The Fuse

Oil Market Scenarios: Up, Down or Sideways?

by Matt Piotrowski | July 24, 2015

The oil market is shrouded in bearish sentiment at the moment as prices continue to trend downward, with Nymex West Texas Intermediate (WTI) falling from around $61 per barrel in the middle of June to $48. The supply glut persists amid high OPEC output, the possibility of Iran increasing exports, and U.S. production holding steady. Continued pressure to the downside appears likely—but not inevitable.

Below are three possible oil market scenarios:

The bear case: The likelihood of $30 oil

The case for weaker prices through the end of this year and into next stems from developments on both the supply and demand sides, with a stronger dollar also undermining prices. OPEC is pumping close to 32 mbd, about 2 mbd above its target, as its members compete for market share and the group’s de facto leader, Saudi Arabia, won’t throttle back to shore up prices. In the lower-price scenario, Saudi Arabia continues to increase production in order to hold onto its share in the increasingly competitive Asian market, while at the same time, Iran sells from its roughly 40 million barrels in floating storage. Iraq also pumps as much as it can, surging to 4 mbd, from about 3.5 mbd at the beginning of the year, despite the Islamic State still wreaking havoc in the country. There’s also the optimistic chance that Iran lifts its production by about 1 mbd in the next year or so.

The case for weaker prices through the end of this year and into next stems from developments on both the supply and demand sides, with a stronger dollar also undermining prices. OPEC is pumping close to 32 mbd, as its members compete for market share and the group’s de facto leader, Saudi Arabia, won’t throttle back to shore up prices.

While OPEC production continues on its upward trajectory, U.S. crude output stays steady around 9.6 mbd, the level it’s been since mid-May, and inventories remain near records, particularly those at Cushing, Oklahoma, the pricing point for WTI. In this scenario, other non-OPEC producers, such as Canada, Brazil, Russia and China, also increase output throughout the rest of this year despite the difficult price environment, further reinforcing the bear market.

“The real story in oil … is supply,” said Goldman Sachs analysts in a research note on Friday. “Low cost supply from producers such as Saudi Arabia, Russia, and Iraq has been reported by JODI [The Joint Organisations Data Initiative] to have surged by 500 thousand bd last month …. This is entirely consistent with our view that such producers should shift towards a strategy of max capacity utilization and capacity growth given the New Oil Order.”

Inventory levels are not just high in the US, but throughout the world. OECD commercial stocks for crude and products hit a record 2.876 billion barrels at the end of the May, with the build being an “astonishing” 3.3 mbd in the second quarter, according to the International Energy Agency (IEA).

It will take some time and higher-than-expected demand to slim down the amount of crude being held in tanks, but demand may in fact underperform. The IEA says it sees global oil demand growing by 1.2 mbd next year, which is some 0.2 mbd slower than growth for 2015. There are a number of risks that could cause growth to be even lower. Although fears of Greece posing a systemic risk to the global economy appear to have faded, high debt levels in Europe should choke growth there. China’s stock market has stabilized after its government took emergency measures, but the country’s growth of 7 percent could portend weaker oil consumption and take away a main pillar of support for prices.

The bear case is further reinforced by the stronger U.S. dollar, which has caused hedge funds and other financial players to sell positions in the WTI crude futures market. “The decline over the last month is mainly from the exodus of major hedge funds,” said Carl Larry, an oil trading consultant with Frost & Sullivan. “The dollar is the more attractive investment, particularly with the possibility of higher interest rates.”

With the Federal Reserve likely to hike interest rates this fall, the dollar may strengthen some more, keeping these market players out of oil. The $33.87 level is a key target for traders, a very likely one now, as that was WTI’s lowest close when prices collapsed in 2008-9.

The case for staying range-bound in the $50-$60 neighborhood

The market may have hit a sweet spot recently with prices mostly in the $50-$60 range, although WTI did fall under $50 this past week. Brent is holding somewhat higher around $55. A number of analysts see the market stabilizing in the coming months with supply and demand rebalancing as a reaction to the price fall. “There is a realization that the market is not going to go much higher right now,” said Larry.

The main factor behind making a case for the market remaining range-bound is U.S. shale output becoming stable.

The main factor behind making a case for the market remaining range-bound is U.S. shale output becoming stable. The explosive growth in shale production over the past few years has been cited as the main factor behind the price fall from $115 last June to current levels in the $50s. The lower oil price environment has kept US shale output from growing, but it’s not collapsing either. U.S. production is essentially holding steady—the glut will not likely get bigger from now on, but there’s so much oil in storage that tightness and another price spike are not likely in the short to medium term.

While more Iranian volumes hitting the market certainly appears bearish at face value, traders have likely already priced in rising exports as Tehran’s deal with world powers had been anticipated for some time. The market is presently so oversupplied that some more barrels leaking from Iran won’t have much effect.

In the meantime, high Saudi volumes are not as supportive for oil prices as they first appear. Saudi Arabia is now pumping more than 10.6 mbd (or even higher), a record, but its exports have been on the decline, falling to under 7 mbd in May. Robust production is in large part because of high domestic demand during the summer as the country needs to use crude for increased power demand. Once summer is over, the Saudis may in fact lower their total crude output.

On the demand side, the global growth rate may ease from this year, but it is still holding up and may very well remain steady moving forward, finding some support from the U.S., where consumption has risen, partly from more driving due to lower prices. In Europe and China, economic headwinds may cap growth but not cause any collapse in demand similar to 2008.

The bullish case for oil

Is there a bullish case for oil? Of course, even though not many market observers are embracing this scenario right now. A sharp rally is not out of the question, but figuring out the timing is tricky. The fall in prices over the past year caught a lot in the industry off-guard and has impacted investment, particularly in high-cost shale plays in the U.S. As a result, the weak price environment risks bringing about underinvestment and ultimately higher prices down the road. Capital for small independent producers, the backbone of the shale revolution, could dry up, forcing even more rigs to idle and output to fall.

The fall in prices over the past year caught a lot in the industry off-guard and has impacted investment, particularly in high-cost shale plays in the U.S. As a result, the weak price environment risks bringing about underinvestment and ultimately higher prices down the road.

At the same time, Iran’s exports may not increase as quickly as some expect. Iran’s production is currently right under 2.9 mbd, and Iran’s oil minister Bijan Namdar Zanganeh said the country’s output could rise to 4 mbd seven months after sanctions are lifted. But years of underinvestment in the country’s oil sector have likely taken a toll and should slow any ramp-up. It’s important to remember that Iran’s output had been declining even before crippling sanctions were imposed by the United States and the European Union. Iran’s production peaked at 6 mbd in the 1970s, but had fallen to the 4 mbd level by earlier this decade.

Elsewhere in OPEC, Libya’s production, now hovering at 0.5 mbd, is still around 1 mbd below its full capacity, a situation that doesn’t look to turn around anytime soon given ongoing conflict between rival factions. “It’s difficult to make forecasts for the country because it is falling apart,” said Davide Tabarelli of Nomisma Energia in Bologna. “Things couldn’t be worse, but there probably won’t be much improvement in oil production until 2017 or 2018.”

The Saudis, meanwhile, could quietly cut back on exports, while the Islamic State might wreak more havoc in Iraq and undermine that country’s growth. This situation would occur against the backdrop of thin global spare production capacity, all concentrated in Saudi Arabia, which does not provide much of a cushion if there are unexpected outages.

On the demand side, growth could overperform, and in fact, there are signs of that right now. In the U.S., for instance, demand has crept back above 20 mbd, up by more than 3 percent year-on-year, after averaging around mostly 19 mbd to 19.5 mbd for the first half of this year. It’s clear that lower oil prices have stimulated more driving among U.S. consumers. Elsewhere, the lower price environment is helping consumer economies weather any economic turbulence, making it more realistic that demand can at least meet the IEA’s expectation of growth of 1.4 mbd for this year, and 1.2 mbd for next.

If this convergence of factors comes together to lift prices out of their current range and shift sentiment, hedge funds and other investors could jump back into the oil market and help accelerate any rally. Then, the bull case would be realized.

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