The Fuse

All Is Bearish in the Oil Markets to Start 2016

by Matt Piotrowski | January 07, 2016

Oil prices have plummeted in the first week of 2016, and it’s hard to identify anything likely to turn the market around in the near future.

Oil prices have plummeted in the first week of 2016, and it’s hard to identify anything likely to turn the market around in the near future. In the first trading week of 2016, Atlantic basin benchmarks fell to the low $30s, while the OPEC basket price plunged below $30 and some Canadian crudes dropped under $20. Physical fundamentals, geopolitical chaos, and macroeconomic trends all conspired to push prices to levels not seen in more than a decade. As of now, there is nothing bullish in the oil markets. Things could change by early 2017, but right now oil producers are bracing for the possibility of even lower prices, while consumers cheer their windfall cost savings.

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Last year, investment bank Goldman Sachs predicted oil prices could approach $20, a scenario which came under heavy criticism at the time, but one that appears to be a real possibility right now. U.S. West Texas Intermediate (WTI) is, in fact, off to its worst start to a year in history, after falling by more than 12 percent in the first three trading sessions.

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Physical fundamentals are sloppy

Fundamentals are imbalanced, and don’t appear to be shifting yet, despite some analysts suggesting supply and demand would tighten this year. U.S. crude inventories remain near record levels, the country’s output has retreated, but not collapsed, and is holding around 9.2 million barrels per day, global tanks are brimming, OPEC is pumping at very high levels, and demand growth—despite being healthy—is in danger amid economic uncertainty.

With OPEC unwilling to cut output to shore up prices, non-OPEC supply, and particularly U.S. shale, is the key for any rebalancing to occur. But so far, U.S. production has held up better than expected.

With OPEC unwilling to cut output to shore up prices, non-OPEC supply, and particularly U.S. shale, is the key for any rebalancing to occur. But so far, U.S. production has held up better than expected. For instance, the latest revised monthly data from the Energy Information Administration (EIA) show output at 9.35 mbd for October, down by only 0.35 mbd from April’s peak. U.S. supply is expected to continue to fall, with some cash-strapped oil companies going into bankruptcy this year, but the pace will likely be slow. Even with producers under pressure from low prices, the EIA sees non-OPEC supply falling only 0.36 mbd this year, while OECD commercial inventories are poised to rise based on the agency’s estimates. Against that backdrop, the market may not rebalance until 2017.

In the meantime, OPEC production is expected to rise in the first quarter, with Iran to start increasing export volumes pending the lifting of economic sanctions. This bump in output will occur alongside Saudi Arabia continuing to produce close to all-out and Iraq boosting exports despite war-torn conditions. The EIA pegs OPEC output this year to increase by 0.31 mbd, an eye-opening number in light of the low price environment.

It’s not just the crude market that’s seeing a glut. Refined products are also experiencing weakness due to excess supply. In the U.S., for instance, inventories of distillate fuel (diesel and heating oil) ended 2015 some 16 percent higher than the beginning of the year. Meanwhile, gasoline stocks shot up by about 15 million barrels throughout December. Demand has received a lift from lower prices, but growth will not be enough to mop up the excess product supply, given that refiners are running at a blistering 92.5 percent utilization and show no signs of slowing down.

Geopolitical unrest fails to lift prices

There’s so much supply in the global oil market that geopolitical events that would normally cause oil prices to skyrocket are going unnoticed or are considered bearish. Growing tensions in the Middle East, even a conflict between two major oil producers, can’t prop up prices under crude’s massive overhang. In Libya this week, extremist group the Islamic State attacked the country’s eastern oil ports with virtually no impact on prices. Libya has been producing roughly 1 mbd below capacity for a while now, and the market has already adjusted to the low Libyan volumes.

There’s so much supply in the global oil market that geopolitical events that would normally cause oil prices to skyrocket are going unnoticed or are considered bearish.

On the first trading day of the year, the market rallied slightly on news of collapsing relations between Saudi Arabia and Iran after the Saudis executed a prominent Shia cleric and protesters in Tehran stormed the Saudi embassy. The conflict is unlikely to lead to direct confrontation between the two, and their hostility toward each other sets up a fiercer struggle for oil market share, which could ultimately lead to lower prices. In the short term, there will likely be more oil from the Saudis and Iranians, not less. Saudi Arabia, for instance, sharply cut its prices for its crude to Europe in order to undercut Iran’s attempt to regain customers in that market. The tension between the two, which stepped up on Thursday with the Saudis allegedly hitting Iran’s embassy in Yemen with airstrikes, undermines any possibility OPEC members will cooperate this year to take action to shore up prices.

Macroeconomics, China big wild cards

Perhaps the biggest factor affecting sentiment so far this year has been the market crash in China, where authorities have had to halt trading twice since January 1 to stem losses.

Perhaps the biggest factor affecting sentiment so far this year has been the market crash in China, where authorities have had to halt trading twice since January 1 to stem losses. The fallout from China has spread to Europe and the U.S., where the S&P 500 has dropped by about 5 percent so far this year. The U.S. market has also taken a hit from lower oil prices, which have undermined majors such as Exxon and Chevron. Low prices are a boon for consumers, but the current oil market environment has spooked equities and is hollowing out the energy sector, which has been a key factor in the United States’ recovery from the Great Recession of 2008-09.

All this macroeconomic turmoil brings about a cloud of uncertainty surrounding oil demand growth, which is also a major factor in rebalancing fundamentals. Most of China’s demand growth is expected to come from the transportation sector, which will be less affected by the economic slowdown. However, the weaker economic growth has a potential to be a drag on oil demand.

“Low prices are not having the effect on production as in the past. There needs to be massive growth in demand to find a balance, but now that is being called into question, particularly because of the slowing Chinese economy,” Brian Milne, energy editor with Schneider Electric, told The Fuse.

Forecasts from the EIA, OPEC and the International Energy Agency (IEA), based upon their reports released in December, all see global oil demand rising between 1.2 mbd to 1.4 mbd for this year, but those outlooks may be revised downward given the economic insecurity seen so far.

“Is there anything to move the market higher? There are so many moving parts in the oil market. If the Middle East deteriorates further, the calculus could change. But right now, we’re in a new environment.”

Market psychology is so weak that speculators have amassed a large number of bearish positions, totaling some 348 million barrels of oil. Speculative positions will be a key to watch to look for a change in sentiment, but investors aren’t likely to change course in the short term given the confluence of bearish factors, both fundamental and financial, including a stronger U.S. dollar. Bloomberg reported last month that some speculators were placing bets with options contracts for $15.

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The current prices levels are likely unsustainable, given that supply will eventually take bigger hits and lost investment in future production poses the risk of possible shortfalls in meeting demand growth down the road. But it’s getting harder and harder to figure out when the inflection point will arrive.

“Is there anything to move the market higher? There are so many moving parts in the oil market. If the Middle East deteriorates further, the calculus could change,” said Milne. “But right now, we’re in a new environment.”