaratne Mar 15, 2016 8:49AM ET
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Excellent article Ellen. Sometime in future market forces will resolve this problem. Countries wants to gain market share and at the same time push prices up. Finally big players and low production cost producers will be winning with supply and demand forces.
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Smart Oil
Smart Oil Mar 15, 2016 8:42AM ET
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China is the biggest oil consumer. Its export tumbles by 25% YOY. Producers blame consumers for falling price. China has moved most oil import to Iran and Russia from OPEC producers. OPEC has lost its voice. Only over supply remains shouting in the market.
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Brad Smith
Brad Smith Mar 15, 2016 8:35AM ET
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Thank you Ellen for this excellent article. I agree that the market should have known better when it comes to the production freeze. Russia and Saudi Arabia in particular have explicitly stated that they will only agree to a freeze if other major producers do the same. Iran has publicly stated that they plan to ramp up their production until they are at pre-sanction levels and they have not shown any signs of backing out from this commitment. The market was far too optimistic on the outcome of a production freeze.
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Bernt Grosse
Bernt Grosse Mar 15, 2016 8:28AM ET
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I find it ironic that the drop in oil yesterday coincided with the Oil ETN UWTI having a reverse split that took the price from $2.53 to $23.50. At the low price almost anyone could trade it. At the high price not likely. Hence volume went from 361 million on Friday to 15.8 on Monday the day of the split. I can't imagine that there wasn't a whole bunch of selling of the ETN by those that don't want to trade a twenty dollar plus unit and hence in my opinion downward pressure on oil futures. Your thoughts would be appreciated.
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Bill Jy
Getuppig Mar 15, 2016 8:23AM ET
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The rate of production from rigs already in use? Rigs don't produce oil, they drill new oil wells. There are thousands of wells in the US that are producing oil. The ~400 rigs are drilling new wells that will produce additional oil in the future.
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