Oil prices have hit their highest levels in 2015, with WTI surging above $60 per barrel. Crude oil inventories in the U.S. declined for the first time since December 2014, perhaps indicating that the glut could be easing.
The EIA reported that oil stockpiles fell by 3.9 million barrels for the week ending May 1, a larger drop than expected. With rig counts falling by more than half since last year, this could be the beginning of a longer contraction. Both weekly production figures and the stock build appear to have peaked, suggesting that supplies are adjusting lower and demand is rising.
That has oil prices surging from their March lows, with WTI jumping more than $15 per barrel, and Brent about $20 per barrel.
But have the markets overreacted? The rise in oil prices over the last few weeks has been so rapid that few predicted it. Speculators have raised their bullish bets to the highest level in years. The optimism may not be justified. In the past, bets to such a degree have often been followed by a fallback in prices, the head of commodity strategy at Saxo Bank told Reuters. Similarly, the top commodities official at Commerzbank told CNBC that the price rise was "premature," and oil prices could dip back below $50 per barrel once the markets come to their senses.
In other words, the markets may have overshot, rising beyond levels warranted by the underlying fundamentals. Oil inventories are still at 80-year highs. The 487 million barrels of oil sitting in storage will take quite a while to draw down. Crucially, oil production is still exceeding demand, leaving oil markets well-supplied.
Another reason oil prices have room to drop is due to geopolitics. The recent run-up in prices could partly be attributed to unrest in Libya. Protests cut off oil flows to the Libyan port of Zueitina in early May, reducing exports below 500,000 barrels per day from the war-torn country. However, if we have learned anything from Libya over the last year, it is that its oil production and exports are highly volatile -- exports could rise again, adding to global supplies.
There is still the potential for a major deal with Iran over its nuclear program. The possibility that Iranian crude could return to the market was widely covered after the framework agreement in early April. And while Iran's oil would not begin to flow until 2016, the expectation of higher future supplies would push down prices immediately after news breaks that a deal is in hand. The deadline for negotiations is in June.
Perhaps the biggest question is how efficient drillers can become. In their quarterly earnings reports, shale companies have emphasized their success in reducing drilling costs, ultimately lowering the break-even price at which they can produce. That remains to be seen. Prominent hedge fund manager David Einhorn had a different take. On May 4 he said the industry is overvalued and can't drill profitably even when oil prices were higher. "A business that burns cash and doesn't grow isn't worth anything," Einhorn said.
Still, if prices remain above $60 per barrel, it could incentivize drillers to get back to work. The rig count, which has fallen by more than 57%, could start to level off and even reverse. Oil prices above $60 could be the magic threshold when drilling resumes. Both EOG Resources (EOG) and Pioneer Natural Resources (PXD) are eyeing a return to the shale patch this summer, as long as prices stay in the $65 per barrel range. New drilling -- and the completion of thousands of drilled but unfinished wells -- will bring new production onto the market, potentially sending prices seesawing back down.
Oil supplies are adjusting downward, but the dramatic rise in oil prices may be too much, too soon.
By Nick Cunningham of Oilprice.com