One of the most talked-about topics in the past year and a half has been crude oil. It has taken a calamitous drop from around $115 a barrel to about $28 in the space of about 20 months, shedding in the process some $87 or 75% of its value. The plunge has unsurprisingly caused severe financial difficulties for oil exporting countries, which in turn has hurt the value of their stocks, bonds and currencies. But it has also created global disinflationary pressures, causing some economies to fall into deflation. Consequently, it has had a big impact on monetary policy decision of almost all the major central banks, leading to increased volatility in equities and FX markets. But how low can it go? Are we about to see a bottom for oil, or are prices set to stay low for the foreseeable future? Whatever direction crude takes, it will almost certainly have major implications for the wider financial markets.
So, what has caused oil to fall this severely in the first place?
Undoubtedly, the excessive supply of oil has been the main reason for the big drop in its price. The glut first started to build in the US because of the shale revolution there. Companies sold their oil cheaper, causing the Organization of Petroleum Exporting Countries (OPEC) to lose market share. Traditionally, the OPEC had acted as a swing producer; it would cut its oil supply if prices fell sharply and increase production if prices rose meaningfully, as it attempted to keep oil relatively stable at a comfortable level. This strategy had served the oil cartel well in the past – especially its largest member, Saudi Arabia. However, with shale oil booming, the OPEC could no longer control the market like before. If the cartel cut its oil output, U.S. and other shale producers would simply fill the void and increase their market share by selling oil cheaper. So in November 2014, Saudi Arabia resisted calls from poorer members of the OPEC and decided to keep the cartel’s production target unchanged, knowing full well that the market was already oversupplied. It effectively waged war on shale oil producers in an attempt to drive them out of business.
However, this strategy backfired as oil prices fell significantly more and remained low a lot longer than what the Saudis and the OPEC had envisaged. Shale producers proved to be more resilient than initially thought. Although US oil production started to respond in the second half of 2015, the glut nevertheless grew – and not just in the US, but now across the globe. One of the other big worries for investors had been Iran’s full return to the oil market. In July 2015, an agreement was signed between Iran and six world powers to lift its nuclear-related economic sanctions if Tehran completed the steps needed to implement the deal. This deal came into effect in mid-January 2016 after the UN’s atomic agency confirmed it had verified that Iran has significantly reduced its nuclear infrastructure. As a result, Iran is now able to trade freely and can therefore export more oil. Crude’s immediate response to the news was another 5% drop at the open on Monday January 18, which saw Brent trade for a time below $28 a barrel. Although oil prices have since made back some of those losses, they remain entrenched in a well-established bear trend.
What now for oil prices?
Oil’s initial negative reaction to the news regarding Iran was inevitable because it now means there will almost certainly be another increase in the already-excessive global oil supply. However, as most of the news had already been priced in, crude prices have since rebounded back to around $30 a barrel. The full impact on prices of the fresh oil supplies from Iran may be felt when the market knows for sure how much crude Iran will actually produce and what the response from its competitors will be. Iran’s Deputy Oil Minister has reportedly ordered to increase production by 500,000 barrels already. But will the OPEC accommodate for this additional supply by reducing existing output? We have serious doubts about that, especially given the increased tensions between Iran and Saudi Arabia recently. Iran had also claimed previously that it will raise oil production by another 500 thousand to make the total increase a million barrels per day about 6 months after the sanctions were lifted. To do this, Iran may have to sell its oil cheaper in order to attract fresh customers, and this may start a price war within the OPEC.
So, whichever way you look at it, the OPEC supply will almost certainly remain excessively high this year. It is unlikely and it doesn’t make sense for the OPEC to make a U-turn on its strategy with oil prices being this low. Indeed, if oil prices were to stage a significant recovery it will mostly likely happen because of a sharp decrease in non-OPEC supply, or a sudden increase in global demand. Up until now, shale oil producers in the US and elsewhere have remained surprisingly resilient to the significantly lower crude prices. However, Baker Hughes’ rigs data does point to reduced drilling activity in the US after consistent falls in the oil rig counts. But a meaningful reduction in supply may be months away. At the moment, US oil inventories are at record high levels and still rising. So in the short-term, the glut is here to stay. Indeed, the International Energy Agency has warned that the global oil markets could “drown in oversupply,” sending prices even lower. The IEA estimates that while non-OPEC supply is set to drop by 600,000 barrels a day in 2016, Iran could fill that void by the middle of the year. Consequently, the global oil markets may be left with a surplus of 1.5 million barrels a day in the first half of the year.
On the other side of the equation, demand has undoubtedly risen due to the significantly lower oil prices. But the IEA has cut its 2016 estimates for growth in the global oil consumption, in part because of worries about China’s economic health. With economic growth slowing to its lowest since 1990 in the fourth quarter of 2015, demand from the world’s second largest oil consumer could indeed decrease this year if the economy deteriorates further.
Thus, there are still lots of uncertainty about both supply and demand forces and for that reason the near term outlook for oil remains murky. We don’t envisage a sharp recovery in oil prices until at least the second half of the year, when production in the US is likely to fall meaningfully. But we also understand that most of the bad news is already priced in, so the bottom could be very near. Traders may get a better ‘feel’ for the direction of oil prices by analysing the charts instead.
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