USO: The US Oil Fund, 4 Reasons To Buy Crude (NYSEARCA:USO)

There’s no perfect gauge of supply and demand conditions in the global oil market.

However, a handful of indicators can help give us a read on oil market balances, and the likely path of prices. That list includes refining profit margins, the shape of the oil futures curve, patterns in US oil inventories and speculative commitments in the crude oil futures market.

In this article I’ll examine these four simple-yet-powerful indicators and explain why they support a case for a tightening oil supply and demand balance and a rally in crude oil, and the US Oil Fund (NYSEARCA:USO) ETF in early 2024.

I’ll also explain why I believe concerns about a glut of US shale oil production and weakening oil demand are overblown.

Let’s start with this:

Crack Spreads

Petroleum refining is essentially a manufacturing business.

Like all manufacturers, refiners buy raw materials – the most important being crude oil – and create products using those raw materials, in this case that’s diesel, heating oil, gasoline, jet fuel and other refined products.

So, a pure-play refiner does not benefit from rising oil prices in isolation – refiners buy crude oil as feedstock for their operations, so rising oil prices represent rising costs.

Rather, refiners profit from the spread between the cost of oil for their facilities and the value of refined products they produce – rising oil prices aren’t bullish for profitability unless they’re accompanied by rising gasoline and diesel prices.

One of the most common measures of refining profitability is what’s known as the NYMEX 3-2-1 Crack Spread, which represents the theoretical profit margin obtained by purchasing 3 barrels (126 gallons) of WTI crude oil and refining that into 2 barrels of gasoline and 1 barrel of Ultra-Low Sulfur Diesel (ULSD).

For example, according to Bloomberg, March 2024 WTI Crude Oil futures currently trade at roughly $77/bbl, March 2024 ULSD futures sell for 279 cents/gallon and March 2024 gasoline futures sell at 224.57 cents/gallon. So, here’s the 3-2-1 Crack spread calculation based on March NYMEX futures for these three commodities:

Simply put, the cost of 3 barrels of oil at $77/bbl is $231. The value of 2 barrels (84 gallons) of gasoline at 224.57 cents/gallon is $188.64 and the value of 1 barrel of ULSD is $117.18 on the same basis.

Sum up those three figures and we get a total of $74.82 in profit for the refiner, which represents the theoretical profit from refining 3 barrels of oil. By convention, the 3-2-1 Crack Spread represents the per-barrel profit; dividing by three yields a crack spread of $24.94/barrel.

Just consider, the crack spread is one way the oil market communicates to refiners and other market participants.

For example, if demand for gasoline is strong in the lead up to summer driving season that will tend to drive up gasoline prices which will boost the crack spread and encourage refiners to produce more gasoline to meet demand.

In 2008, for example, the crack spread peaked at the end of May and fell sharply through the summer:

As you can see, the crack spread peaked about a month-and-a-half before oil prices hit their 2008 highs in July. The sharp drop in the 3-2-1 Crack spread through the summer of 2008, a period when gasoline demand is seasonally highest amid summer driving season, was a prescient indicator that demand was weakening.

Of course, WTI collapsed in the final months of 2008 from a July peak of over $145/bbl to a December 2008 low under $40.

Right now, however, I’m not seeing any signs of weakness in oil demand apparent in the crack spread:

The blue line here represents the average weekly 3-2-1 NYMEX crack spread over the past three years – 2020-21, 2021-22 and 2022-23 – plotted over the calendar one-year period from the end of November.

The orange line represents the weekly crack spread from the end of November 2023 to the present. As you can see, the crack spread has been trending higher since that time and has generally remained above the 3-year average seasonal average.

There’s just no sign of a collapse in US demand for refined products like gasoline and diesel.

The futures curve tells a similar tale:

Calendar Spreads

You can buy (or sell) futures contracts for WTI oil delivery in every month of the calendar year – the futures curve plots the price of oil for delivery in each month of the year for several years into the future.

In several recent articles for Seeking Alpha, including my recent articles on Comstock Resources (CRK) and Southwestern Energy (SWN) I’ve explained why the shape of the futures curve for natural gas is more important than the front-month or spot price of gas.

And much the same can be said for the WTI futures curve.

Consider this chart:

This chart shows the WTI oil futures curve on two dates: January 29, 2024 (orange line) and February 28, 2020 (blue line). Both lines are plotted through the end of 2029.

As you can see, the WTI futures curve in late February 2020 shows a distinct upward slope, a condition known as contango. For a commodity market in contango, the price of oil for immediate delivery is lower than the price of oil for delivery further into the future.

Markets in contango encourage storage.

Just consider that if you can sell a barrel of oil for immediate delivery at $50/bbl or sell a futures contract for delivery in 6 months at $60, you have an incentive to store your oil and sell futures to deliver that crude in six months at a higher price. As long as the cost of storing oil for 6 months is less than $10/bbl, you can earn a (risk-free) profit by selling the futures and storing the physical crude.

That’s the market’s way of telling participants there’s too much supply and encouraging the storage of oil rather than further deliveries into a glutted market. The steeper the contango, the more bearish the implications.

The current futures curve (orange line) has a distinct downward slope, which is known as backwardation.

As I write this article, the price of oil for delivery in December 2024 is $73.64/bbl while oil for delivery in March 2024 is $76.84/bbl. This backwardation discourages storage and encourages immediate delivery – after all, why store oil until December 2024 to sell it at a lower price than is available in the open market right now?

So, backwardation is generally associated with a tighter supply/demand balance for oil and acts as a tailwind for prices.

One widely followed measure of the shape of the curve is what’s known as the prompt spread – the difference between the front-month price of oil and the next contract. Generally, I use the most actively traded futures contract for oil and the next month out.

For example, the most active contract for oil is for March 2024 and the next contract out would be April 2024; the current price of the March contract is $76.97/bbl while April sells for $76.84/bbl.

That’s a negative spread (backwardation) of $0.13/bbl.

Here’s a chart over the past few years:

This chart shows the futures curve spread on this basis since the end of 2020. While the curve has remained in backwardation for most of this period, the degree of backwardation has varied significantly over time.

I’ve labeled weeks where the curve has flattened (less backwardation) noticeably and then steepened sharply again (more backwardation). These dates generally marked short-to-intermediate term lows for oil prices:

This table lays out the return from the US Oil Fund (USO) over 4, 8 and 13-week (one quarter) holding periods following each of the dates labeled on my spread chart above.

As you can see, a pattern of a flattening curve followed by steeper backwardation has tended to signal further upside for USO.

Of course, the curve actually flipped into significant contango in mid-December 2023 and reached backwardation of as much as 17 cents/bbl last week. That certainly fits with the bullish pattern in the spread we’ve seen over the past few years and suggests a tightening in the US oil market since late last year.

Let’s turn to sentiment:

Contrarian Commitments

On Fridays after the market close, the Commodity Futures Trading Commission (CFTC) issues its weekly Commitment of Traders (COT) Report.

This report details positions held in US-traded futures, including the popular NYMEX West Texas Intermediate (WTI) crude oil futures, broken down by type of trader. I look at this data in several ways, most centered on identifying contrarian signals for oil prices.

The contrarian logic is simple – when futures market speculators are heavily long oil futures (bullish on prices), then crude is vulnerable to a downside reversal. The opposite is true – the market may be primed to bottom — when speculators are positioned to favor weakness.

There are a few potential rationales for this, let’s cover two of the most common.

First, if most speculators are committed to a bullish view, there’s less marginal uncommitted buying power on the sidelines to push prices still higher. If most speculators are already long, who is left to buy?

And if speculators already have a hefty gross short position in crude, favoring lower prices, there’s less cash on the sidelines looking to short crude.

Second, when traders are heavily net long oil, the market is likely already pricing in significant good (bullish) news, which leaves oil vulnerable to downside surprises. After all, if a speculator is long oil and prices are rising, they’re likely sitting on unrealized profits; on any whiff of bad news the market would theoretically be vulnerable to selling pressure as traders look to covert paper profits into money in the bank.

The corollary is that when traders have a sizable bearish position in futures, significant bad news about crude is already in the price.

Regardless of the rationale, observant readers probably noticed a few potential pitfalls of a contrarian approach to oil markets including how we define a “speculator,” and what constitutes a “heavily net long” or short position in oil futures.

Here’s how I answer those questions.

First up, look at the Commitment of Traders Report and you’ll see CFTC divides traders into two main categories, “Commercials” and “non-Commercials.”

Commercial traders are defined as entities that use the futures market to hedge exposure to commodity prices. For example, an airline might use oil futures to hedge their exposure to rising jet fuel costs while an oil producer might use WTI futures and options to lock in prices for their production and protect against downside volatility in the commodity markets.

Traders who are using futures to hedge their exposure to commodity prices aren’t speculating on prices, they’re using futures to reduce risk. In addition, a commercial consumer of oil is likely to always be net long oil futures to protect against rising prices while a commercial producer of oil is likely to be net short oil futures to protect against a sharp move lower in prices.

So, when it comes to gauging speculative activity in oil markets with an eye to identifying contrarian opportunities the key is to focus on non-commercial traders as defined by CFTC.

And that brings me to the definition of market extremes – identifying situations where speculators are heavily net long or net short oil futures.

Here’s a look at a long-term chart of non-commercial net position – gross longs less gross shorts – dating back to the late 1990s:

Two points jump out.

First, non-commercial traders haven’t been net short WTI on this basis since 2004.

And second, the definition of a large position has changed over time. In the past decade alone, non-commercial traders have been net long as much as 784,290 contracts covering 784.29 million barrels of crude back in January 2018 to as little as net long 170,119 contracts in late June last year.

So, rather than using raw data on the number of contracts held by non-commercials long or short, I transform the data to create what’s known as a Z-Score. Specifically, I create a Z-Score of futures market positions based on a trailing 104-week (2-year) lookback window.

To accomplish this I first look at the moving average net position of non-commercial traders in the NYMEX West Texas Intermediate futures and options market over the past 2 years, and the standard deviation of net positions over the same time period.

To create the Z-Score I simply compare the current non-commercial net position to the average over the past 2 years and divide by the standard deviation. A positive reading of 1.5, for example, would tell me non-commercials are net long oil 1.5 standard deviations above the trailing average; vice versa for a reading of -1.5 standard deviations.

On Friday January 26^th, the CFTC reported non-commercial traders were net long 205,472 WTI oil futures contracts and options. Since each contract covers 1,000 barrels, that’s equivalent to a notional position of net long (gross longs minus gross shorts) of 205.472 million barrels.

Over the past 104 weeks, the average non-commercial position is net long 291.543 million barrels and the standard deviation of positions is about 68 million barrels. So, the Z-score would be -1.27 standard deviations:

(Current Observation – Average) / Standard Deviation = Z-Score

(205,472 – 291,543) / 68,058 = -1.27

In other words, non-commercial traders have a relatively light net long position in the oil market today relative to average exposure over the past two years.

Here’s a chart of West Texas Intermediate Front-Month oil futures compared to the non-Commercial Z-Score of futures market positions I just outlined:

The blue line (right-hand scale) shows the non-commercial commitments while the orange line (left-hand scale) shows the front month price of oil. I’ve labeled a few obvious extremes on my chart.

First up, in mid-January 2016, West Texas Intermediate (WTI) non-commercial commitments reached more than -2 standard deviations on this basis and oil was trading around $30/bbl. The absolute closing low for crude came on February 11^th around $26/bbl and, as you can see on the chart, WTI doubled to the low $50’s/bbl by late 2016 and early 2017.

So, while extreme speculative bearish positioning didn’t mark the exact low for crude in early 2016, it did highlight a time when conditions were ripe for a reversal.

Interestingly, non-commercial commitments reached the opposite extreme — +2.8 standard deviations – by late February 2017, about a year later.

This signal was also useful. As you can see in this chart, oil prices peaked in late February 2017 at near $55/bbl and slid to as low as $42.50/bbl in late June of the same year.

The January 2019 extreme bearish reading also provided a useful signal. Just before that signal, between October and December 2018, WTI oil prices plunged from a peak of more than $76/bbl to a nadir of $42.50/bbl as part of a broader risk-off trade that also hit the S&P 500. As oil prices plunged, non-commercial traders built an increasingly bearish speculative position, reaching -1.8 standard deviations in early January 2019.

This did mark a good contrarian buy signal as WTI hit highs of $66.30/bbl in late April of 2019.

However, it’s also true that not all the extremes on my chart represented meaningful turning points for oil. For example, on February 23, 2018, non-commercial commitments hit +2.9 standard deviations above the trailing 2-year average, a heavy net long position in oil.

That marked a decent contrarian sell signal on a (very) short-term basis. WTI prices pulled back from a high of around $66/bbl in late January 2018 to a low of around $59/bbl by mid-February. However, oil prices hit higher highs over $76/bbl in October 2018 and, as I noted earlier, the big sell-off in crude in 2018 happened in the final quarter of the year.

The August 9, 2022 contrarian buy signal was a dud.

After all, non-commercial commitments plunged to more than 2.5 standard deviations below the 104-week mean, the most bearish speculative positioning of any week covered by my chart on this basis and a contrarian buy signal.

However, in this case the speculators were proved correct – oil plunged from over $90 at that time to the mid-$60’s in March 2023.

A couple of observations can help with interpreting this data:

Trend-Followers

First up, non-commercial futures traders are generally trend-followers.

Take a look at the raw net commitments, overlaid with the front-month price of oil, since the end of 2021 as an example:

As you can see, speculators generally reduced their net long exposure to WTI from the spring of 2022 through to the summer of last year as oil prices generally declined.

Non-commercials then added to their net longs as oil prices rose from June through September 2023 and, finally, reduced their net long exposure to crude late last year as oil prices fell from a September peak over $90 to a December low under $70/bbl.

So, one of the things I look for when identifying a buying opportunity with non-commercial commitments data is a situation where oil prices see significant downside and non-commercial commitments reach an extreme level on the z-score basis I outlined earlier.

That set-up suggests speculators are embracing the downtrend in oil and have been building up significant profits on the short side. That leaves the market vulnerable to an upside reversal on any whiff of bullish news for crude as those speculators look to lock in their profits by covering their shorts (buying to cover oil futures).

In addition, a prolonged downtrend accompanied by a major shift in speculative commitments suggests that a lot of bad news is priced in the oil market. If market expectations for oil are already low, it’s easier to see an upside surprise such as a larger than expected inventory drawdown, weaker supply growth or stronger-than-expected demand.

One more chart to consider:

This chart is based on non-commercial gross short positions in WTI futures and options. The z-score construction is exactly the same as the chart of net commitments I showed your earlier; however, this chart only considers the absolute size of non-commercial shorts and ignores any long-side exposure. Thus a reading of +2 would suggest a speculative short position that’s 2 standard deviations above the 2-year average, a sign of negative sentiment toward oil and a potential contrarian buy signal.

Generally, I look for situations where the gross short position spikes +2 standard deviations above average and then declines back below +2 standard deviations – I’ve labeled buy signals on this basis with black arrows above.

Signals in February 2016, October 2019, May 2020, and July 2023 all preceded significant rallies in oil driven, at least in part, by speculative short covering.

This simple indicator signaled excess bearishness early this year (January 12^th, 2024) and oil prices have traded higher since that time.

Again, you can’t rely solely on commitments data to identify buying opportunities in crude oil and the US Oil Fund, it’s best used in concert with other fundamental data points such as the prompt spread and crack spread indicators I outlined earlier.

However, the hefty gross short position in crude late last year and low net speculative long position both suggest sentiment in oil markets is bearish and the market is primed for upside surprises and a rally.

Inventories: IEA vs. OPEC

More broadly, the International Energy Agency (IEA) and the Organization of the Petroleum Exporting Countries (OPEC) have outlined very different forecasts for the US and global oil markets this year.

In its January 2024 Oil Market Report, the IEA forecast global oil demand growth of +1.2 million bbl/day this year and for non-OPEC oil production of “close to” 1.5 million bbl/day. With the IEA also projecting OPEC oil production to be flat in 2024, this implies oil supply growing faster than demand, which suggests rising storage and a headwind for oil prices.

OPEC’s latest oil market report released on January 17^th posits a different view:

This table lays out OPEC estimates for global oil demand, non-OPEC production and OPEC natural gas liquids (NGLS) production, all quoted in millions of bbl/day, for full-year 2023, full-year 2024 and for each quarter of this year.

The boldfaced line titled “Call on OPEC” is the most important on the table as it signifies the amount of oil OPEC needs to supply to the global market – crude oil not NGLs and unconventional oils from OPEC countries – to balance supply and demand.

If OPEC pumps more than the call on OPEC, then global oil inventories should build over time, which tends to be bearish for prices.

The opposite is true when the cartel pumps less than the call on OPEC – in this scenario, the world needs to draw down inventories of oil to meet demand. Falling oil inventories tend to be bullish for prices.

For example, the latest estimates from OPEC for last year – still subject to revisions as more accurate data is collected – shows total global oil demand of 102.11 million bbl/day, non-OPEC supply of 69.06 million bbl/day and OPEC NGLs of 5.41 million bbl/day.

That adds up to a call on OPEC of 27.64 million bbl/day; since OPEC produced only 27.01 million, global oil inventories fell and the oil market tightened last year.

OPEC does not include a quarter-by-quarter breakdown of forecasts for cartel oil production through 2024. However, as you can see, the “Call on OPEC” for 2024 is expected to be 28.49 million bbl/day compared to 27.64 million in 2023. That means that if OPEC does not increase oil production in 2024, their estimates suggest global inventories should fall at an even faster pace this year than in 2023.

That’s a completely different picture from what the IEA presented in its latest forecast.

So, why are these forecasts so different?

Well, as I noted earlier, the IEA forecasts global oil demand growth on the order of +1.2 million bbl/day in 2024, while my table above shows OPEC expecting some 2.25 million bbl/day in consumption growth from 102.11 million bbl/day in 2023 to 104.36 in 2024. Demand is the biggest delta between OPEC and IEA.

Also, OPEC is looking for non-OPEC supply growth of 1.34 million bbl/day, which is a bit less than IEA’s close to 1.5 million bbl/day.

Of course, there’s no way to know whether IEA or OPEC is closer to the mark for the 2024 supply/demand balance. However, the recent pattern in US oil inventories suggests a tightening US oil balance:

This chart shows total US oil inventories since the beginning of 2023 (orange line) compared to the trailing 5-year average level (blue line).

As you can see, US oil inventories historically rise from January/February through to May/June as refiners build up their stocks of crude oil ahead of summer driving season, which represents peak seasonal demand for refined products.

Inventories decline from June through September/October as refiners draw down inventories to meet high demand. And, in the autumn months, there’s usually a second (much smaller) seasonal bump higher in inventories ahead of winter heating season (partly due to heating oil demand).

Through 2023, US inventories followed the usual pattern, building early in the year and then falling into September, followed by a small build into December.

However, since early December, US oil inventories have fallen sharply and they’ve continued to fall into the second half of January, when the seasonal line (blue line) on my chart suggests they should normally be expected to rise.

Some of this is due to temporary weather-related disruptions. However, the pattern is clear – inventories are both below average for this time of year and have been falling counter-seasonally.

This suggests that, at least for now, demand is exceeding supply in the world’s largest oil market, the United States.

Granted, conditions could be different in other countries and the supply-demand balance could be looser. But, US oil inventories, production and demand estimates are released weekly by the Energy Information Administration, so the US market is the most timely, visible, and high frequency read we have on the health of the global oil market.

And, so far this year, the pattern in the US oil market looks closer to the OPEC forecast than the more bearish IEA outlook.

Target and Risks

The US Oil Fund tracks US oil futures, rolling from one month’s contract to the next month over a 10 trading day rebalancing period each month, which is outlined on the fund website here.

For example, at the end of 2023, USO tracked the February 2024 WTI futures contract, rolling exposure to the March 2024 futures between January 2, 2024 and January 16, 2024.

The fund will then roll out of the March and into the April 2024 contract starting on February 1^st and ending on February 14, 2024. Unlike the ProShares Ultra Bloomberg Crude Oil ETF (UCO), the USO fund is not leveraged and does not seek to magnify returns in oil futures – simply put, a 1% daily rise in oil prices should translate into a roughly 1% rise in USO.

I have written cautionary articles about commodity exchange traded funds (ETFs)tracking natural gas prices before on Seeking Alpha, including a successful strong sell call on the ProShares Ultra Bloomberg Natural Gas ETF (BOIL) last July and a skeptical piece on the United States Natural Gas Fund (UNG) back in May 2023.

However, natural gas prices are more volatile than the price of oil and the price differences between the front-month and next month contracts tend to be smaller for oil in percentage terms. This helps alleviate the contract roll costs and compounding error risks that plague funds like BOIL and UNG.

In contrast, the USO ETF has done a good job tracking front-month oil futures prices over the past 12 months:

Since the end of December 2022, the price of USO is up slightly more than the generic front-month futures price on a weekly basis. That’s mainly because the generic front-month oil futures contract tracked by Bloomberg rolls on a different date than the USO ETF.

You can clearly see the weekly cumulative price change between oil and USO has tracked closely over time.

Bottom line: Buying USO represents a reasonable way to express a bullish view on oil prices over the short-to-intermediate -erm.

In this article I’ve outlined a bullish case for oil based on the view that speculators are bearish crude (futures commitments are far below the 2-year average) even as the prompt spread and crack spreads suggest demand is healthy.

Moreover, the bearish fundamental narrative for crude centers on the IEA outlook for 2024 where supply exceeds demand and inventories build as a result. However, the early read from US oil inventories is the opposite. Indeed, US oil inventories suggest a tightening in the global supply/demand balance more in-line with OPEC’s bullish estimates.

Should my more constructive case for oil prove correct, oil prices could be expected to retest recent highs over $92/bbl, implying some 20% of price upside from the current level:

This $92.50 to $93.00/bbl level for WTI isn’t just a technical resistance level – there is some rough fundamental backing for a target in that region as well.

According to Bloomberg, IMF estimates Saudi Arabia needs a Brent oil price of $85.80/bbl just to achieve fiscal breakeven – the Saudis need prices around that level to fund all of their government spending needs.

And, of course, Saudi Arabia is the largest oil exporter in the world and the largest producer within OPEC. The country generally sets the tone for the cartel as a whole; for example, over the past year, the Saudis have pledged extra oil production cuts beyond those implied by their OPEC quota to support prices.

Over the intermediate to long-term, I believe Saudi Arabia is likely to target oil prices a comfortable margin above their fiscal breakeven. This would imply Brent oil prices in the mid to upper $90’s and WTI, which normally trades at a discount to Brent of around $5/bbl, in the low $90’s per barrel.

I’d expect a 20% rally in WTI futures to translate into a roughly 20% move higher in USO to the mid-$80s (last year’s intraday peak was near $83).

Of course, there are both upside and downside risks to this call.

On the downside, global oil demand historically drops when there’s a recession such as in the second half of 2008 as I explained earlier in this article. A quick drop in demand can lead to a significant decline in oil prices – oil fell from over $140 in the summer of 2008 to under $40/bbl in December as I outlined earlier.

Per Bloomberg, front-month WTI futures declined from a closing peak of $37.20/bbl in September 2000 to a low of $17.45 in late 2001 with that decline associated with the 2001 recession as defined by the National Bureau of Economic Research.

Also, US oil production could certainly exceed expectations. However, the January 2024 IEA report I outlined earlier is already projecting some 450,000 bbl/day of oil production while OPEC’s estimate is even higher at 600,000 bbl/day.

Meanwhile, US drilling and completion activity is declining:

This chart shows the total oil-directed rig count since the beginning of 2021 as reported by Baker Hughes in blue. The rig count represents the total number of oil rigs actively targeting crude oil in the US.

The orange line shows the total number of fracturing spreads working in the US for both oil and natural gas. Before a shale well is put into production it must be hydraulically fractured – the frac spread count shows the number of crews actively completing shale wells in the US.

The oil-directed rig count peaked at 627 active rigs in late November 2022 and now stands at 499 rigs – this means fewer new wells being drilled.

The frac spread count reached a cycle peak of 300 in November 2022 and now stands around 240 – this means fewer shale wells being completed, fractured, and put into production.

Halliburton (HAL), one of the leading service providers to the US shale industry, reported earnings on January 23rd. The Q&A portion of the conference call, included this exchange:

Analyst Question: Yes, good morning, Jeff, team. Appreciate the time. First question is around — more macro question, which is one of the things that surprised us last year was the exit to — exit of U.S. oil production, which came in above I think where consensus expectations were. You have unique visibility into the U.S. completion and volumes. What do you think happened there? And as we think about 2024, how do you think about exit rate of U.S. growth? Maybe talk about the moving pieces including DUCs?

Answer Halliburton CEO Jeff Miller:

Yes. Look, if I’m thinking about production growth in ’24 production is a function of service intensity. So simply put, more sand, more barrels, and we saw peak levels of service intensity throughout last — really in the first half of last year, and a lot of that comes on in the latter half. And I think, some of this is efficiency in the sense that we are delivering more sand to the reservoir. And that comes in a lot of forms. The e-fleets are part of that, and some of the technology that we’ve brought to market.

But I also think that the market that we see for next year, it’s hard for me to forecast at this point exactly what operators will do, because every operator plays their own game. But at the same time, I would probably take the over on rigs because I think that, we’ll run out of DUCs at some point. I think I would take the under on production only because whatever you think it is, I’ll take the under only because what we see are stable customers delivering to their plans, but what we don’t see is a lot of the smaller companies coming into the market in an effort to really amp up production.

So, I think, from our perspective at Halliburton, very stable market. But from a production standpoint, as we watch it unfold, it’ll be a matter of how much incremental sand gets pumped to overcome what is clearly going to be a decline rate that comes with, when we add barrels rapidly, obviously, they fall off rapidly.

Source: Halliburton Q4 2023 Results and Conference Call January 23, 2024

Simply put, Halliburton was asked about stronger-than-expected US oil production in 2023 and their expectations for 2024.

CEO Jeff Miller’s answer was all about service intensity and the amount of “sand” pumped into wells. This refers to the process of hydraulic fracturing, which involves pumping a mixture of mainly water and sand into a well under pressure to create fractures in the reservoir rock and aid the flow of oil to the well.

Miller noted that the peak of service intensity was in the first half of 2023, but there’s a delay between an increase in fracturing activity and the flow of new production from a well. So, as he said, most of the production related to the H1 2023 surge in activity came in the second half of the year.

He goes on to say that he believes the rig count will be higher than the consensus expects in 2024, while production will be lower than expected.

The reason is drilled uncompleted wells, known by the acronym “DUCs.” These are wells that have been drilled, but not yet fractured and put into production. If a producer has a large inventory of DUCs, they don’t need more drilling rigs to increase production – such a producer can fracture DUCs without using a rig.

However, Halliburton believes the industry is running out of DUCs and will therefore need to drill more wells to maintain production.

The second part of his answer is even more interesting.

In the first half of 2023, a significant portion of drilling activity represented smaller (often private) producers ramping up production, often to increase their value in a potential takeover deal. And there were several high-profile takeovers of private operators last year, including Matador Resources (MTDR) purchase of Advance Energy Partners I profiled on Seeking Alpha back in July.

However, Halliburton now sees larger producers just trying to execute their capital spending plans and the absence of smaller producers trying to “amp up” output.

Faster-than-expected US oil production growth is always a downside risk for crude. However, quantitative data on rig and frac spread counts coupled with qualitative comments from Halliburton suggest that US oil production growth could, if anything, surprise to the downside this year.

All told, my view is that the balance of the risks favor upside for oil prices in early 2024. USO rates a buy with a target in the mid-$80s.