Crude Prices Headed to a Breakout

Jim Brown
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Crude oil closed at $97.35 on Friday and a right at a six-month low. Is this a buying opportunity?

Unfortunately I think we are going lower before we go higher. The long term crude chart shows an ascending wedge, pennant, flag or whatever else you want to call it. It is a series of higher lows and lower highs that will eventually culminate in a breakout that could be sharp. The breakout could be either up or down but I am betting it will be to the upside.

The chart shows a lot more uptrend support than downtrend resistance. The peaks in the spikes over $105 are brief and only four of them in the last four years. However, the uptrend support has been tested numerous times and it always held.

The reason behind the rising price is three fold. First, consumption is continuing to rise. The EIA said it is rising 1.0 million barrels in 2014 despite the weak overseas economies. In 2015 it is expected to rise another 1.5 million barrels. If the global economy every finds some traction the demand will accelerate and within a couple years we will back into a shortage of oil like we had in 2008. It is only a matter of time. Meanwhile demand keeps moving higher and depletion keeps slowing existing production.

The second reason is that OPEC or more specifically Saudi Arabia will not let the prices decline much below $100. They need something in the range of $95 a barrel to keep their social programs functioning and keep the civil unrest at a minimum. If Brent dips under $100 Saudi Arabia will begin cutting production to support the price.

Lastly, we have a price problem in the USA. The huge amount of shale drilling currently underway costs a lot of money. Some analysts have recently pointed out that some of the shale wells are unprofitable below $85. That means as WTI slips under $95 we will see a slowdown in drilling. If it drops much under $95 we will see a slowdown in production. Producers will shut in wells until the price rises again.

If you had an asset, call it an oil field with 100 wells and your cost to produce was $85 you would want to get as much as you could for your oil. With oil at $100 you are making $15 a barrel minus royalties and taxes. With oil at $90 by the time you subtract royalties and taxes there is not much left. Many managers will elect to not pump oil at breakeven prices and absolutely not at prices that lose money. You can't make up a loss per barrel by simply pumping more barrels. Everybody knows the long term trend for oil prices is well over $100. Why would you want to produce your limited resources today for a minimal profit when you can wait a few months for the supply-demand balance to correct and then sell it for $100 or more?

When natural gas prices fell so low there were thousands of wells that had been drilled but not completed. Exploration and production companies did not want to spend the money on completing the well until it became profitable to do so. The same will happen with oil wells if the price declines much under $95. Drilling will slow, completions will be postponed and wells will be shut in to prevent producing oil for a loss.

Granted there are some companies that have shale costs in the $50-$60 range and they will keep producing. However, with oil prices falling they will slow the pace of new wells.

This is not rocket science. This same scenario happens in every price cycle for oil. In 1998 when oil was selling for just over $10 a barrel there was a wholesale stacking of rigs and the majority were left to rust and were never put to work again. That was a painful lesson for everyone involved. Two entire generations of oil field workers left the oil patch and found jobs elsewhere. When the rebound began it took ten years to find and train enough workers to replace them. In 2009 after the oil spike and financial crisis caused the wholesale stacking of rigs again a new generation of workers had to be hired after the crash. I had a son that was making nearly $100K running a rig and his company shutdown more than 50% of their rigs and everyone lost their job. In 2010 when the cycle restarted all those workers had new jobs in different industries.

As a manager of an exploration company with a large fleet of rigs this is your weekly nightmare. You don't want to go through this again. Fortunately with the memory of the 2009 crash still vivid those managers will be quick to act to slow drilling and production if prices begin to decline.

This is why crude prices are not going much lower. If we do go lower I would expect the low $90s to be the bottom. Armchair analysts will be predicting much lower numbers because America is going to be energy independent in the coming years. I have illustrated the fallacy of that numerous times in past commentaries. We would have to discover and produce eight more fields the size of the Bakken or six more the size of the Eagle Ford region to make us energy independent for oil. It is not going to happen and the decline rate in existing fields means it would be a constant race to find a new Bakken every year from that point forward.

Oil prices are not going much lower. The entire capital structure today is predicated on expensive oil. Companies will do whatever they have to in order to keep prices high.

Oil Inventories

Crude oil inventories rose +1.4 million barrels as refiners began slacking off on production ahead of Labor Day. They have been running full speed since mid July and the distribution channel should be full of gasoline for the last holiday weekend of summer.

Once past the holiday the plants will begin shutting down for maintenance and to switch over to winter fuel blends. This means crude inventories will begin to build as this process begins and continues through September.

Crude inventories at Cushing rose slightly by 400,000 barrels to 18.4 million. Capacity utilization declined from 92.4% to 91.6%. This is down from the high from the year at 93.8% four weeks ago.

Crude oil imports rose +283,000 bpd and accounted for all the inventory gains. Demand for crude declined -179,000 bpd and U.S. production rose +103,000 bpd. It is a miracle there was not a much bigger inventory build with a net impact of those numbers +565,000 bpd or almost four million barrels for the week.

Gasoline inventories declined -1.2 million barrels after a 4.4 million barrel decline in the prior week. Demand collapsed with a -437,000 bpd drop. Imports rose slightly by +35,000 bpd but production fell sharply by -261,000 bpd.

Distillate inventories fell -2.4 million barrels while production, imports and demand were little changed. This is likely a result of some lag time between some reports from the field. Distillate inventories remain well below their five-year average and this suggests the U.S. economy is still struggling.

In the graphic below green represents a recent high and yellow a recent low.

Propane inventories continue to soar with the addition of +1.8 million barrels to bring inventory levels to 70.3 million and just above the five year average for this period.

If you need propane for the winter now is the time to buy it. Demand has risen for the last three weeks. I bought 500 gallons last week for $1.64. That is half what it cost in my area late in the winter. Prices are going up after Labor Day.

The EIA chart showing the inventories in PADD2 is a good illustration of the shortage last winter. Supplies declined to only 7 million barrels at the low in March.

Natural gas inventories rose +78 Bcf to 2,467 bcf. This continues to be the fastest build in 11 years. They are still -530 Bcf less than last year and -575 Bcf below the five year average at 3,042 Bcf.

Inventories of gas in storage rose more than 1 Tcf since mid-April for the fastest gain in more than 11 years.


The S&P futures are up +6 points late Sunday evening. I warned last Sunday that expiration week was normally the strongest week of the month and that definitely came true. Unfortunately the next two weeks are typically rough for investors. I expect the market to be choppy until after Labor Day so be prepared.

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Jim Brown

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