(6/15/2015 revision from original article posted on 04/13/2015)
The all Important OPEC meeting finally set the tone for oil prices for the remaining of 2015. In fact, Goldman Sachs published a report titled predicting oil will stay at lower levels for the rest of the decade! “We see potential for OPEC/the US to gain share longer term, even as WTI falls from $60 to $50 by the end of the decade.”
You see, OPEC is determined to maintain market share, and their view is that the best avenue to accomplish this is through lower prices. As to US shale production, this is driven by natural gas producers who believe that the equity markets reward them for growth, and that means production growth. Additionally, this has occurred in the US natural gas sub-sector, as producers have continued to ramp gas production higher on the back of the fracking revolution since 2006 even as gas prices have moved significantly lower.
But what can we expect from oil prices on a short term and long term outlook?
According to Bloomberg, bullish (long positions) in oil futures dropped in May, pointing to evidence that speculators are losing faith in the oil rally as they become more convinced that OPEC will keep increasing supply past their highest level since 2012. Even the International Energy Agency (IEA) has opined that “OPEC’s push to defend its share of the global oil market has just begun and its members may further increase production.” Indeed, Saudi Arabia has increased production to the highest level in at least three decades.
However, the reality of bearish oversupply fundamentals continues to grow as recent data shows global supply 3.2 million b/d higher than a year ago this April. In addition, US production remains elevated as US shale producers continue to grow production and Saudi is determined to maintain their market share. At current prices, OPEC led by Saudi have the most profitable barrels as they are by far the low cost producers. Speculation on oil futures cannot sustain oil prices higher. At best, continued bullish futures activity will keep prices in its current trading band of $50 on the low side to possible $70 per barrel on the high side.
Like any market, the oil market is affected by primary and secondary drivers, which affect price movements.
Primary drivers are market fundamentals such as supply and demand. Their impact is pervasive and long-term in duration. Secondary drivers include currency movements, financial speculation, and geopolitical events. Their influence is generally more short-term; however, they can be significant and volatile in their impact. Often, there are multiple drivers in play that work in opposite directions – some tending to push prices higher and others tending to pull prices lower. Let’s take a look at recent bullish and bearish signals for oil prices.
Bullish Oil Price Signals
The two primary drivers of price (oversupply and flagging demand) are generally pushing toward lower prices; however, certain secondary influences are in play that are at least partially offsetting this trend.
1- Rising Mid-East geopolitical tension: The recent bombing intervention into a deteriorating Yemen by Saudi Arabia and its Mid-East allies is the first time in several months that a geopolitical event has been a catalyst to higher oil prices. This event overrode a bearish oil storage report from the EIA of growing oil inventories, essentially negating market fundamentals of supply and demand on the same day.
2- Financial industry forecasts: A more extensive and volatile secondary influence on oil prices, is oil price futures speculation by financial intermediaries (global banks, hedge funds, traders).
Speculators in oil price futures have increased their long positions since the end of January, as they have bet on prices stabilizing in the $50 per barrel range, and that prices will recover sooner by 2016. Their reasons for a quicker price recovery are the following regulatory and economic perceptions.
- The potential of increasing US fracking regulations that will curb US onshore production and correct a global oversupply situation.
- A possible lifting of the US oil export ban that will push global oil price benchmarks as US WTI and North Sea Brent closer.
- A positive view that the global economy will improve and generate higher global oil demand.
The perception is that these influences will create a floor of support to oil prices in the $40 to $50 per barrel range and allow for a quicker price recovery.
Bearish Oil Price Signals
For every yang there is a ying, and there are certainly factors at work that are tending to pull oil prices further downward:
1- Strength of the US dollar
As we have been following the trend, over the last six months, the US dollar has strengthened relative to the Euro from 0.77 € / 1 US$ to 0.94 € / 1 US$, (or how we see on the forex dance floor, EUR/USD range from 1.39 – 1.04) This secondary influence has pressured oil prices lower, because as we have mentioned before, often time when USD goes up, oil prices go down and vice versa. Although not a perfect correlation, there exists a long-standing inverse relationship between the US dollar and crude prices.
2- Possibility of Iranian oil entering the market from lifting of sanctions
The most significant bearish signal on the oil landscape today is the prospect that the nuclear negotiations with Iran will result in the removal of sanctions and the subsequent unleashing of Iranian oil onto the international market. The prospect of Iranian oil entering an already oversupplied market has raised fears of even lower global oil prices. It is reported that Iran has the capacity to increase its production by 1M b/d, and that it may hold roughly 30M barrels of oil in storage. It is more plausible that Iran may be able to increase production by roughly 500k barrels per day over a three to six month period, and reach 1M b/d over the ensuing twelve months.
The reason for the gradual gain in incremental production is the need to resuscitate wells that have been shut-in or fields that still need to be developed. Additionally, Iran’s ability to increase its production may be limited due to its technical and capital constraints, and the deteriorated condition of its infrastructure. However, if sanctions are removed, and Iran is able to increase its oil production, it would most likely occur several months from now in the midst of the summer driving season when concerns of US oil storage reaching capacity is no longer an issue, and US onshore production growth is slowing. Regarding the pace of Iranian barrels entering the open market, they must be concerned that any sudden or significant increase in oil supply by them in an already oversupplied market would pressure prices lower and reduce their realized revenues. Having said that, it requires that we assume the Iranians are rational in their market thinking.
If Iranian (Shiite controlled) barrels do enter the market, an equally important dynamic into this complex equation is what will be the response from the Sunni regimes of Saudi, Kuwait, and UAE?
Do Saudi Arabia, Kuwait, and UAE maintain, decrease, or increase their production? While the answer is uncertain, sustained elevated production for the Saudis, Kuwait, and UAE, that are currently operating near maximum levels for existing fields and with spare capacity at historically low levels will be a challenge.
3- US Onshore Production
On April 1, the EIA reported that week over week U.S. onshore oil production had declined slightly. This is first time in several months that growth has been arrested. Consequently, despite the high level of resilient US onshore production that has caught many in the market by surprise, the “rate” of US onshore production growth is slowing. The full consequence of slower US production growth will be more apparent by the end of the first half and into the latter half of 2015. In addition, there has been confusion in the market, as investors have not appreciated several key factors, such as the high level of onshore shale production productivity and the amount of financial price hedges in place by producers that delays and softens the immediate impact from lower prices.
If the leveling of production continues , it should have a stabilizing effect on prices. The EIA said on Wednesday that U.S. production declined by 18,000 barrels per day last week, a fall of 0.19 percent.
So What Now?
Putting it all together, we could say that after our expected price recovery, the prices won’t fall significantly further with prices remaining in a trading range of $45 to $65+ per bbl extending into 2016 or even well into the next decade.