Black gold’s strong start to the year shows no sign of waning. Brent and WTI finished at fresh 11-month highs on Tuesday as those of a bullish disposition continued to take heart from Saudi Arabia’s intended supply-side restrictions. All the while, the worsening pandemic was shrugged off as were reports of deteriorating OPEC+ compliance to pledge output cuts. Conformity fell to 75% in December, among the lowest levels since the supply pact started in May 2020, according to tanker tracker Petro-Logistics.

Also helping to underpin the feel-good factor is the firm belief that global oil demand will rebound in 2021. The extent of which, however, has recently been undermined by the recent rise in Covid-19 infections and re-imposition of lockdown measures, a fact that was echoed yesterday by the EIA. In releasing its latest oil forecasts, the agency trimmed its global oil demand projections for each quarter this year. The upshot is that it now expects world oil consumption to average 97.77 mbpd in 2021, down 390,000 bpd from last month’s estimate. The message is clear: the pandemic will continue to adversely affect global oil demand in the coming months. On a brighter note, the EIA forecast a return above the psychologically important 100 mbpd threshold in 2022.

Returning to the here and now, the energy complex is making further gains at the time of writing amid expectations for another pullback in US crude stocks. Overnight, the API reported that crude inventories fell by 5.8 million bbls last week, smashing expectations for a drop of 2.3 million bbls. This would mark the fifth weekly decline if confirmed by government data later today. Meanwhile, product inventories maintained their upward trajectory. Gasoline and distillate fuel stockpiles rose by 1.9 million and 4.4 million bbls respectively. The oil market seems invincible right now. Yet given the near-term risks, it is only a matter of time before we see some profit taking.

 A gift from the Saudi gods

US oil producers were bracing for another year in survival mode after a disastrous 2020. Record low oil prices back in April triggered the biggest-ever shutdown in US oil production. A subsequent swathe of job losses, bankruptcies and hefty budget cuts meant that supply was widely expected to decline for a second consecutive year in 2021. However, the onset of the new year has provided struggling US shale producers with an unexpected lifeline. Saudi Arabia’s pledge to reduce production by 1 mbpd in February and March has given the US shale patch a much-needed supportive kick up the backside.

The pleasing announcement for US oil producers comes amid signs that the shale industry has only just started getting back onto its feet. Activity in the country’s oil and gas sector jumped in the fourth quarter, according to the Dallas Federal Energy Survey, the first positive reading since early 2019. Spearheading this recovery is a return of drillers to the well pad. US oil rigs rose for the seventh week in a row in the seven days to January 8, according to Baker Hughes data. At 275, the number of active oil rigs is at the highest since May, although still a far cry from levels prior to the pandemic. In any case, the recovery in drilling has helped US crude oil production stabilise at around 11 mbpd, down by about 2 mbpd from pre-pandemic levels.

And looking ahead, the recovery in drilling activity should accelerate. This is because the Saudi “gift” has sent US crude prices back to pre-Covid levels and, crucially, above breakevens. According to BloombergNEF’s estimates, US oil producers have cut their average breakeven costs from $56.50/bbl last year to $45/bbl now. That figure drops into the 30s for some of the most prolific basins such as the Permian and Eagle Ford. It’s not surprising, then, that the head of the IEA said this week that a “big chunk” of US shale is profitable at current oil prices.

The modest recovery in drilling is therefore a shoo-in to gain momentum in the coming months. What is less clear is whether this flurry of activity will spare the US oil patch from another annual decline. The answer is most likely not. More wells are constantly needed to offset fast-falling output from existing wells. And production rates from existing wells in the US shale patch are expected to fall faster than production gains from newly drilled wells. What is needed are even higher oil prices. Though the current price backdrop has become more favourable for drilling it is still not high enough to trigger meaningful supply growth. Oil would have to hit $60 to $65 per barrel to restore US output by 1 mbpd, according to data provider IHS Markit.

But even then, US oil producers would still have to operate in an uncertain capital environment. Dwindling access to capital coupled with the need for spending discipline will limit domestic oil production growth. What’s more, higher oil prices will provide little comfort to US oil producers if the incoming Biden administration is serious about clamping down on US crude supply.

Consequently, it will be nigh on impossible to see any significant recovery in US oil supply this year. Any recovery will take years and may very well not reach the record highs seen on the eve of the Covid-19 pandemic. Instead, the focus in 2021 should be on stemming the anticipated decline in production this year. In that respect the omens are encouraging. In its latest forecasts, the EIA said US oil production will shrink by 190,000 bpd this year, a smaller decline than its previous forecast for a drop of 240,000 bpd. The worst may be over for US oil production, but it’s still a case of lower for longer.