The nearly 20 percent rally in oil prices over the past week raised hopes in the oil industry that the financial bloodshed might be over. But hopes were quickly dashed on February 4 when prices erased much of their gains – March deliveries of WTI dropped by a whopping 8 percent in a single day.
Oil prices had risen over a three-day stretch on the back of major capital expenditure cuts among the oil majors. BP, ExxonMobil, Chevron, ConocoPhillips, and Royal Dutch Shell have all promised multi-billion dollar reductions in their spending for the year, recognizing the bear market for crude. The realignment in spending encouraged oil markets as investors hoped that the production overhang was close to balancing out. On top of that, rig counts dropped at the quickest rate on record the end of January.
As such, many thought that the supply side was quickly correcting to the new low-price environment. But the storm may not be over.
The Energy Information Administration (EIA) released its weekly status update on crude oil inventories across the country. The EIA reported that oil stockpiles (excluding the Strategic Petroleum Reserve) increased by 6.3 million barrels, way above analysts' estimates of about 3.7 million barrels. That has total oil inventories at 413 million barrels, the highest level in over 80 years.
In other words, oil production is still running way above demand, contradicting the notion that cutbacks were already here. Investors may have jumped the gun when they bought back oil in late January and early February. Big oil companies are making historic spending cuts, and rig counts are dropping like flies, but actual oil production is still at elevated levels. It will likely take a bit more time before a real reduction in output takes hold, meaning an oil price rally is not here just yet.
In fact, the brief jump in prices can be attributed to major money movers betting on a rebound, rather than any real fundamental change in supply. There is always volatility, and speculators always move the price up or down, but that is especially true in the current environment. Oil price volatility is at its highest rate since 2009, whipsawing back and forth more than at any time since the financial crisis.
That is why the three-day rally may not be foretelling a real turnaround just yet. "I don't think anything's changed fundamentally, except for the psychology of the market," Chandravir Ahuja, an analyst at Kolmar Americas Inc, told Reuters in an interview. "We're moving a lot more on headlines that we probably would on a normal day."
Interestingly enough, some banks argue that if oil prices rebound too quickly, the oil industry won't make the production cuts needed to balance the market. That would lead to a longer period of low oil prices than it would otherwise. If oil prices rise too much further "we see risk of counterproductive behavior that would push off recovery and make us more bearish 2H15 and 2016. ...Even a bounce may give producers and creditors hope and reinforce bad behavior," Morgan Stanley stated in response to the latest rally.
Citigroup doesn't see the bottom yet. "In all, for the market to truly balance, US oil rig counts would have to fall significantly further and the bottom of the price trading range for 2015 is likely to be a good deal lower," the bank said in response to the price jump.
But who knows? Dozens of analysts have been burned in recent months when making bets on the energy sector, expecting that oil prices had bottomed out while they still had further to fall. Supply and Demand eventually tend to guide prices in a sensible direction, but along the way there is extreme volatility and a lag effect. The sharp drop in prices following a 19 percent jump over the last week should be a reminder – nobody really knows where prices are going and nobody is going to be able to pinpoint the bottom.
By Nick Cunningham of Oilprice.com. Oilprice has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.