August has been a good month for crude oil. After dipping to a three-month low at the end of July, prices made a strong comeback this month, rising 12.7% so far in the period.
ETFs tied to oil (see our Oil ETF Channel), such as the $3.4 billion United States Oil Fund (USO) and the $1.5 billion VelocityShares 3x Long Crude Oil ETN (UWTI), jumped sharply as well. Month-to-date, USO was last trading up 11.6%, while UWTI was last trading up 34.6%.
August Returns For WTI Futures, USO, UWTI
Speculation that some of the large OPEC countries, such as Saudi Arabia and Iran, might be ready to freeze their production levels has been cited as the catalyst for oil's rally.
But rather than focusing on an elusive production freeze from OPEC, traders should be more focused on production in the U.S.―which saw its first big increase in months.
First Big Increase This Year
After eight months of steady declines, U.S. oil production finally saw a big jump. Output in the lower 48 states (which excludes volatile Alaska production) rose by 100,000 barrels per day in the week ending Aug. 12, the largest weekly increase in 15 months, according to the Energy Information Administration (EIA).
(Fresh data from the EIA yesterday showed production dipped 55,000 barrels per day in the week ending Aug. 19.)
That puts at least a temporary end to the downtrend in U.S. production, which peaked in June 2015 before falling about 1.2 million barrels per day in the following year.
While it's too early to call the bottom in U.S. production, some analysts believe that output may have troughed. They argue that with oil prices last trading around $47/barrel―up more than 75% from their worst levels of $26 earlier this year―there's an incentive for U.S. producers to drill more.
The data suggest that's exactly what producers are doing. The U.S. rig count, published weekly by Baker Hughes, shows that the number of rigs drilling for oil in the country rose to 406 last week. That's the highest level since February, and a 28% gain from the lows of May.
Higher Production Coming Soon?
More rigs in service translate into more wells drilled, and more production in the future. That simple formula hasn't always held true throughout history, but it's likely to this time with so much easy-to-reach shale oil still left underground despite the temporary setback from the bust of the past two years.
Moreover, today's rigs are more efficient than ever. New well oil production per rig in key shale regions is 578 barrels per day, up 33% from a year ago and 90% from two years ago, according to the EIA's Drilling Productivity Report.
Both the oil and the means to get it are there; it's just a matter of price. The rising rig count suggests prices may have rebounded enough to make drilling economical again.
If that's the case, then it's only a matter of time before U.S. output begins to reverse course and rise again. The recent 100K barrel/day jump may be the start of the reversal―or perhaps it will take a bit longer to see it.
After all, there is a lag between changes in the rig count and changes in production. When the rig count peaked and began plunging at the tail end of 2014, U.S. production continued climbing for another seven months before it too peaked and began to decline.
US Oil Production (Red) vs. Rig Count (Blue)
Applying that seven-month lag to the bottom of the rig count in May suggests production could begin to climb by December.
Of course, nothing is set in stone. These are unprecedented times for the oil market and no one knows what will happen as different variables interact with each other. Bulls argue that prices still aren't high enough to spur a meaningful rebound in drilling that reverses the production decline.
After all, a certain amount of drilling is required just to keep production constant. Drilling must move beyond that steady-state level to actually grow output. Perhaps prices still aren't high enough for that to happen.
In the next several months, it will become increasingly clear what's in store for the next stage of the oil cycle in this shale era. This is a real-life case study that will be analyzed for years to come by energy analysts.
Contact Sumit Roy at email@example.com.