Oil Futures Curve Is Looking Pretty Flat

 | Aug 18, 2017 | 2:30 PM EDT
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This week's Baker Hughes rig count data provided some feed for oil bulls heading into the weekend. The most closely followed figure, the U.S. oil rig count, fell by five and now sits at 763. To me, the numbers were indicative of producers waving the white flag in marginal areas and those using marginal production technologies. 

The rig count in the Permian Basin was flat on the week, as it was in the South Texas hotspot Eagle Ford shale. In fact, the net decline of six rigs came from the Williston basin in North Dakota and the Granite Wash and Mississippian plays, two areas mainly located in Oklahoma. Also, the overall decline in rig count was entirely comprehended by a drop in six vertical rigs, a technology that has largely been rendered obsolete with the advent of horizontal well design. Vertical rigs account for only 7% of the total North American rig count, and it is not a surprise these units are being sidelined. 

To put it simply, oil prices haven't recovered to the level that many in the industry had expected. Even after today's jump, West Texas Intermediate front-month futures sit at $48.47, a frustratingly low level for producers. I see many stories about the profitability of different North American oil plays at $45 and $40 a barrel; I even saw one this week waxing poetic about producers' ability to produce profits at $35. Hogwash. There is not a single U.S. oil exploration and production company that I know of that is fully exploiting acreage without the hopes of oil above $50 a barrel. Yes, U.S. E&Ps are still producing at rates that exceed last year's levels here in the high $40s, but there is still excess capacity among equipment suppliers, and that has to scare the bulls. 

One must remember that except in some very, very unpleasant areas of the world, oil is not sold for cash. Oil is almost always sold based on a futures price, and it is the slope of the futures curve that, assuming contango is in effect, allows producers to lock in higher future prices for future production. 

So how far does one have to go out on the futures curve to find $50 oil? As of this writing, the first post-$50-a-barrel WTI quote on the CME Group's quote board is December 2020. It's astounding to me how flat the oil futures curve is in today's trading. It's as if U.S. producers are going to be subject to sub-$50-a-barrel pricing past the next election, and if true, there is a significant number of wells being drilled today that will never hit targeted levels of internal rate of return. 

That's the rub, and that's what is going to finally stop this seemingly inevitable move northward in U.S. oil production. This week's Energy Information Administration report showed U.S. production of 9.502 million barrels per day, a full 10.5% increase over the level reached in the corresponding week last year. That's too much oil, but remember, that production is as a result of capital allocation decisions made in December and January, when future-month oil prices were much higher than they are today. 

So even as U.S. oil inventories -- 466.5 million barrels this week -- have continued to trend downward through the summer, the outlook for further inventory depletion is not great at a 9.5 million weekly production clip. Also, this week's exports totaled only 877,000 barrels, and that level has fizzled after crossing the 1 million barrel mark to much fanfare during the spring. The Arabian Gulf is much closer to India and China than the Gulf of Mexico, and until that changes, exports are not going to solve the problem of depressed crude prices. 

We need to produce less, and that is going to hit the producers in the marginal plays the hardest. The stronger players will continue to benefit from advancing technology and the services companies will need to continue to consolidate to cut costs. We have seen this in water services, where three of the top players -- Rockwater bought Crescent and then was taken over by Select Energy Services (WTTR) -- have merged into a $1 billion-plus behemoth. Look for more transactions of that type in the future.

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