OPEC Calls Oil Bottom for the Wrong Reasons

By Markets Fool.com

A week ago, my colleague Matt DiLallo noted that OPEC Secretary General Abdalla El-Badri had called a bottom for oil prices. In fact, El-Badri declared that oil prices could rebound to new highs of $200 in the future.

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As the head of OPEC, which produces about a third of the world's oil, El-Badri is an influential figure. Furthermore, his general contention that a reduction in oil investment will eventually lead to higher prices is correct, because new wells are constantly needed to offset production declines from older wells and to meet demand growth.

However, that doesn't mean oil has bottomed. Despite widespread announcements that oil companies are cutting their investment budgets, supply is still much higher than demand. Until this excess supply is addressed, oil companies will be in for a lot of pain.

Oversupply in the physical crude market
In recent months, oil suppliers have been producing more crude than refiners have needed to meet end user demand. As a result, stockpiles have been on the rise.

According to the International Energy Agency, commercial petroleum inventories in the OECD countries rose by 12.5 million barrels in December. That runs counter to the industry's normal seasonality: In a typical year, OECD petroleum stocks would fall by 54.8 million barrels in December.

By contrast, oil demand in the first half of the year is traditionally seasonally weaker. So far, U.S. inventory data for the first few weeks of 2015 have fit that trend. According to the U.S. Energy Information Administration, U.S. commercial crude oil inventory surged from 382.4 million barrels on Jan. 2 to 413.1 million barrels by Jan. 30.

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In other words, U.S. crude oil inventory on average increased by more than 1 million barrels per day last month. Oil traders have been willing to hold this extra inventory because crude oil futures for later in 2015 and 2016 are significantly higher than the current spot price --enough for traders to make a tidy profit (even after storage costs) by buying now and selling later.

Oil bulls' hopes
Bulls have been pinning their hopes for a rapid oil price recovery on falling capital expenditures among oil companies. Between the last few days of January and the first few days of February, crude oil prices rallied more than 20%, due in part to a report from Baker Hughes that the domestic oil rig count dropped to a three-year low and oil giant BP's decision to reduce 2015 capex.

BP recently became the latest oil company to cut its 2015 capex budget. Photo: The Motley Fool.

However, the impact of capex cuts can be deceptive. First, there is a lag between capital spending reductions and production declines. Oil companies desperate for cash flow might not drill as many new wells, but they will try to maximize production from existing wells. For oil majors such as BP, many projects have multiyear lead times, so capex cuts today won't impact production until late in the decade.

Second, just six months ago, exploration companies were expanding significantly. Capital expenditure reductions are coming against a baseline of strong production growth. Even with significant cuts, many oil producers will be able to increase production in 2015.

Third, as logic would dictate, oil drillers are shutting down their least productive rigs first. This means declines in the rig count don't cause a proportional reduction in output from new wells.

Production cuts remain elusive
To see these three dynamics in play, consider shale driller Continental Resources' evolving plans for 2015. In September, Continental projected its capex would rise from $4.6 billion in 2014 to $5.2 billion in 2015, driving a 26%-32% increase in production.

In November, Continental Resources announced that it was cutting planned 2015 capex to $4.6 billion in response to the drop in oil prices. In late December, it slashed 2015 capex plans again, this time to $2.7 billion. The company now plans to operate an average of 31 rigs this year, compared to an original plan of 53.

However, despite cutting its 2015 capital expenditures budget by nearly 50% and its rig count by about 40%, Continental Resources still projects production growth of 16%-20% this year, adding to the glut of oil.

How much oil can be stored?
Given the long lag between cuts in capital spending and declines in production, the trajectory of petroleum prices for the next year or two will be determined by the ability and willingness of market participants to store oil. Based on recent supply and demand trends, there probably won't be excess demand to draw down oil inventories until the second half of 2016.

Oil is piling up in storage facilities across the world. Photo: The Motley Fool.

So far, traders have been happy to stash oil in tank farms across the world. A few supertankers have even been booked to serve as floating storage facilities this year.

As of Sept. 30, the Energy Information Administration reported there were 226 million barrels of working crude oil storage capacity left in U.S. tank farms and another 55 million barrels of capacity at U.S. refineries. Normally, that would be plenty of spare capacity, but commercial crude oil stocks have already surged by more than 30 million barrels in the past four weeks.

Furthermore, this available capacity might not all be usable for practical purposes. For example, it wouldn't make sense to ship crude oil to the West Coast for storage if it eventually needs to be refined in Texas.

In Cushing, Oklahoma -- a key hub for the U.S. oil industry -- crude oil stockpiles have risen by 29% in the past four weeks and have more than doubled since early October. At the current rate of inventory growth, Cushing's 71 million barrels of working crude oil storage capacity could be full within a few months.

As capacity fills up, storage costs will rise, making long-term crude storage less economically attractive. This will push crude oil prices back down to rebalance the market.

The only realistic way to avoid further weakness in the crude oil market this year would be for OPEC to cut production. Yet that is the one thing OPEC Secretary General El-Badri wasn't willing to predict.

With OPEC pumping more oil than its official quota of 30 million barrels per day, the world will remain awash in oil for much of 2015. The "invisible hand" will eventually help petroleum prices stabilize at a sustainable level -- but only after oil producers face more lean times.

The article OPEC Calls Oil Bottom for the Wrong Reasons originally appeared on Fool.com.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.