Energy related stocks were under pressure on Tuesday as oil prices failed to break higher and instead dropped to two-week lows on lingering concerns about global oil supplies. WTI crude settled at $52.17 per barrel on Tuesday, down 1.6% on the day. The market is struggling to find a balance between the production cuts currently being implemented by the Organization of Petroleum Exporting Countries (OPEC) and Russia on one side and the developing rebound in U.S. shale oil production that is adding to oil supplies on the other.
The oil market remains tough for producers, many of which have reported relatively weak full year 2016 financial results. For example, the UK’s BP (BP) reported results on Tuesday showing a replacement cost loss for the full year of 2016 of $999 million, which was an improvement compared with the loss of $5.2 billion for the full year of 2015, but still not what investors had been hoping for.
Oil companies in the U.S. are also struggling. The three major oil producers reported less-than-stellar full year 2016 financial results over the last few weeks. (See also: Big Oil Faces Uphill Battle in 2017.)
Goodbye Easy Oil Trading Profits
Unlike U.S. producers, European oil majors run substantial oil-trading operations that in the past have helped to diversify operations and profits, as well as aid in securing oil supplies for refining. The trading operations of BP and Royal Dutch Shell (RDS.A, RDS.B) greatly benefited from two years of excess supply in oil markets by trading oil futures contracts that allowed them to buy oil cheaply and sell it for more money at a later date. As excess oil supplies have dried up, this trade has become less profitable.
Bloomberg published a story on Tuesday saying that BP made a small loss on its trading operations in the fourth quarter, while Shell said its trading profits showed almost no growth in the same period. The article goes on to say that BP and Shell handle about 20% of global oil trading between them, and compete with independent oil traders like Vitol Group, Trafigura Group and Glencore plc.
Volatility to the Rescue
The trading operations of all these companies have suffered because the price of oil for immediate delivery has risen to align with the higher long-term prices seen in futures market. For example, the spread between lower-priced oil to be delivered today compared to higher-priced oil to be delivered in one year peaked at $12 per barrel in 2015. Today the difference is less than one dollar. This could change, however, if price volatility picks up, especially in oil priced for immediate delivery. Any break down in OPEC’s recent production agreement or higher than expected U.S. production will be felt in near-term oil prices. This could restore the pricing conditions that support these companies' trading operations. (See also: Crude Oil Soars After OPEC and Non-OPEC Countries Agree to Production Cuts.)
Oil Market Tug of War
The dynamics of supply and demand are still playing out in the oil market. For example, S&P Global Platts reports that OPEC achieved 91% of their required cuts in January, with production down 1.14 million barrels per day (b/d) from October levels. These reductions have come more quickly than many market watchers expected and have helped to bring oil prices off their lows. But concern is growing that other producers may be willing to step in where OPEC leaves off, especially U.S. shale oil producers, which are quickly ramping up production. (See also: Is Oil Forever Stuck at $40 to $60 Per Barrel?.)
The U.S. Energy Information Agency released its Short-Term Energy Outlook for January on Tuesday, in which they say U.S. crude oil production averaged an estimated 8.9 million b/d in 2016. The agency goes on to forecast that U.S crude oil production will average 9.0 million b/d in 2017 and 9.5 million b/d in 2018. Some analysts are forecasting for an even larger ramp up in U.S. oil production if oil prices provide the right incentives.
Disclaimer: Gary Ashton is an oil and gas financial consultant who writes for Investopedia. The observations he makes are his own and are not intended as investment advice. Gary does not own any companies mentioned in this article.