The Fuse

Six Reasons to be Bearish on Oil; Six Reasons to be Bullish

by Matt Piotrowski | November 18, 2015

Oil prices are back on the defensive, with U.S. West Texas Intermediate falling briefly below $40 on Wednesday and Brent trading down to $43. Despite the recent dip, prices have generally held in the $40-$50 range in recent months. Even with relative stability, the market is wading through a lot of uncertainty. Will the supply response from low prices cause the market to rebound? Have prices found a new equilibrium in the $40 range? With inventories so high, could prices actually have further to fall?

With so many mixed opinions and divergent forecasts in the oil market, here are factors that could push prices either way.

Six reasons for a bear oil market in 2016:

  • Commercial inventories. Global commercial stocks for crude oil and products grew by an enormous 1 million barrels per day for the first three quarters of this year. In the OECD, inventories are now at more than 200 million barrels above the five-year average, according to OPEC. With supply remaining ahead of demand during the current quarter, inventories should still grow further before any stock draws occur. The world is running out of tank space, but the steep contango provides financial incentive for floating storage—the expensive practice of storing crude on supertankers. In order for the oil price to rebound, the market needs to work its way through the large volumes sitting in tanks and at sea, which will take time.

In order for the oil price to rebound, the market needs to work its way through the large volumes sitting in tanks and at sea.

  • U.S. shale has not collapsed. Total U.S. crude output averaged 9.32 mbd in September, down only .274 mbd, or 2.8 percent, from the peak in April, according to the latest revised data from the Energy Information Administration (EIA). With prices remaining low, high-cost U.S. shale will undoubtedly decline, but it will likely be a gradual tapering rather than a steep drop. This will slow any rebalancing of the market.
  • Iran increasing supply. The global oil market is eagerly anticipating Iran’s ramp-up of production next year once sanctions are lifted. Tehran says it can bring .5 mbd back onto the market in 2016. The increase will be gradual, but it will be sold into an already oversupplied market. In order to regain market share, Iran will have to sweeten its terms by offering large discounts—a development that could weigh on global prices. Iran’s oil minister said the country will increase production next year even if prices are in the $30s.
  • OPEC’s competition for market share. Saudi Arabia’s decision to defend market share instead of cutting output to shore up prices set off fierce competition for Asian customers. Middle East OPEC exporters, West African producers, and Russia are all trying to sell into the high-growth Asian market. The Saudis are also trying to undercut the Russians in Europe. This competition should become even fiercer when Iran increases its volumes, possibly putting further downward pressure on prices, or at least keeping them in check. OPEC is now producing around 31.76 mbd, according to the International Energy Agency (IEA), some .46 mbd above the call on its crude for next year. Against this backdrop, the surplus could persist through the end of 2016.

The competition for market share should become even fiercer when Iran increases its volumes, possibly putting further downward pressure on prices.

  • Demand growth underperforming. The IEA pegs global oil demand growth at 1.2 mbd for 2016. While this is a meaningful increase, it is .6 mbd lower than current estimates for 2015. Global demand could also underperform IEA’s 1.2 mbd estimate. There are a variety of risks to growth, including China’s economy slowing down, possible economic fallout in Europe following the Paris attacks, and oil-producing countries seeing slowdowns amid budget pressures. Pessimism on the demand side coupled with non-OPEC supply remaining resilient could keep prices in the current range, or even push them lower.

Oil price speculators have accumulated the largest number of bearish bets since August.

  • A stronger U.S. dollar. The U.S. dollar index has risen by roughly 5 percent in the past month or so, another factor besides the oversupply that is weighing on prices. The dollar has an inverse correlation with crude prices—the dollar’s value affects purchasing power for importing countries and impacts revenues for exporters, while a stronger dollar typically prompts speculative traders to sell oil futures and other commodities and buy more of the greenback. Oil price speculators have accumulated the largest number of bearish bets since August. If the Fed raises interest rates in December and the dollar continues to strengthen, oil prices could fall further.

Six reasons for a bull oil market in 2016:

  • Falling non-OPEC supply. Although non-OPEC supply has been resistant, most forecasts see it falling in 2016. This is a stark turnaround from the trends in recent years, when rising non-OPEC supply more than offset increases in demand. High-cost shale production is likely to take the biggest hits, but output in the North Sea, Russia, and Brazil may also see declines. Overall, the drop in upstream investment as a result of the price collapse is almost certain to tighten the market at some point.

The drop in upstream investment as a result of the price collapse is almost certain to tighten the market at some point.

  • Geopolitical risk/low OPEC spare capacity. With numerous conflicts in the Middle East, geopolitical risk abounds. The recent Paris attacks by Islamic militants and the subsequent increase in air strikes on Syria reflect heightened tension in the region. Besides Syria, Yemen, Libya and Iraq are all experiencing ongoing turmoil. While OPEC is pumping near record levels, there are still a large number of outages in the MENA region. If the market tightens, limited spare capacity of just above 1 mbd—all concentrated in Saudi Arabia—becomes more worrisome.
  • Economic growth/demand overperforming. In the U.S., demand has responded to the low price environment and performed better than expected. OECD demand, in all, is poised to be positive this year, rising by about .5 mbd. While many estimates don’t see continued increases in 2016, low oil prices are stimulating economic growth and consumption, and may bring about higher-than-expected demand. In China, a surge of gasoline demand has occurred despite a slowing economy, while India is still seeing blistering growth. While the Asian juggernauts are also expected to slow, the need for oil in transport and the petrochemical sector will remain high, possibly even stronger than originally envisaged.

Strategic stockpiling can help mop up some of the global surplus and put a floor under the market.

  • China and India strategic stockpiling. China is importing a large amount of crude in order to fill its strategic petroleum reserve (SPR). By some estimates, roughly .4 mbd or higher is being sent into its stockpiles. By 2020, the tanks will hold 500 million bbl of oil. This means the aggressive buying from the Chinese government will continue, particularly as it takes advantage of the low oil price environment. In India, the country began phase one of building its SPR this year, and has the budget to continue filling it in 2016. This buying can help mop up some of the global surplus and put a floor under the market. With tighter fundamentals, strategic buying becomes a key bullish factor.
  • OPEC eventually throttles back. As of now, it does not appear OPEC will cut based on Saudi Arabia’s resolve to fight for market share. However, some Middle East experts see OPEC members coming to an agreement to manage supply levels in 2016 to allow for Iran’s increase in volumes and to boost prices. Many of the group members are under stress because of high breakeven prices, which could force a rethink of their current strategy if the oversupply worsens and the price fails to rise.

A large wave of buying among investors would likely cause an accelerated price rise.

  • Speculators make bets on higher prices. A confluence of tighter fundamentals, a strong macroeconomic backdrop, growing geopolitical instability, and a shift in sentiment could spur speculative money to make bullish bets on oil. Speculative players tend to have a herd mentality, so if and when they see the market bottoming out, they may start betting on higher prices. A large wave of buying among investors would likely cause an accelerated price rise. Moreover, those who are shorting the market (betting on lower prices) would have to cover their positions, also contributing to a sharp price rise. At that point, oil prices would be off to the races.

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