Market Insider

Oil's drop back into a bear market could slow down US drilling

Key Points
  • U.S. oil producers may be looking to reduce spending and trim back drilling plans for next year, as oil prices fall sharply.
  • Oil futures fell into a bear market, and many U.S. energy stocks set new 52-week lows.
  • Analyst say oil could briefly break $40 but it's not expected to stay there.
Oil enters bear market territory

Just a few months ago, oil prices were above $50 and there was a swagger in the step of the U.S. shale industry.

But that has changed, now that prices have dipped precariously close to $40 per barrel, and threaten to go even lower. Many producers consider $40 as the line they cannot cross and still make a profit, so it will impact U.S. oil production if prices remain low.

"These are financial decisions. What was becoming unbridled confidence will be less unbridled," said Daniel Yergin, vice chairman of IHS Markit.

West Texas Intermediate futures for August were trading at just above $43 per barrel Tuesday, and prices were down about 2.5 percent, as the July contract expired. WTI has fallen about 20 percent from the peak it made in January, just as OPEC and non OPEC producers began a program to cut production by 1.8 million barrels a day.

"It's clear the oil price is not only measuring supply and demand. It's taking the temperature of sentiment and sentiment is overwhelmingly negative now," said Yergin.

The agreement reached late last year between OPEC, Russia and other producers temporarily kept oil in the $50s per barrel, and that encouraged U.S. shale drillers to crank up production. U.S. oil output jumped, reaching 9.3 million barrels a day this month, after troughing at about 8.5 million barrels a day last September.

Oil output, however has been rising, due to higher production in the U.S. and increased output from Libya and Nigeria.

"The global guys have been much more restrained. The U.S. guys are the ones that have been spending like crazy because of the combination of shale; the better wells they are drilling and the lower costs they've had. The U.S. guys built a better mouse trap but even that better mouse trap gets challenged," said Daniel Pickering, president of Pickering, Tudor, Holt.

Pickering's firm will be hosting a two-day industry conference in Houston starting Wednesday, and he expects to hear a changed mood from producers.

"We may get some signs that U.S. guys are going to take a breather on spending," said Pickering. "U.S. rig count is up 22 weeks in a row. One of these days we're going to have a down rig count because the U.S. guys are scared enough."

A number of analysts said U.S. crude should hold above $40, but it could fall into the $30s briefly.

Here's why oil could head to the $30s: BofAML Strategist

"It's hard to see the U.S. sustainably below $40. The reason being even though you have a lot of efficiencies in the system now, that is a number at which a lot of the really best spots in the U.S. stop making money," Pickering said, noting that capital market access would be difficult at that point. "If the world is worried the U.S. is now the swing player, oil in the $30s is going to make that swing producer slow down."

The S&P energy sector was down 1.2 percent in afternoon trading Tuesday, about a percent better than early morning lows. In early trading, 11 energy companies in the S&P 500 hit fresh 52-week lows. Schlumberger and Range Resources were at lows last seen in January, 2016. Marathon, Concho Resources and Anadarko were at the lowest levels since May, 2016.

"Quite honestly OPEC is done in terms of being able to support the price," said Kyle Cooper, managing director, research at IAF. "They can still prevent a collapse but they can't support the price they want because the price they want is far above what U.S. oil needs, to be able to produce."

Yergin said he expects to see a cut back in U.S. drilling if the price remains low.

"The impact is not coming tomorrow or next week, but this will have a big impact on what happens next year. Who is going to have the same confidence they had four weeks ago?" said Yergin.

He said OPEC may not do anything in response, though it could have an emergency meeting and consider cutting back even more on production. "I have a little trouble seeing what they would do. If I were them I would take the long view and say this was good," he said, of the shale shakeout.

Analyst say the market should rebalance but it is taking much longer than expected. "OPEC got what they wanted. They got prices up, and U.S. oil producers said thank you very much. They elevated it long enough to get hedges in place, plans in place and we 're only 300,000 barrels from the peak of recent oil production," he said.

Cooper said many of the drillers have hedges that will allow them to continue with plans this year, and the impact of reduced activity from low prices would come in 2018 if they continue to be low, he said.

"I think the answer is even with hedges, nobody hedges everything. Folks very seldom hedge 100 percent of their production and when you get scared, you get scared," he said.

Watch: The energy sector's $43 problem

Analyst: Most energy sector players have an awful problem at $43 oil