WTI Crude Oil: Backwardation? No, Back to Contango


On March 8, 2017 crude oil plummeted more than 5%, with WTI price falling through $50 a barrel for the first time since December. The sudden move was triggered by EIA reporting a massive build-up in American crude oil inventories, hitting record levels according to data going back to 1982. The remarkable growth in inventories means US shale oil drillers are increasing their production, benefiting from the higher prices oil has reached since OPEC agreed to cap production back in November. In this article we will analyse the American oil supply side and the effect of the bearish sentiment on oil futures markets. Both these issues represent a serious test for OPEC strategy.

Oil market general overview

Crude oil experienced high volatility during 2016, when Saudi Arabia led other OPEC countries to pump as much as possible, aiming at stealing market share from US shale producers. Oil dropped below $30/barrel. At the beginning of the year, fears over the sustainability of Chinese growth and a production record caused a steep fall in the oil price. On February 11, WTI touched a 13-years low at $26.05/barrel.

The low oil price forced many players to switch off production because producing oil at such low prices caused major losses. This move hurt especially US producers with a break-even point greater than that of OPEC countries. This issue, along with the recovery of emerging markets and the USD depreciation, caused the price of oil to slightly rebound.

In September, a first struck of an agreement between OPEC countries led to an increase in prices. After a period of uncertainty over the OPEC’s commitment to freeze production, on November[1] the first real cuts were made along with Russia and oil prices strongly rebounded. From the beginning of 2017, WTI was trading between $50 and $55.

US oil supply

The large share of US oil production consists of shale oil. Shale oil is a type of crude oil that is trapped within layers of shale rocks. Major shale oil companies produce it through the so-called fracking, shooting a mixture of mostly water and sand under high pressure against a rock formation until it fractures.

One of the pros of shale oil is its flexibility: the initial drilling only accounts for 40% of the total costs. The role of shale oil within the oil market is becoming prominent thanks to its exponential growth: from 200.000 barrels per day of production in the US of the early 2000s, it reached 4.9 mb/day in 2015 (52% of the total national production).

Starting in June 2014, US oil supply remarkably declined following the oil price crash, triggered by OPEC to force into bankruptcy shale producers operating with high break-even prices. However, US oil production has recently picked up. Many drillers are decreasing the WTI price needed to reach the break-even point. Unlike the first shale oil boom, this time many shale oil producers started extracting oil when the WTI reached $40-$45, so that OPEC’s efforts to cut production and boost prices were partly substituted by shale production.

WTI Crude Oil - Figure 1Chart 1: Most low-cost oil is in US shale reserves (source: Financial Times)

Another interesting feature of shale oil is its cost saving trend: average costs per barrel have dropped by 30-40% for US shale wells, but just 10-12% per cent for other oil projects. This is one more reason why more and more oil producers are shifting their focus from sea wells to fracking. The revamping US oil production is clearly shown by the growth in US inventories, which has recently reached record high of 528.4 million barrels, and the impressive growth of rigs. Since May 2016, US drillers have added 267 oil rigs, showing confidence of a bright future.

WTI Crude Oil - Figure 2Chart 2: WTI – Oil rig counts (source of chart data: Thomson Reuters)

[Continua a leggere su bsic.it]

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © mar-17 BSIC | Bocconi Students Investment Club

[1] The official OPEC deal was struck on November 30th 2016.