The price of oil keeps going up and up and up. This is no surprise considering how the industry is approaching things. Being the leading commodity, this is a problem since it affects prices across the board.
With oil, there is really no mystery how it works. Think back before COVID-19 hit and what was the talk track with oil? People were talking about the glut of oil. Storage rates in Cushing were through the roof, for what little space was left. People were leading oil tankers just to store the oil in. We were swimming in the stuff.
This, of course, led to a decline in prices. As the price of oil dropped, many companies encountered financial issues. Oil drilling, as most can guess, is a capital intensive business. Hence, there is a load of debt these companies are carrying. This means when prices head south, many of the fringe companies start to feel it. Defaults go up which then affect lending to the entire industry.
When COVID hit, the economy was lockdown globally and demand for oil plummeted. This put the oil producers into overdrive. They had to plug every hole they could.
Here is what the oil rig count looked like at the beginning of 2019.
If we fast forward to when COVID hit, we can see the exact week that the shutdown occurred. Look at what happened with the rig counts. They started in the high 600s and had dropped by 500 in only a couple of months. Notice the week-to-week drops.
Oil companies operate the same as everyone else. In the stock market, price movements down tend to be a lot quicker than moves back up. Typically, it takes twice as long for a stock market to bounce back after a bear market. As powerful as greed is, fear is a more powerful force.
Thus, people will stay on the sidelines still licking their wounds.
We see the same behavior from the oil companies. The pace of decline was incredible. Since the bottom, rig counts have gone back up. However, it is nowhere near the pace of the decline.
Here is the most recent rig counts.
Certainly we can the counts move higher but the pace is a far cry from that of the drop. This is leaving us with a lot less oil being produced right not as compared to 18 months ago. Here is where we see the supply/demand ratio in commodities in action.
With a situation like this, even though demand is down from where it was before COVID, the supply is down even more. We also have a lot of speculation in the market right now about future demand increasing as things open back up and "get back to normal".
The challenge with this is the presumption behind it. We are a long way from normal. In fact, many question whether we will ever head back there. Things are different than they were before, whether some care to admit it or not.
Economic data is already showing some signs of weakening. When lending is starting to tighten, that does not bode well for the prospects of the economy in the second half of the year. This is something that the bond market is already warning us about.
Now we get a second consideration. The approach by the oil companies is not alerting us to the fact that the economy is going to be screaming going forward. Their tactic is showing great uncertainty when it comes to this. They are concerned that demand will not bounce back.
As with many things, you have the speculation and then there is the metrics. With oil, as with almost all commodities, the only metrics that enter the picture are supple and demand. If the demand starts to suffer, this crushes the speculation in the market. Hence, the massive run up in oil prices can turn very quickly.
If demand does remain strong, then the oil companies will keep increasing the rig count. It is obvious, at the pace they are advancing, it will take them a while to get to the point where they are pumping like before. Of course, if the demand is there, it is in the corporations best interest to meet it. Yet, they are hesitant since they are still licking their wounds from a year ago.
This is why it typically takes 18-24 months for the commodity supply/demand equation to flip. In oil, there will come a point where output will create a glut again. The industry will reach that point. Therefore, prices will go up to a certain point and then the pumping will increase to the point that oil is coming out our ears.
And guess what happens to price in that situation.
Commodities are highly cyclical. We must watch both the supply and demand side of the equation. If I had to guess, and this is not financial advice, I would not be long oil for too much longer. The signs of weakness are starting to appear and this could end up affecting prices. A lot of goods were pulled forward during the pandemic since people were not spending money on services. This means that manufacturers are afraid to be caught short again. So they are pumping out what they can as business stock up.
What happens once that takes place? If demand drops since orders were pulled forward, the entire sector is going to take a short term hit. Oil will be at the top of that list since it tends to be the big boy on the block.
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