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When will crude prices swing upward?

February 1, 2016 By and    

It is highly probable that the crude pricing pendulum has finally reached the point of equilibrium and is ready to swing into an upward trajectory.

160129-crude-prices-with-pendulum

The chart above shows West Texas Intermediate (WTI) crude closing prices from Oct. 1, 2014 going forward. We choose to look at this time frame because it shows the impact of the Organization of Petroleum Exporting Countries’ (OPEC) decision to change its role in the global crude production hierarchy.

That decision came in November 2014. Leading up to that November, crude prices were in a continued downtrend that began after WTI crude had reached $104.59 on July 21, 2014. By Oct. 31, 2014, WTI crude was trading at $80.54, a drop of $24.05, or 23 percent. Crude traders were expecting OPEC to announce a cut in production to support prices.

However, global oversupply that was primarily fueled by increased U.S. production caused a fall in crude prices. OPEC saw no benefit in cutting its own production, only to see market share lost to high-cost producers in the United States. Instead, at its November meeting, OPEC announced it would not cut production to support prices but would increase production to defend its market share. After this, prices plummeted.

At that time, the break-even point for production from U.S. shale formations was $60 per barrel. OPEC expected to see prices fall below that mark and then recover as U.S. production fell. This is where its expectations were skewed. It expected U.S. crude production to fall sharply below that mark, and it did not.

Instead, U.S. crude producers cut expenses, completed wells already drilled, optimized production and pre-sold production at prices that would allow them to make a profit. As a result, the break-even point for U.S. shale production dropped to below $40 in many cases. This week, Continental Resources, one of the big crude producers from shale formations, said it would need $37 per barrel to be profitable.

Through all of these changes in crude production hierarchy, prices were volatile, seeing some periods of recovery, but the downtrend remained intact. The pendulum may have finally swung to where the downside risk for crude is at least even with the upside risk.

Looking at the chart above, the pendulum has gone from point “C” to point “A.” When crude closed at $26.55 on Jan. 20, it had gone well below where it needed to go to do the maximum damage to U.S. crude production. All of the short-term measures crude producers took in 2015 are no longer available to them. Many did not hedge their production for this year. The inventory of drilled-but-uncompleted wells has been exhausted. There are no more cuts to be made in expenses.

For most U.S. producers, the only thing left to do is to cut capital spending, pay off debt (perhaps by selling assets) and hope crude prices recover before they have to file for bankruptcy. They will see an inevitable decline in production during this painful holding pattern. We expect U.S. crude production to fall rapidly during this year. The U.S. Energy Information Administration is expecting production to fall 700,000 barrels per day (bpd) from where it was last year. We would not be surprised if it is worse.

Currently, global crude overproduction is around 2 million bpd. Demand for crude is supposed to be up 1.2 million bpd this year. If this is true, then just the decline in U.S. production will be enough to rebalance supply and demand. Of course, there is the expectation for more production from OPEC, especially from Iran now that sanctions against it have been lifted. There are also going to be production increases from Iraq and perhaps other OPEC countries. However, the United States won’t be the only country to experience a decline. Russia is expecting production to decrease, and other producers will see declines as reduced capital spending prevents the replacement of depleting wells.

There is the potential for another downturn in crude, but we think there is a good chance the low has been reached and momentum of the price pendulum will slowly swing toward more upside risk.

This week, there has been a lot of support for crude on talk of cooperation among global producers to cut production. We doubt that will happen but believe the talk should limit the downside for crude. In fact, we do not believe a production agreement is necessary for crude supply and demand to balance and for crude prices to swing higher.

For that reason, we believe U.S. propane retailers need to shift to a supply management strategy that would see them use pre-buys and financial tools to hedge more of their future supply needs – a strategy that guards against upside price risk.

We went into 2015 with markets falling, recommending that our clients be no more than 30 percent long for the winter of 2015-16. The market never gave us indication that we should be any longer than that 30 percent, as the spot market remained the place to be.

However, for the upcoming winters, the recommendation will tend to be on the higher end of the spectrum with as much as 80 percent of future supply that needs hedging. With crude prices swinging upward, U.S. propane supply growth swinging downward and U.S. export capacity increasing, we believe future price risk is on the upside.

In our upcoming hedging workshop, we will show propane retailers how to prepare for upside price risk. Please consider attending the April workshop.

 

For more Cost Management Solutions analysis of the energy market that helps propane retailers manage their supply sources and make informed purchasing decisions, visit www.lpgasmagazine.com/propane-price-insider/archives/.

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