The Fuse

Top Five Oil Market Uncertainties

by Matt Piotrowski | September 04, 2015

  • Why has there been so much volatility lately, and will it continue?

Oil prices rose by more than 25 percent in three sessions (August 27-28, 31) but then sold off sharply and have subsequently remained steady. U.S. West Texas Intermediate (WTI) bounced off its low of just under $39, soared to $49.33 before retreating back to the mid-$40s. Why such wild price swings? Most of it can be attributed to speculative activity and overreactions to dubious headlines.

Going forward, volatility may not be as sharp as it was in the past week or so, but wild fluctuations will be expected as the market tries to find its equilibrium price—if there is one—and reacts to (sometimes scary) macroeconomic news.

The downtrend in prices from late June to late August brought in a large amount of speculators on the short side of the market—those betting on lower prices. Traders on the short side of the market, however, had to buy back the same number and type of contracts that they sold short in order to cover their positions. In covering these short positions all at once, speculative investors led a furious rebound that added new bullish players buying into the rally.

October contract

In other words, the spike was almost entirely technical in nature, with some help from positive developments in the U.S. stock market. There were headlines about force majeure (contract cancellations) in Nigeria, and other talk of cash-strapped OPEC members turning to other producers to cut output, but no significant changes have occurred on the fundamental side. The global market is still swimming in oil. Going forward, volatility may not be as sharp as it was in the past week or so, but wild fluctuations will be expected as the market tries to find its equilibrium price—if there is one—and reacts to (sometimes scary) macroeconomic news.

  •  What exactly is going on with U.S. production?

Even though the market remains glutted, one potentially supportive development has occurred—declining U.S. production. Crude oil output averaged 9.3 million barrels per day in June, according to the latest revised data from the Energy Information Administration (EIA). That was down from the monthly peak of 9.6 mbd in April. So, it’s clear that production fell throughout the second quarter. But what about in the months since? The EIA’s average for the last four weeks is 9.32 mbd, which is mostly flat with June. But the latest four-week average could be too high, given that output has been revised considerably downward. All the figures for the last four weeks, which cover most of August, are likely to be adjusted—but nobody knows by how much.

U.S. output is falling amid the current low price environment, but it’s unclear what the pace of the decline is.

The initial estimates for June showed production at 9.6 mbd, some .3 mbd higher than the revised data, a huge revision. A similar revision could be in store for July and August. The latest weekly numbers from the EIA put output at 9.2 mbd, another indication that U.S. production has indeed taken a hit. The key takeaway from the latest data is that output is falling amid the current low price environment, but it’s unclear what the pace of the decline is.

  •  Will the Saudis cut production even if prices fall to the $20 level?

No. There continues to be talk of emergency OPEC meetings and the cartel putting together plans with other producers to cut output and lift prices. But the key player here is Saudi Arabia, and it has not given any indication that it will throttle back in order to tighten the market. Nor has it given any indication that it is targeting any specific price level. As for now, the lessons of the 1980s, when it cut production but prices still fell and new supply came online, will stay with Saudi Arabia. The Saudis are competing for market share with other members of OPEC, so they would lose out if they cut back on exports. Meanwhile, they also do not want to prop up costly U.S. shale output by taking their own supply off the market. Saudi Arabia, taking the long view, appears poised to ride out the low price environment for as long as necessary as it has a sovereign wealth fund and other investment vehicles and is not strapped for cash.

  • How will China’s demand growth perform with the country undergoing so much economic turmoil?

With China still one of the major demand growth centers, and as the outlet for many OPEC producers along with Russia, any slowdown in the Chinese economy has wide implications for the global oil market and will delay a price recovery.

While it’s clear that China is not the juggernaut it once was, demand growth is not likely to collapse, but the pace of growth will slow.

The country’s stock market has taken major hits, and further stoking worries were Purchasing Managers Index (PMI) numbers, key manufacturing indicators, this week that showed a contraction. Economists have rapidly revised their economic growth estimates for China—for instance, Goldman Sachs reduced its 2016 GDP forecast to 6.4 percent from 6.7 percent. While it’s clear that China is not the juggernaut it once was, demand growth is not likely to collapse, but the pace of growth will slow. Demand in the petrochemical and transportation sectors remain healthy, and China is still in the midst of filling its strategic stockpiles, meaning it needs to import extra barrels of crude. Nonetheless, demand growth is set to fall into next year—both OPEC and the International Energy Agency (IEA) forecast China’s growth to slow by .03-.04 mbd next year to around .33-.35 mbd.

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  • Will the U.S. government lift the ban on crude exports in the coming year?

The EIA’s exhaustive study on the impact of lifting the export ban received a lot of attention this week, and both the Senate and the House will debate repeal in the fall. Although there is momentum to lift the ban, it remains a contentious issue. A bill allowing exports is unlikely to pass through both chambers of Congress and be signed by the president because of voters’ sensitivity to pump prices. The EIA’s conclusions were ambiguous, with the impact of a repeal dependent upon various moving parts, with the agency providing the nebulous assessment: “Effects of removing crude export restrictions depend on price and resource assumptions.” Under the base-case scenario, the agency stated that gasoline prices would be unaffected or fall slightly, while repealing the ban would be, for the most part, neutral for domestic production. The U.S. has loopholes in the law that bans exports, meaning volumes shipped from the U.S. may continue to rise, but will continue to do so under the radar as producers seek to trim down the country’s oversupply. Recent data show that the U.S. exported about .48 mbd of crude during the first half of the year, with most of it headed to Canada, and the Department of Commerce recently approved crude oil swaps with Mexico.

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