The Oil Rebound is a Flimsy House of Cards

Over the last few months, oil companies have announced huge cutbacks…

Last week, Cenovus said it would cut staff by 15% and freeze pay for those who were allowed to stay onboard. Apache, which has over 200,000 acres in the Eagle Ford, announced it would only operate a dozen rigs during 2015, maybe less.

That’s a 70% drop so far during the crude bear market.

Schlumberger is firing 9,000 employees, Halliburton is shedding up to 6,500, and its recent acquisition, Baker Hughes, is dropping 7,000 workers.

All told, companies have cut over 100,000 jobs worldwide as oil prices have declined to levels not seen since the recession. In late January, WTI oil prices hit a near six-year low when they dropped to $44.45 per barrel.

In financial pressrooms around the world, the dominant narrative is that companies announcing job cuts and capex suspensions have caused the recent gains for oil prices on the market.

If you weren’t aware, since the low in January, prices have climbed 17%:

The theory goes like this:

Because oil firms are suspending new drilling programs, these companies will stop producing so much oil, and the glut will slowly subside. Not bad, right?

The only problem is that this theory is a fantasy as is, and investors should pay closer attention if they don’t want to get burned…

Oil Rebound is a Flimsy House of Cards

Don’t get me wrong — the revised spending plans of these companies have helped investors in the short term. With oil moving up again, many people are ready to buy and have driven up prices, if only slightly.

But these spending cuts are merely a band-aid on a bullet wound.

Despite the budget slashing and cuts to rig counts, North Dakota clocked a banner month in December in terms of oil production. Drillers boosted per-day oil output to 1.2 million barrels even though rigs have been suspended.

Between November and February, 51 rigs have been shut down, and yet the Bakken is still seeing its crude output rise.

This means the recent oil price gains investors have seen are based on news and not substance. The problem is that the supply glut won’t stop anytime soon, while U.S. shale producers are still adding more supply.

These supply numbers could change once the capex cuts start to take hold of production numbers. Because prices have only gone up on announcements, there’s still a window for the cuts to affect production.

And it’s well known that shale wells are quick to decline after an initial frack, so while companies cut new rig programs, eventually supply growth should plateau.

To time such an event would be useless, but I do have a suggestion for investors who want to recoup some gains when oil goes back down…

Drillers Have to Pay for This By LAW

Cost cutting for oil producers is all about trimming the fat and only spending money on the things they absolutely cannot do without.

And what’s more necessary than anything else? The expenditures the law requires companies to have.

For example, all companies — not just oil — are required to pay employees, at the very least, the minimum wage. So when times get tough, companies have to cut jobs because they can’t afford to pay everyone the minimum.

If they tried to just cut everyone’s wages below the minimum, there would be lawsuits and financial penalties levied by the government.

Same goes for oil companies…

If drillers want to keep the feds off of their backs, they have to abide by state and federal regulations (which are many) as well as royalty contracts.

Royalty contracts are agreements between producers and landowners near oil reservoirs. In the Eagle Ford and Bakken, as an example, some landowners receive royalties on every barrel of oil and every cubic foot of gas harvested on their properties.

However, right now in North Dakota, disgruntled royalty owners are fed up with oil companies wasting resources and losing them vast sums of money.

Because of this, they are pushing legislation that is set up to provide a windfall to a company that’s cornered a $150 billion market.

Here’s a more detailed glimpse of what’s happening and how you can play it.

Good Investing, 

Alex Martinelli

With an eye squarely focused on the long-term, Alex Martinelli takes the art of income investing to a higher level within the energy sector. His research has helped hundreds of thousands of individual investors identify well established companies that have a long history of paying out dividends to their shareholders. For more info on Alex, check out his editor’s page.