Oil Prices Are Rallying: Is Another Plunge Coming Next?

By Markets Fool.com

The price of Brent crude oil has rallied more than 10% in the past week, bringing relief to many oil bulls and energy companies. The rally was helped along by a sharp drop in the U.S. oil rig count during the first full week of April as well as a smaller than expected increase in U.S. crude oil inventories last week.

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However, the supply of oil and petroleum products is still running well ahead of demand. Based on the latest estimates from the International Energy Agency, this situation could potentially continue for more than a year -- but for the fact that storage capacity is quickly filling up.

If OPEC keeps pumping oil as fast as it can -- and there's no sign that it's wavering on this strategy -- oil prices may need to fall even further to bring supply in line with demand.

Falling rig count -- but steady production
The number of rigs drilling for oil in the U.S. has plunged by more than 50% since last October. Last month, the pace of decline began to moderate. Whereas oil-service giant Baker Hughes reported that the rig count dropped by 94 in a single week in late January, the weekly declines had slowed to 11 by the end of March.

However, Baker Hughes reported last week that the rig count decline had accelerated once again, falling by 42. Many oil market analysts believe the rig count won't bottom out for another two to three months.

While the rig count has dropped dramatically this year, oil production hasn't suffered yet. That's because oil companies naturally idle their least productive rigs first, focusing resources on their most profitable areas. Last week, U.S. crude oil production fell by 20,000 barrels per day compared to the prior week -- but that was still up by more than 1 million bpd from the same week a year ago.

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At some point, reduced drilling activity will lead to more significant production declines, because the production of new shale oil wells tends to drop off quickly over time. But when exactly that will happen is less clear.

Supply and demand could stay out of balance
Oil prices rallied significantly following the release of the U.S. Weekly Petroleum Status Report this Wednesday. Aside from the modest production decline that was reported, bulls' optimism was driven by a smaller-than-expected 1.3 million barrel increase in U.S. crude oil stocks. (In some weeks during the past few months, U.S. crude oil inventories have jumped by about 10 million barrels.)

Oil bulls saw this as evidence that U.S. crude inventories will start falling soon, now that U.S. refineries have completed most of their seasonal maintenance. However, one overlooked reason for the smaller-than-expected stock build was that crude imports dropped by more than 1 million bpd compared to the previous week.

Crude oil import numbers tend to jump around from week to week. This decline was probably an anomaly rather than the beginning of a trend. With refinery maintenance season in Asia just getting started -- and peaking next month -- U.S. oil imports will probably bounce back in the next few weeks. This could lead to more big increases in crude oil stocks, even with U.S. refineries running flat out.

An uncertain outlook
The International Energy Agency also sounded a note of caution about the oil market's recovery this week. One notable aspect of the IEA's most recent oil market report is its forecast that the "call on OPEC crude and stock change" -- essentially the difference between world demand and non-OPEC supply -- will average 30.35 million bpd during the second half of 2015.

That's above OPEC's official production quota of 30 million bpd. Thus, if OPEC sticks to its quota, world oil inventories would indeed begin to decline later this year.

There's just one problem. OPEC has been consistently producing above its quota lately. In March, OPEC production surged to more than 31 million bpd. That pace could continue -- or even increase -- if Iran is allowed to start increasing its exports later this year.

If oil production continues to outpace demand in the second half of 2015, oil prices will need to fall even further to force more high-cost oil off the market before the next seasonal downturn in demand in early 2016. With U.S. oil inventories already at levels not seen since the Great Depression, overproducing and storing the extra crude is a tactic that won't work next year.

The article Oil Prices Are Rallying: Is Another Plunge Coming Next? 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.