After hitting a 52-week low in late June, oil prices have rebounded significantly, with Brent crude prices recently reaching $5 per barrel and WTI near $50 a barrel. Oil traders finally seem to be gaining confidence that the OPEC production cuts announced in late 2016 are helping to rebalance the oil market.
However, this confidence is probably misplaced. Rising oil prices have become an automatic cue for big production increases in the U.S., short-circuiting every rally. There's no reason to believe this time is any different.
Shale drillers keep boosting output
Since early 2015, the oil market has been characterized by periodic rallies followed by big corrections. For more than a year, most of this volatility has taken place within a fairly narrow trading band of $45-$55 per barrel.
As a result, shale oil drillers haven't been driven out of business, but they have been forced to become more and more efficient. The typical breakeven oil price has plunged from $80 a barrel to $35 a barrel since 2013. Thus, even with oil prices around $50 a barrel, shale drillers are ramping up production quite aggressively.
Just in the past week, several U.S. oil companies indicated that they would continue to increase production even though oil prices had moderated since the first quarter. EOG Resources (NYSE:EOG) announced that it is continuing to wring out efficiency gains, allowing it to boost production growth without additional drilling. EOG now projects that its full-year U.S. crude oil production will rise by 20%.
Meanwhile, Pioneer Natural Resources (NYSE:PXD) lowered its full-year production guidance, due in part to unexpected drilling delays. Even so, it expects 15%-16% overall growth for the year, including a 17%-18% increase in crude oil output.
Lots of uncompleted wells
Some oil bulls are taking heart at the fact that growth in the oil rig count is finally tailing off. As of late July, the U.S. oil rig count stood at 766, little changed from the prior month. By contrast, the rig count had more than doubled over the previous 12-month period.
However, companies like EOG Resources and Pioneer Natural Resources are managing to get more oil from each well, by improving their site selection and fine-tuning drilling techniques.
Additionally, the number of drilled but uncompleted wells is at a record high. These are oil wells that still need to be "fracked" to begin production. To some extent, oil companies are behind on fracking because drilling activity has increased so much in the past year; to some extent they are strategically waiting for higher prices to turn on the tap.
Whatever the cause, the backlog of uncompleted wells has surged past 5,000. Reducing that to a more normal level would increase output by hundreds of thousands of barrels per day -- without any additional drilling.
Every price bounce is a hedging opportunity
Another factor supporting output growth is that oil producers are actively hedging again. Every time bulls drive oil prices up, shale drillers can start locking in relatively favorable prices for their future production. For example, Pioneer Natural Resources has hedged the price for 90% of its projected oil production for the rest of 2017 and 50% of its projected 2018 oil production.
Hedging allows shale drillers to firm up their drilling plans, rather than having to scramble every time oil prices plunge. This means that investors cannot necessarily expect a quick reduction in shale output whenever the next oil market crash comes.
The glut will not be gone for long
Thanks to the quick rebound in shale oil output, U.S. production has reached an average of 9.4 million barrels per day over the past month, up from 8.8 million barrels per day last December. So far, production continues to rise steadily, despite moderating rig count growth.
Furthermore, the summer is maintenance season for Alaska's oil infrastructure. This has temporarily reduced Alaska's oil production by more than 100,000 barrels per day. When this production comes back on line this fall, it could send U.S. oil output soaring toward record levels of about 10 million barrels per day.
Meanwhile, the OPEC cartel appears to have the unrealistic hope that short-term production cuts will rebalance the oil market. There is much less support among OPEC members for long-term reductions in output. However, this means the oil market could be flooded again after the March 2018 expiration date for the current round of cuts.
Quite simply, oil demand growth isn't keeping up with suppliers' ability to ramp up production. This dynamic doesn't seem likely to change anytime soon -- and it will eventually undermine any rally in oil prices.