The Fuse

Oil Prices Face More Headwinds, Near-Term Rebound Unlikely

by Nick Cunningham | August 21, 2015

Oil prices have sunk to fresh six-year lows, are on their longest losing streak in about thirty years, and the bear market is not over yet.

Oil prices, which have sunk to fresh six-year lows, are on their longest losing streak in about thirty years, and the bear market is not over yet: The coming months offer more threats to the crude market, on top of the ongoing surplus in supply. The main impetus this past week for lower prices was new data released by the U.S. government showing an unexpected build in crude oil stockpiles as a result of higher imports.

West Texas Intermediate (WTI) dropped more than 4 percent, and is now flirting with falling below $40, levels not seen since the depths of the financial crisis in 2008-2009.

Refinery maintenance season

One major factor holding down prices is the looming refinery maintenance period. Refineries in the U.S. have been running at record levels, as stellar margins have prompted refiners to defer routine maintenance and operate flat out. Low crude prices and strong demand for gasoline and other refined products have kept refineries busy this summer.

However, keeping the pedal to the metal has risks, exhibited by the outage at BP’s Whiting refinery in Indiana, the largest refinery in the Midwest. Whiting has the capacity to produce 413,000 barrels per day of refined products, but leaks in piping at the refinery caused BP to unexpectedly shut down the largest of its three distillation units on August 8 in order to make repairs. As much as 120,000 to 140,000 barrels per day of gasoline production has been temporarily lost.

One major factor holding down prices is the looming refinery maintenance period.

Other refineries will also need to soon cut back in order to conduct seasonal upkeep that usually occurs in autumn after peak summer demand. At least six Midwest refineries plan on undergoing maintenance this fall, which could further reduce refining capacity, and in turn undermine oil demand.

The outage at Whiting has inflated refining margins–the sudden drop in capacity has caused prices for gasoline to spike, and refining margins briefly jumped above $50 per barrel, the highest level since September 2008 according to Bloomberg. Margins have since fallen back but remain elevated. Boom times for the downstream sector could tempt other refiners to push off maintenance for a few weeks, but ultimately, the facilities need to eventually go offline.

The pending maintenance season could reduce refining capacity temporarily, leading to growing stockpiles of crude. The drawdown in oil stocks at Cushing, Oklahoma, which has been underway since the spring, could reverse as a result. That, in turn, would further depress crude oil prices.

The Fed and interest rates

Another potential threat to oil prices is the decision by the Federal Reserve to raise interest rates. Commodities of all sorts have boomed over the past decade, but the historic run-up in prices ended in a spectacular bust in 2014, with many commodities—including crude oil—still searching for a bottom. The Federal Reserve has hinted that after almost a decade with interest rates near zero, it would finally begin to slowly raise rates beginning in September.

Any Fed rate hike could exacerbate the commodity bust: Raising interest rates will strengthen the U.S. dollar, which has already appreciated against a variety of currencies this year.

Any Fed rate hike could exacerbate the commodity bust: Raising interest rates will strengthen the U.S. dollar, which has already appreciated against a variety of currencies this year. A stronger greenback will depress demand for dollar-denominated commodities, as products such as crude oil suddenly become more expensive for non-dollar countries.

To make matters worse, emerging markets, which have been a large source of global economic growth in the years since the 2008-2009 global recession, are running into trouble. The slump in commodity prices, cracks in the Chinese economy, and a stronger dollar are raising concerns for the economies of emerging markets. Almost $1 trillion of net capital has flowed out from the 19 largest emerging markets over the past year, nearly double the volume that fled during the financial crisis. Fed action will only keep this trend in place by strengthening the dollar.

In other words, an increase in interest rates could depress demand, putting downward pressure on oil prices.

Ironically, it was the massive monetary expansion on behalf of the Fed from 2008-2014 that contributed to higher production, which in turn punctured prices last year. Low interest rates brought down the cost of borrowing for drillers across the world. Moreover, for big investors scrambling for yield, pumping up oil companies with debt was an attractive investment. As a result, many wells were drilled that might otherwise not have been possible if interest rates were higher. The outcome was a rapid expansion of crude oil production, which inevitably led to the collapse in prices.

But low oil prices—as well as low prices for other commodities—puts the Fed in a bind. Cheap energy has kept a lid on inflation, which undermines the Fed’s case for a rate increase. So while low interest rates fueled the oil production boom, persistently low oil prices seemingly justify keeping rates low.

Moreover, jacking up rates could push struggling oil companies deeper into distressed territory.

Moreover, jacking up rates could push struggling oil companies deeper into distressed territory. Energy companies account for 14 percent of the high-yield bond market, a jump from 5 percent a decade ago. If interest rates rise, the markets will shift money away from distressed companies to other investments that have suddenly become more attractive. This trend could cut off a financial lifeline to embattled drillers in the oil patch, leading to more defaults.

Causing panic in high-yield markets might be something that the Fed takes into consideration as it weighs a rate increase. With inflation not an immediate problem, the central bank may delay the tightening of monetary policy. However, should the Fed ignore these factors and stick to its original plan of a rate increase in September, oil prices could struggle to rebound, at least in the near term.

Supply and demand

Of course, refining utilization and interest rates a mere sideshow to the fundamentals of oil supply and demand. And there is little in this area to support prices.

In its August Oil Market Report, the International Energy Agency (IEA) estimated that global oil production will exceed demand by 1.4 million barrels per day in the second half of 2015, and with the supply overhang not correcting itself until likely late 2016, oil prices could stay “lower for longer,” the Paris-based energy agency concluded.

The longer-term picture looks tighter. With the global oil industry shying away from developing major new fields with prices so low, decline rates coupled with rising demand will likely erase the glut, and could eventually cause prices to rally in dramatic fashion. But in the meantime, there is little reason to think oil prices will rebound in the near future.

ADD A COMMENT