Oil prices have climbed by about 50 per cent from their February lows, topping $40 per barrel. But the rally could be reaching its limits, at least temporarily, as persistent oversupply and the prospect of new shale production caps any potential price increase.

U.S. oil production has steadily lost ground over the past two quarters, with production falling more than a half million barrels per day since hitting a peak at nearly 9.7 million barrels per day (mb/d) in April 2015. American oil companies have gutted their budgets and have put off drilling plans, with many projecting absolute declines in 2016.

That has sparked a renewed sense of optimism among oil traders. Moreover, supply outages in places like Iraq and Nigeria have also knocked at least a quarter of a million barrels per day offline, an unexpected disruption that put upward pressure on prices in March. Geopolitical unrest still has the ability to influence prices, even while the world is awash in oil. More oil bulls are piling on in anticipation of the April OPEC meeting, on an unfounded belief that the production freeze may actually have any material impact on global oil supplies.

But while oil traders have found some reasons to believe that oil prices are rising, there are just as many, if not more, data points to backup bearish sentiment. Storage levels in the U.S. continue to set records, hitting 523 million barrels for the week ending on March 11. Until inventories start to deplete in a significant way, oil prices will face a lot of resistance trying to break above $40 per barrel. Iran also continues to add production, albeit at a slower-than-expected rate.

In fact, the rally to $40 was largely driven by speculation. As short bets peaked and started to unwind, traders closed out positions at a rapid clip, helping to push prices up by $12 to $13 per barrel in less than two months. The trend continued last week as hedge funds and other major money managers increased their net-long positions on crude by another 17 per cent. Short positions are now at their lowest levels since last June.

But now, with oil traders taking the most bullish positions in months while the fundamentals still have not shifted in a correspondingly significant fashion, traders have set up the conditions where oil prices could snap back to the downside. Once it becomes clear that OPEC won’t come to the rescue, and traders have taken bullish bets to unwarranted levels, prices could fall back to the mid-$30s.

It isn’t just a speculator’s game, however. The physical market could change as well with oil prices as high as they are – shale drilling could comeback with oil prices at $40 per barrel and above. Some areas of North Dakota have breakeven prices at around $20 to $25 per barrel. Drilling for oil in shale is already a “short-cycle” event – a well can take weeks or months to be completed, whereas an offshore project can take several years.

On top of the quick lead times, U.S. shale companies are also sitting on thousands of drilled but uncompleted wells (DUCs). Over the past year, companies did not want to complete their wells and sell their output into a depressed market and/or they needed to save cash in the short-run so decided to defer well completions.

That means a wave of production, the extent of which is unclear, could come back online when oil prices prove enticing enough. Reuters cited a Wood Mackenzie estimate that found that the backlog of DUCs has already begun to decline, falling by about one-third over the past six months. In the Permian Basin and the Eagle Ford, more than 600 wells sit on the sideline awaiting completion, which could lead to the production of an additional 100,000 to 300,000 barrels per day. The backlog of DUCs should be worked through this year and next, returning to normal by the end of 2017.

“If the number of DUCs brought online is surprising to the upside, that means U.S. production won’t decline as quickly as people expect,” Michael Wittner, global head of oil research at Societe Generale, told Reuters. “More output is bearish.” Companies could even be forced to complete more wells in a rush to meet debt payments.

Neil Atkinson, head of the oil market division at the International Energy Agency (IEA), largely agrees with the potential shale restart. “If prices keep rising, we could find that because of the cost cutting and the technology improvements that some of this marginal production is switched back on,” he said in a March 18 interview with Fuelfix. “But how long does it take to reassemble crews, get the labor, the equipment and all the rest of it? This is what we don’t know.”

Baker Hughes reported that the oil rig count actually turned positive last week, rising by one to 387 (the overall rig count declined by four to hit 476, due to the loss of five natural gas rigs). Obviously, one data point does not prove a trend, but the dramatic declines in rig counts in 2016 have slowed and basically come to a halt in March. It is too early to tell, but drillers could begin to add more rigs if oil prices rise above various breakeven points. That is not good news for oil prices.

(Republished with permission from oilprice.com)