Catching a Falling Knife in Oil Markets

"Don't try to catch a falling knife" is sage advice for investors trying to identify the trough in a market like oil following a sharp selloff.

Yet big moves also create the greatest potential for the mispricing of financial assets and commodities, which is what makes them attractive to contrarians and specialists.

Fear about catching a falling knife suggests the market is in the grip of an unsustainable one-way herd mentality (the precise opposite of the advice about not trying to pick the top of a bubble).

But with crude oil prices halving since June, the balance between risk and reward has shifted from further falls towards a rise in prices in the future.

Prices realised by oil producers in Texas have fallen below $50 per barrel and those for producers in North Dakota are sub-$40.

Prices are now too low to provide the cash flow to sustain drilling programmes and nowhere near enough to provide the financial incentive to make equity or debt available.

PAINFUL ADJUSTMENT

Continental Resources (CLR), one of the largest producers in the Bakken, revised its capital budget for 2015 down for the second time in two months just before Christmas.

"This revised budget prudently aligns our capital expenditures to lower commodity prices," the company said in a statement, putting a brave face on the enforced changes.

Lending to oil and gas explorers will slow sharply in the months ahead as banks and securities investors seek to reduce their credit exposure to the sector.

Even with cost reductions and improvements in efficiency to improve well economics, it is only a matter of time before U.S. oil production peaks and begins to fall if prices remain at current levels.

Prior to the Christmas holidays, the number of rigs drilling for oil across the United States had already fallen by 110 (7 percent) since early October, according to oil field services company Baker Hughes (http://link.reuters.com/dyk73w).

Hundreds more rigs will be idled in the next few months as existing drilling programmes are completed and much smaller ones are undertaken in 2015.

Continental, for example, said it will reduce its rig count from 50 to 34 by the end of the first quarter and average just 31 in 2015.

If those cuts are mirrored across the whole industry, an extra 550 rigs could be idled across the industry by the middle of this year, taking the rig count below 1,000.

In the very short term, U.S. oil output will continue rising as the record number of wells drilled before October are completed and enter their most productive phase.

However, decline curves for oil wells, especially shale wells, are very steep. Output falls to a half or even a third of its initial level by the end of the first 12 months.

Thousands of new wells must therefore be drilled each year simply to sustain output at its current level of more than 9 million barrels per day.

Drilling can become more efficient (faster time to depth, longer laterals, less time spent moving locations and rigging up, and targeting only the richest parts of the shale plays).

And costs can be reduced (cutting pay rates for contractors, day rates for rigs and fracturing equipment, and prices for sand and other materials).

But it is hard to imagine the industry cutting costs and raising efficiency enough in the short term to offset fully a 40 percent or more reduction in the number of rigs operating.

BALANCE OF RISKS

Successful speculating is all about the balance of risk and reward. The conservative position when Brent and WTI prices were trading above $100 per barrel was to assume that prices would need to decline in the short to medium term to eliminate the obvious emerging imbalance in the market.

Now Brent and WTI prices are trading below $60, and realised prices for many U.S. producers, who have been the marginal suppliers in the oil market, are below $50 or even $40, the conservative position is to assume there will have to be a limited recovery at some point to put the market back on a more sustainable trajectory.

Hedge funds and other money managers have started to think along these lines according to the position data contained in the U.S. Commodity Futures Trading Commission's weekly report on Commitments of Traders.

Aggregate short positions betting on a further fall in the price of WTI-linked futures and options were cut 30 percent from the equivalent of 113 million barrels at the start of November to less than 78 million before Christmas (http://link.reuters.com/byk73w).

By contrast, hedge funds long positions betting on an increase in prices have remained broadly steady at a little under 300 million barrels since the end of October, down from 450 million in June.

Those long positions have lost a substantial amount of money: as much as $30 per barrel over the last two months.

However, the ratio of long to short positions, one way to measure the hedge fund community's overall outlook on prices, plunged from 13:1 back in June to a low of just 2.5:1 in November but had edged up closer to 4:1 before Christmas.

By John Kemp