Turning off 2% of the world's oil production is a major step toward higher prices in a sector that has been ravaged by low prices. But the road between higher prices and full-blown recovery is like the Long Island Expressway -- full of potholes and roadblocks.
preliminary agreement to cut its crude output by over 2 million barrels a day came Friday after nearly two days of meetings between top oil ministers from Saudi Arabia, Venezuela, Iran, Kuwait, Algeria and Mexico. Ratification is expected at OPEC's full meeting March 23.
The decision already has had an impact -- crude oil prices are up nearly a third from February lows.
Yet even if oil producers get more money for every barrel they sell, their spending is unlikely to increase significantly until oil prices firm to the $17 to $21 range, where a wide variety of drilling projects become more economically viable. And that means the impact of higher oil prices will trickle, not flow, through the industry.
Major oil companies, with their huge production volumes, will see the greatest benefit the soonest. But given the recent dismal environment, which led to spending cuts, they still will surely approach the winter budgeting season with caution. In addition, the majors are much slower to turn spending plans on and off than their independent counterparts.
Independent producers, however, are hurting the most financially. Banks are pressuring them for interest and loan principal payments. The swiftness with which last year's oil price downturn hit small oil producers has changed the thinking on drilling project economics. Exploratory drilling -- which requires substantial capital outlays with no guarantee of a return -- has suffered and will continue to be examined with a fine-toothed comb.
"What you have to think about
from producers' point of view is that after losing money for the last nine or 12 months ... incremental cash flow will go toward improving the balance sheet," says Dan Pickering, head of oil service research at Houston-based investment bank
Simmons & Co.
This means oil-service firms will be among the last to feel the higher prices. Rig rental and utilization rates likely won't improve for months. Likewise, service and construction companies won't see order improvements until oil companies increase spending budgets.
While analysts say a higher trading range between $13 and $16 per barrel has been established, there is skepticism that $16 oil can be sustained. After hitting a high of $15.20 on Friday,
crude futures for April delivery settled at $14.49 per barrel, up 18 cents.
Before oil-price confidence is regained, a few things need to be sorted out about Friday's agreement.
First, the cuts need to be explained. The agreement states that beginning April 1 OPEC will cut production by 2 million barrels per day, or about 2.6% of world production. But the actual figures released by OPEC ministers add up to about 1 million barrels; the entire 2-million-barrel output cut has not yet been accounted for.
"I am still wanting to see how they're planning to hit this vague 'more than 2-million-barrel-per-day' total," says Tim Evans, senior oil analyst at
Pegasus Econometric Group
in New York. "What is the breakdown going to be?"
Second, OPEC has to prove that it can adhere to this latest round of cuts. Compliance with last year's cuts of over 3 million barrels has hovered around 77%. At that rate, Friday's cuts would yield a decrease of 1.5 million barrels. Evans says that is still enough of a cut -- if OPEC "makes good" on it -- to put the market into a moderate supply deficit for the second quarter, when demand drops seasonally.
At the very least, the cuts may stem the flood of layoffs and capital spending cuts that have besieged all segments of the patch. The decline in the rig count -- a leading indicator of the service industry's health -- will likely slow as well, says Simmons' Pickering.
The first area to see a drilling rebound will be shallow water, which is geared to natural-gas drilling, says Bob Christensen, who follows independent oil companies at
"The cuts certainly make the natural-gas picture better," Christensen says. About 3% of the natural-gas market was displaced last year by cheaper residual crude oil fuels, he says. With higher crude and crude product prices, industrial customers may once again turn to natural gas, increasing the need for natural-gas drilling.
Investors who bought into this theory, buying drillers with large shallow-water drilling fleets, such as
, have been rewarded over the past week with a jump in share prices. Ronny Kraft, chief executive of
Gothan Capital Management
, a New York-based hedge fund, sees the drillers and some of the larger service companies as providing "the biggest bang for the buck " with rising oil prices. The service companies and drillers take the first and deepest hits in a downturn, so they see sharper stock increases when prices come back.
Shares of oil-service companies have run up 29% since late February.
But even Kraft isn't convinced it's time to go long the whole group. He holds GLM, but he is only trading the larger service companies, such as