The Fuse

What’s Weighing Down Oil Prices?

by Leslie Hayward | July 07, 2015

nymex

Crude oil prices have dropped to their lowest level since early April, as the crisis in Greece and the likelihood of sluggish Chinese growth dampen the global demand outlook. West Texas Intermediate crude flirted with a drop below $50 per barrel Tuesday morning, before recovering somewhat in the afternoon. But temporary stability doesn’t mean prices don’t have further to fall—right now, numerous economic and geopolitical factors are putting downward pressure on price, and few are likely to be resolved in the near term.

With so many factors pulling down crude oil prices, some traders are commenting that there’s no telling where the bottom might be.

On the supply side, the first uptick in the U.S. oil directed rig count since it began collapsing in December 2014 reflects the overall resilience of U.S. shale producers. Ongoing talks between the P5+1 and Iran are also casting a long shadow over markets: In addition to Iran’s promises to double oil exports immediately after sanctions are lifted, the country’s massive floating storage is looming as officials insist it will be sold off “at any price.” With so many factors pulling down prices, some traders are commenting that there’s no telling where the bottom might be.

Greece and Market Uncertainty

Right now, there are three possible scenarios for Greece and the Eurozone: Some kind of debt relief package, a structured default within the Eurozone, and, of course, an exit. None of these three scenarios have any real upside implications for oil prices, but the possibility of an exit—growing more likely by the day—has significant potential to drive a further selloff.

There is the question of why a country like Greece, which is neither a major producer nor consumer of oil, has any meaningful impact on oil prices. It all comes down to uncertainty.

Naturally, there is the question of why a country like Greece, which is neither a major producer nor consumer of oil, has any meaningful impact on oil prices. There are a few reasons which all boil down to one thing: Uncertainty. Whether Greece stays within the Eurozone or not, the current situation is relatively new economic territory, with unknown implications for the economic health of countries that have adopted the Euro. Europe’s sluggish growth following the financial crisis has been a critical factor dragging down global oil demand growth over the past five years, and poorer Eurozone countries like Greece have played a significant role in that dynamic. At the same time, if Greece does truly leave the Euro, it creates an escape route for the other European countries that are struggling with austerity measures imposed under the common currency (the PIGS: Portugal, Italy, Greece, and Spain). While an isolated Greek exit may not have sweeping implications throughout the region, the other countries in this group are more integrated with the rest of Europe, and a “Grexit” sets a destabilizing precedent.

Another factor is that to the extent that Greece’s crisis spells further weakness of the Euro against the dollar, oil imports are more expensive by comparison for European countries, which can put some downward pressure on European demand. In general, commodity prices tend to move in the opposite direction of the strength of the dollar. That said, for European consumers, this impact is less noticeable because of the heavy tax burdens imposed on retail fuel.

“The Great Fall of China”

According to Bloomberg, this month China’s Shanghai Composite index completed its biggest three-week tumble since 1992. The rout in Chinese shares has erased at least $3.2 trillion in value, or twice the size of India’s entire stock market. China is the world’s number one materials consumer, thus, tanking Chinese stocks have wide-ranging implications for commodities markets, especially oil. In June’s Oil Market Report, IEA noted that Chinese oil demand growth was stronger than anticipated, up .5 mbd year over year. IEA could revise this assessment when July’s OMR comes out in a few days. In the meantime, CitiBank and Deutsche Bank see that Chinese markets have further to fall, but China’s workaround is to suspend the stocks of the index from being traded at all—with $1.5 trillion in shares currently frozen. According to Business Insider, this could mean more pain for commodity prices across the board.

Iran: Barrels at Sea

Iran oil company map

Iran and the P5+1 missed the initial deadline to finalize a deal to lift sanctions on Iran’s oil exports, and now have until Thursday of this week to complete negotiations. However, there is general certainty that an agreement will be reached, and the country is almost finished preparing new contract terms for international oil companies hoping to return to its vast conventional reserves. As we noted in this space last week, despite bullish rhetoric from Iran’s leadership, there are no shortage of short and long-term obstacles to Iran’s oil production outlook. Realistically, Rapidan Group estimates that a deal will allow Iran to sell an additional .2 mbd of crude for the remainder of 2015, building to .5-.7 mbd by mid-2016.

Although a gush of new production is unrealistic in the near-term, Iran has been storing some 40 million barrels of oil in super tankers at sea, which it is looking to sell at extremely short notice.

However, in an already oversupplied market, even an incremental increase of supply from Iran has a meaningful psychological impact. Furthermore, although a gush of new production is unrealistic in the near-term, Iran has been storing some 40 million barrels of oil in super tankers at sea, which it is looking to sell at extremely short notice. Mehdi Varzi, a former official at the state-run National Iranian Oil Co told Reuters, “The first thing they will try and do is offload quite a lot of that storage. (Oil Minister Bijan) Zanganeh has already warned OPEC: Make room for us. In other words, we are going to sell this oil at any price.” Both of these factors—the floating storage, and the psychological impact of lifted sanctions—will continue pushing prices down.

Shale Power

RIG COUNT OMG

Finally, there’s the fact that the U.S. oil directed rig count saw an uptick last week for the first time since they began their precipitous drop last December. According the Baker Hughes, the oilfield service company that reports the data, oil directed rigs increased by twelve overall in the week ending July 3. Broken down by the three major plays, the Bakken shale added two rigs last week, the Permian added one, while Eagle Ford arguably led the recovery with three. Other slight gains were added in the Woodford, Utica, Niobrara, and “uncategorized” shale formations.

crude oil production forecast

Shale oil production has already proven highly resilient, holding strong against the downturn in both the rig count and oil prices themselves.

Generally, shale oil production has already proven highly resilient, holding strong against the downturn in both the rig count and oil prices themselves. While oil directed rigs have fallen 60 percent since their highs last year, crude oil production in the lower 48 states (excluding the Gulf of Mexico) has dropped by only .25 mbd—a decline of 3.2 percent. EIA expects production to fall by less than 1 mbd total before recovering in the beginning of next year. The twelve rigs that came online last week obviously don’t represent any meaningful changes in supply, or even that U.S. production is about to begin increasing again. However, they do send a market signal that shale oil producers are willing to continue drilling even when prices are at or below $60 per barrel.

This signal, combined with the other pressures discussed here, alongside the fact that OPEC production is at the highest level since 2012, are all reasons to expect further oil price declines in the second half of the year.