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Late last week, crude oil prices took a nosedive. WTI (West Texas Intermediate, the benchmark crude rate for futures contracts in New York) declined 4.8% on Thursday, fueled by massive overnight (and overseas) sell-offs. That translated into a 7.7% dive for the week to date.
If there has ever been a better example of the tail wagging the dog, I haven't seen it.
As you've seen me say before, swings in oil prices often have less to do with market dynamics and more to do with paper traders – people trading futures, options, and other hedges. Of course, what does happen in the actual market may be the initial prompt for how such derivatives are played.
This time, however, we had an avalanche of events that magnified the impact.
The Concerns Used to "Justify" the Crash Have All Been Answered
It began in the U.S. markets as main trading support levels weakened, prompting the unwinding of long positions.
Now, there were no new developments to bring this about. Questions over whether OPEC would extend production cuts/caps in June for another six months, a rise in U.S. extraction rates, and concerns over demand levels remained.
But all these concerns have been in vogue for some time.
And all of them have already been answered…
The OPEC restraint will almost certainly continue for at least the rest of this year. Some discussion has emerged over whether the cartel and main non-member producers like Russia would increase the reductions. But that (however unlikely) has nothing to do with maintaining the current floor for prices.
Meanwhile, U.S. production has been increasing. Yet the levels reached by the beginning of May have also resulted in something beyond pressuring prices. The current level is once again putting the very companies raising production under the threat of a renewed round of debt default.
In other words, the production growth is not sustainable.
The operators most fueling the aggregate production rise are almost literally one step ahead of the sheriff, producing and selling to stay afloat. However, the cash flow is eaten up (and then some) by the increasing cost of the debt load.
At current prices, there is no basin in the United States where wellhead prices (the first level when production comes out of the ground and the price received by the operator) are profitable. Wellhead prices run about 15% or more below market price. With market prices south of $50, these companies leading the production rise are once again facing revenue levels insufficient to survive.
Finally, the angst being expressed about oil demand not growing is a chimera. Demand continues to be well within seasonal margins in the American market and is once again expanding elsewhere.
In short, the price collapse last week had little to do with oil – but a lot to do with paper cut on oil. That makes for a textbook example of a …
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.