David Dismukes, LSU Center for Energy Studies

The new year is bringing welcome relief to U.S. producers. As of mid-January, crude oil prices have climbed by 30% since August 2017, to almost $70 per barrel.

This welcome change in price, unfortunately, rests upon a number of somewhat limited and temporary factors.

For instance, the catalyst for the new year change in prices originated in the North Sea with the unplanned shutdown of the Forties Pipeline System in mid-December 2017.

Geopolitical factors have also turned bullish for prices as OPEC extended its production cuts for yet another year; political unrest started to awaken in Iran, and the possibility has arisen that the U.S. could re-impose sanctions, including on oil exports, on Iran, given its perceived lack of compliance with its nuclear agreement with Western nations.

All of these are transitory influences that really cannot be expected to support higher prices on a more sustained basis.

There is one structural change, however, that has arisen over the past several months that could help to support these recent changes in crude oil prices over a longer period of time.

Since mid-2017, there has been a continual and significant easing of the high level of crude oil inventory that has plagued markets for the past two years. U.S. crude oil stocks peaked in August 2016 at 1.37 billion barrels, a record storage level that was 20% greater than its prior five-year average.

As of mid-January, those crude oil storage levels were down to just 8% higher than that five-year average.

While these trends suggest a “turning of the corner” for the 2018 crude oil prices, there are some harbingers ready and willing to pop this new year bubble. 

First, while crude oil storage numbers are moving in the right direction, they are still at trend and not yet below five-year averages. So, from a storage perspective, the market can be thought of as being in “balance” and not necessarily “tight.”

Second, while crude oil storage numbers are falling, the storage numbers for refined product, particularly gasoline, are rising. Ultimately, crude oil is a derived demand from refined products, and as these refined product inventories grow, the demand for crude oil, and the ability to further reduce crude oil inventories, will fall.

Third, the geopolitics of energy is a fickle handmaiden. While turmoil can, in many instances, lead to perceived/anticipated supply interruptions, it can also create opportunities for pushing more supply to the market.

The unrest in Iran is a function of an unhappy and restive population that is predominantly under the age of 21. What better way to quell that unrest than through increased internal security measures and increased domestic spending and social programs—the cost of which are paid for by petro-dollars, which increases, not decreases, Iran’s incentive to bust its OPEC agreement and stick the consequences to its fellow OPEC adversary and regional political rival, Saudi Arabia.

Lastly, the big wild card for 2018 will be U.S. production. To date, the drilling response to recent price increases has been relatively muted.

Over the past several years, U.S. producers have reacted almost instantaneously to price increases by increasing drilling.

This consistent past emphasis on drilling has drawn some degree of displeasure from the financial community, since producers are coming under increasing pressure from equity analysts, and ultimately investors, to focus on de-leveraging their balance sheets, not increasing drilling, with their new-found price gains.

While most producers seem to be heeding this investor sentiment, it might not last very long since there are two factors that could re-energize U.S. unconventional drilling activity. 

First, U.S. production continues to increase, largely due to production from wells that were drilled over the past several years but have been awaiting fracking crews to complete. To date, there are still a large number of drilled but uncompleted wells (“DUCs”) that could be made ready for production relatively quickly in some of the more prolific producing areas in the U.S., like the Permian and Eagle Ford basins.

A more rapid completion of these DUCs could lead to a situation where U.S. production continues to meet or surpass its anticipated 2018 forecast of 10 million barrels per day.

Second, the implications of the recently passed U.S. tax reform should give independent producers at least some opportunity to both shore up their challenged balance sheets and repatriate some of these new-found tax rebates into additional drilling activities.

If this does happen, then we could find the recent price increases to be very short-lived and to have, once again, sown the seeds of their own demise.

David E. Dismukes is a professor and the executive director of the Center for Energy Studies at LSU. He holds a joint academic appointment in the department of environmental sciences.

This article was originally published in the first quarter 2018 edition of 10/12 Industry Report