Oil Traders Mindset on US Production Needs to Catch Up

psw01 2016-2-24

The mindset of many oil traders remains heavily bearish.  Many are in disbelief that prices can be rising with such severe oversupply remaining.  They cannot understand the incentive OPEC, Russia, Oman and others have to cap or even cut production.  The mindset remains one that US production has barely dropped and can increase dramatically on the smallest price increase.

This flawed mindset is produced by EIA weekly production estimates that have been wildly off the mark.  EIA monthly data and Unaccounted for Oil category in the weekly reports proves the weekly estimate varies wildly from reality.

In trading knowing the trend and especially knowing trend reversals is key.  A big problem arises when the easily interpreted reported data does not match up with the reality.

The above chart indicates why many traders do not fully embrace that US production is falling and falling fast, and will continue to fall fast.  Weekly reports have touted how "robust" US shale production has been in the face of low prices going back to early last fall.  Indeed if you look at the weekly production estimate it was flat to rising from September 2015 to mid January 2016.  But the monthly production data is telling a completely different story.  It shows US production clearly falling since September.  The problem is the monthly data lags by 2 months and many traders don't even follow the monthly reports.  Worse yet, the EIA monthly production forecasts had projected steady production increases through February 2016.  All the data has proven the rising forecasts to be wrong through December, and is indicating the January and February forecasts were wrong as well.

The traders that follow the mainstream media have the belief that US production has just started to fall and has only been falling for 3 weeks, when in reality US production has been falling for 5 months.  So most traders have a mistaken belief that it took sub $30 oil to get US production to fall when the reality is sub $45 oil had production falling, and sub $30 pretty much has producers in panic mode dropping about 25% of active rigs in a month.  The rig count is now about 400, which was the number in operation in 2009 to support total production levels around 5MM bbl/day.

This will lead to a mindset where many traders will continue to believe every move up in price will spur US producers to bring on more oil.  I even read an article stating that $40 is the new $70 and that as soon as $40 is hit to expect a big spike in output.  Recent history does not support that assertion.  Even the CEO of EOG has stated they will not look to boost output until prices remain above $60 for a considerable period.  I take that to mean 3 months or more since they moved in summer 2015 with 2 months over $60 and look what happened.  I believe WTI will actually end up hitting $70 before US production stabilizes and begins to rise.

The reason the Saudis are now supporting moves to support oil prices and get them on an uptrend is that it is now clear to them based on published data that oil prices are plenty low to kill off US and Canadian production, as well as other high cost producers.  It is clear that sub $45 had US production in decline and anything close to $30 was near panic mode.  This means they can allow prices to creap up about 50% with a negligible change in shale producers mode of operation.  Once drilling rigs are laid down, they will not come back into service until prices top $60.  In fact there is likely to be a slow decline in rig count until $60 is hit.

The chart below puts the US oil rig count in historical context with 2009 when prices were comparable.  When WTI price is included it is seen that in summer of 2015 rig counts began to rise after $60 was hit and the same is true for 2009.

North America Rotary Rig Count (Jan 2000-Current) 2016-2-19