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Why Higher Oil Prices May Not Last

December 6, 2016

Despite the resounding optimism from financial markets last week after the Organization of Petroleum Exporting Countries agreed on an output reduction deal, the subsequent rally in oil prices may burn bullish traders.  Although it is easy to see why removing approximately 1.200 million barrels per day from existing oversupply would help rebalance the market, this is a very narrow view of the factors driving prices.

In many ways, OPEC has given a major lifeline to unconventional oil producers, namely the US shale industry.  The horizontal drilling techniques that have become commonplace in the western states were forced to shutter operations as oil prices fell below extraction costs, taking a substantial portion of US output offline.  However, now that oil prices are rebounding, producers may rapidly bring shuttered production back to life, breaking the fragile equilibrium that has driven oil futures higher.

Rising Prices Mean Rising Production

The fact that OPEC came together to form an agreement is truly a remarkable step considering the vast disagreements that exist between member nations. Raging political and economic disputes between regional powerbrokers Saudi Arabia and Iran threatened to derail any accord.  While the agreement proved their respective resolve, the deal only tackled one part of the problem which was the supply side of the equation within OPEC.

While US production has slumped over the last year, production from the Gulf States and Iran only climbed during the period as members waged a war of attrition for market share.  However, now that prices have risen back above the breakeven costs for many shale producers, output is roaring back to life.  According to the latest data distributed by the US Energy Information Administration, oil production across the US rose to 8.699 million barrels per day (bpd) during the week of Thanksgiving.

The Rally May Be Cut Short

Even though US production is still well-below the 9.200 million bpd in output recorded a year earlier and the 9.595 million bpd reported during July of 2015, it highlights the rebound in production and the potential upside should prices remain elevated.  Due to its flexibility, shale production is much easier to bring back online compared with other forms of drilling.  This point is emphasized by the US oil drill rig count rising for the 5th straight week to 477 active rigs.  A rising rig count is likely to contribute to increased production, adding to the downside pressure in oil prices more medium-term.

One of the reasons this production is so important is because when combined with rising Canadian, Russian, and Brazilian production, the output cuts set to be implemented by OPEC on January 1st may be completely overwhelmed by rising supply from other regions.  Although Russia has pledged to reduce its output gradually over 2017, there are still questions as to whether OPEC members will honor the deal struck in Vienna.  If past history serves as any indication, there is a high likelihood that the deal will fall apart as members operate solely out of self-interest.  Therefore, any incremental cuts from OPEC may not be effective enough to propel prices significantly higher from current levels.

Technically Speaking

Looking at NYMEX oil futures, the rally over the last few sessions has been tremendous, with prices reaching the highest point since July of 2015.  At present, prices are climbing just above the $51.50 resistance level that forms the basis for an ascending triangle breakout pattern.  The pattern, which is formed by the combination of resistance and a prevailing upward trend that cause prices to narrow within a range can result in significant directional momentum when the formation is completed.  A candlestick close above resistance would be an early indication that a breakout is in progress.

 

 

Supporting further upside in oil futures are the 50-day and 200-day moving averages which are trending below the price action and acting as support.  Although the 50-DMA has not proven as solid, the 200-DMA prevented a deeper retreat in prices twice over the last few weeks as a testament to its strength.  However, despite the upside optimism, certain momentum indicators suggest that prices have run too high.  The Stochastic Oscillator is currently trending in overbought territory, suggesting that a near-term pullback in prices may be imminent should the %K and %D lines retreat below the 80.0 level.

Looking Ahead

Although optimism has prevailed since the announcement of the OPEC deal, many risks to the outlook remain unaddressed.  Should non-OPEC production continue to rise amid higher oil prices, all the gains could rapidly sour, especially if global oil demand growth is unable to soak up excess production in 2017.  As a result, the possibility of growing global oil output and cheating on the deal could all conspire to drive prices back towards the low $40.00s over the medium-term if left unchecked.