A False Sense of Security for U.S. Oil Producers?

Dave Meats: In November 2016, OPEC announced that it would cut production by 1.2 million barrels a day for the first six months of the current year. Since then, oil fundamentals have improved significantly and prices have risen by about 17%. Our concern is that this creates a false sense of security for U.S. producers, which are accelerating operations to capitalize on these higher prices.

The number of tight oil rigs has already doubled from the May 2016 trough. That hasn't had much impact on production yet, but remember, it takes six months to bring a well online after starting to drill it. So the volumes generated by ramping shale activity won't find their way to market until the middle of the year. After that, production could grow quite quickly.

From OPEC's perspective, its strategy is working, since global stockpiles are currently declining. But they won't return to pre-downturn levels before the agreed cuts expire at the end of June. Therefore, there is a high probability that the cartel will extend the deal into the second half of 2017 to give it time to work. And unfortunately, that's probably the last thing the industry needs, because if it keeps prices propped up, producers will have more incentive to add rigs.

The supply response from this incremental activity, coupled with OPEC's inevitable return to full production, could throw crude markets back into oversupply in 2018. Therefore, investors looking for upstream exposure should focus on low-cost producers with strong balance sheets, like RSP Permian and Diamondback Energy.