Oil is a volatile commodity, and one need look no further than the movements in the first few months of 2020 as proof. The price of crude oil (WTI) started the year above $60, and infamously dipped to below -$37 in April.
Several factors contributed to the wild swings and precipitous drop:
- A supply glut emanating from the price war between the two largest producers outside the US, namely Saudi Arabia and Russia
- A precipitous decline in demand because of the Covid-19 epidemic and mandated shutdowns
- The subsequent evaporation of storage capacity for crude
One aspect of the current volatility in oil prices that can potentially provide some foresight is the effect of active rig counts on subsequent oil prices. Going back 30 years, it appears that troughs in active rig counts roughly coincide with near term lows in the price of crude. This is not surprising, as high marginal cost operators begin to shut down production or exit the business when the price falls enough to no longer justify production. One week prior’s drop in rig counts brought the total to the lowest reported rigs since May 2016, and was down nearly 60% from a year prior. Today, Reuters and Baker Hughes reported an all-time low in operating oil and natural gas rigs:
“The rig count, an early indicator of future output, fell by 34 to a record low of 374 in the week to May 8, according to data on Friday from energy services firm Baker Hughes Co. going back to 1940.”
What is more interesting however, is the price movement in the period following the troughs in active rig counts. Our research shows that on average, over the past 30 years, prices have increased over 50% from the lows in the month where active rig counts hit their troughs, to highs six months later. While just as in today’s market, many fundamental factors are at play in any given period (think of both Gulf Wars, the global financial crisis, European debt crisis, etc.), rig count troughs seem to have consistently provided great insight into potential price movement in the months ahead.
In summary, once one considers the low rig counts, technical indicators being oversold, and the fundamental aspects of the economy coming back online over the coming months, historically, this could be viewed as one of the unique opportunities to enter the oil market.
Disclaimer – Author holds both long and short positions in oil and derivatives of oil. Article is for educational purposes only. No investment advice is intended.