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Shale Restart Threatens WTI Rally

Summary:
West Texas Intermediate has been on a roll, rising above a barrel last week for the first time in two months. This, however, may be about to end.The number of active drilling rigs in the United States has been falling for nine weeks straight and is now 60 percent lower than it was in late March, Reuters' John Kemp said in his weekly column on prices. That's when hedge funds began scooping up WTI contracts, Kemp noted, accurately predicting that the price level at the time was unsustainable.Indeed, despite posting its first negative price ever last month, the U.S. benchmark has been doing better now, thanks almost exclusively to the deep production cuts that shale drillers have been forced to implement. And yet the situation remains extremely volatile with the downward potential for

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West Texas Intermediate has been on a roll, rising above $30 a barrel last week for the first time in two months.

This, however, may be about to end.

The number of active drilling rigs in the United States has been falling for nine weeks straight and is now 60 percent lower than it was in late March, Reuters' John Kemp said in his weekly column on prices. That's when hedge funds began scooping up WTI contracts, Kemp noted, accurately predicting that the price level at the time was unsustainable.

Indeed, despite posting its first negative price ever last month, the U.S. benchmark has been doing better now, thanks almost exclusively to the deep production cuts that shale drillers have been forced to implement. And yet the situation remains extremely volatile with the downward potential for prices still too abundant for comfort.

An oil pipeline major said earlier this month that some shale producers were ready to start ramping up production again once WTI stabilized around the high-$20s or low-$30s. Energy Partners' Mackie McCrea, for one, said that a quarter of shut-in wells in the Permian had already restarted as of May 10.

With WTI now at over $30 a barrel, the trend could accelerate… and put a cap on prices.

On the other hand, evidence suggests the industry is still in full reduction mode. The Houston Chronicle's Paul Takahashi reported last Friday that producers were still idling rigs and suspending new drilling plans as many of them needed much higher WTI prices to return to profitability. Takahashi also quoted Rystad Energy analysts as saying fracking activity in the shale parch would tank this quarter and only start recovering in the next quarter.Related: Was This The Best Energy Trade Of The Decade?

"A modest recovery is expected in the third quarter, but stable West Texas Intermediate oil prices in the low- to mid-$30s are required to see this recovery in selected core acreage positions operated by producers with strong balance sheets," Rystad's head of shale research Artem Abramov told the Houston Chronicle.

Reuters' Kemp agrees: "But with futures prices back over $30 per barrel, if they rise much more, some drilling will start to become economic again, perhaps limiting further upside potential for prices," he wrote in his latest column.

This is what common sense dictates, too. Most shale drillers have serious debt burdens, and if they don't produce oil—and sell it—then can't repay this debt. Of course, there is the problem of temporarily unsellable oil, but there are signs of demand improvement, however tentative, which has already prompted Morgan Stanley to declare that the worst was over for the industry.

Last week, the CFTC warned that WTI prices could swing into the negative when the June contracts expired.

But this did not happen, possibly because of the new optimism among hedge funds and other large buyers that the worst has to be if not over, then close to over. Once you start shutting in wells and suspending new drilling, the effect of the lower production is bound to be felt sooner rather than later in a market starved for good news.

This is what happened with WTI. Optimism about the immediate future of U.S. demand and supply, strengthened by a surprise draw in weekly oil inventories, is driving prices higher. The question now is whether shale drillers will stay the course long enough for a sustained—and more sustainable—recovery in prices. Bearing in mind that as of March, there were only five shale oil producers that could turn in a profit at WTI at $31 a barrel, it's less than certain.

Many of these shale producers will have to restart production to survive. News about rising production anywhere in the shale patch will have a quick and negative effect on prices on its own. Combined with more news about improving demand, however, it could pass unnoticed. Until the production ramp-up trend accelerates. We've seen it before and recently enough for at least some traders to remember.

By Irina Slav for Oilprice.com

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