Wolf Richter: Wall Street Has a Dream About the Price of Oil

Yves here. I e-mailed Wolf today after seeing a new Wall Street Journal story on bullish IEA oil price forecasts for the second half of the year. From his reply:

The fundamentals are clearly against any kind of quick rise in the price of oil. That said, with enough speculative money piling in, prices could rise (they already did by 20%). But that would just support more production and higher storage levels, which would then be the next shoe to drop.

In my experience in the oil patch in the mid 1980s and on, this will take a while to work out. But as we say, nothing goes to heck in a straight line.

As you mentioned, the rig count drop is irrelevant near term.

But even long term, the rig count drop is misleading. Drillers cut out the oldest most inefficient rigs, and they stopped drilling in the most inefficient and expensive plays (wells that produce a lot of water, for example). They’re cutting the least productive wells and the worst equipment, but they are maximizing their most productive wells and the best equipment. I don’t know what the net difference might be, but it’s not equal to the total number of rigs that they idled…

Wall Street is already pumping up prices for next year. In 2016, a lot of junk-rated drillers are going to run out of liquidity. At the current oil prices or below, they’re unlikely to obtain more funding at reasonable terms. Vultures will be moving in with senior secured debt at extortionary rates and tight terms to where they get most of the company when it defaults and restructures. This will hurt banks, investment banks, PE firms, etc. So they WANT oil prices to go up, after a big tradable crash to end no later than in Q3.

That’s my interpretation.

The entire industry, the IEA, EIA, the Russians, everyone in the game wants prices to go up. So they’re talking them up. But if prices go up and drilling restarts in full, now with a focus on efficiency, it’s going to be a much bigger mess shortly thereafter than what we have now.

I don’t know where prices might go, but I doubt all those industry voices that claim that prices will soon go back to a “sustainable” level. That’s not how real oil busts get worked out. Last time, 700 banks failed, real estate in the oil patch crashed, restaurants closed, young people left because there were no jobs, terrible things happened…. And I haven’t seen any of it so far.

By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street

The price of oil has bounced 20% since January 29 when the benchmark West Texas Intermediate had dipped below $44 a barrel, but according to Edward Morse, Citigroup’s global head of commodity research, that dizzying bounce is a “head-fake.”

Because the fundamentals are still terrible. Oil production in the US is still rising, despite drillers shutting down drilling activities at a record pace. Drilling fewer new wells is hurting oil field services companies, and the pain is fanning out across the oil patch and beyond. It hit private equity firms, it sank energy junk bonds, it triggered layoffs, but it isn’t curtailing oil production. Not yet.

So the US remains by far the largest contributor to “global oil supply growth,” the US Energy Information Administration just pointed out, with production in 2014 jumping by 1.59 million barrels a day. By comparison: in Iraq, the second largest contributor to global oil supply growth, production edged up by 0.33 million barrels a day.

And…

“Brazil and Russia are pumping oil at record levels, and Saudi Arabia, Iraq and Iran have been fighting to maintain their market share by cutting prices to Asia,” explained the Citi report, cited by Bloomberg. “The market is oversupplied, and storage tanks are topping out.”

Production will continue to rise, despite plunging drilling activity, and won’t slow down until the third quarter this year. As the oil glut is growing, it wreaks havoc on the price of oil, potentially pushing it, according to the report, into the neighborhood of $20 a barrel – “for a while.”

Analysts, faced with the oil glut that resulted from the US shale oil revolution, are scrambling to bring their erstwhile sky-high expectations into line with reality. They have slashed their projections for the energy sector; and according to FactSet, revenues are expected to plunge 36% in the first quarter. The plunge is so steep that it will drag revenue “growth” for all S&P 500 companies combined into the negative, -2.3% in Q1 and -2.6% in Q2.

And the US shale oil revolution has defanged OPEC. It can no longer control oil prices at will to maximize profits for oil-producing countries, including the US. A sort of an unpleasant free market has suddenly re-broken out. “It looks exceedingly unlikely for OPEC to return to its old way of doing business,” Citi’s report said. “While many analysts have seen in past market crises ‘the end of OPEC,’ this time around might well be different.”

But Citi is an integral part of Wall Street, and Wall Street dreams of a V-shaped recovery of everything because that’s where the quick and big bucks are to be made. Prices even in the current range are unsustainable for the industry, the report pointed out, and will entail a wave of “disinvestment from oil,” of the type we’re already seeing. But then, after oil plunges into the $20-range, presumably by no later than the third quarter, mirabile dictu, the price will soar, according to the report, and I mean SOAR, with Brent hitting $75 a barrel by the end of this year – more than tripling in a little over a quarter.

From $52 a barrel to $20 and then to $75 in just one year? That’s the kind of V-shaped recovery that dreams are made of. Every trader lusts for this. Wall Street lusts for it. Hedge funds can hardly contain themselves at the mere thought of it. So whose book is Citi talking up?

If the price of oil stays in the current range, liquidity for much of the oil patch will run out in 2016, and that’s when waves of defaults will begin to cascade through bank and private-equity balance sheets. And beyond that, investment banks stand to lose a lot: in 2014, Citi earned $492 million in energy-related investment-banking revenues – more than any other bank! More even than JP Morgan [How Wall Street Drove the Oil & Gas Drilling Boom That’s Turning into a Disaster].

So Wall Street must have a V-shaped recovery in place by 2016, or else.

We have watched the price of natural gas drop to ludicrously low levels – and stay there. Natural gas producers have been bleeding for years. Those that could, switched production to shale plays that were rich in oil, condensate, and natural-gas liquids that brought much higher prices and allowed some of these gas wells to be profitable. But now, their prices have plunged as well, and that solution has gone up in vapors. Yet, production continues to soar from record to record! There has been no V-shaped recovery in the price of natural gas. And if or when there is a price spike, it won’t be the right side of a “V,” but a spike after years of terrible bleeding.

OK, oil is different. It’s a global commodity, which landlocked US natural gas is not. And there was a V-shaped recovery after the financial crisis as the central-bank money-printing binge around the world inflated nearly all assets. This time around, there isn’t a financial crisis, and no sudden collapse in global demand. Instead we have lackluster demand, rising production, and increasingly a glut. And the Fed, the biggest perpetrator at the time, is sitting on its hands. So that breath-taking, stunning V-shaped recovery back to paradise might remain what dreams are made of.

Meanwhile, far from Wall Street, and out in the oil patch, the cutbacks in the exploration-and-production sector are hitting oil-field services companies hard. They too are cutting back. The impact is rippling out further. And the bloodletting will go on. Read…  Oil Rig Count Plunges 29% from Peak. Halfway to Bottom?