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Midweek Sector Update: Near-Term Forces Could Push Oil Prices Lower

Midweek Sector Update: Near-Term Forces Could Push Oil Prices Lower

The British government said over the weekend that it would support airstrikes in Syria, targeting Islamic State militants. And the French government has made similar statements. Despite the noteworthy headlines, the international coalition confronting IS has already targeted the group in Iraq, and without new military commitments, the announcement does not appear to amount to a significant strategy shift.

However, due to the outcries over the swelling refugee crisis, in which growing numbers of refugees are arriving on European shores, the governments of Western Europe are scrambling to respond. Many European governments have announced plans to take in more refugees, amid mounting international media attention, but the crisis has illustrated very starkly the failure of the international community to address the source of the problem – in Syria and Iraq. As it stands, it does not appear that the conflict will affect the oil markets in the near-term.

Meanwhile, the North Sea oil industry is facing an existential crisis. Low oil prices have forced spending cuts and contraction across the world, but the offshore oil and gas fields in the North Sea are some of the world’s costliest. Mature fields have been in decline for years, and companies have to constantly invest capital to keep the decline merely at a slow pace, rather than a precipitous one. However, persistently low oil prices could send the North Sea oil and gas industry into a sort of death spiral. According to the FT, the North Sea is at “serious risk” of shutting down. Related: The Biggest Red Herring In U.S. Shale

The problem is that many companies share certain infrastructure, so when one company shuts down its operations and pulls out, that leaves the cost of maintaining collective infrastructure (such as pipelines or processing facilities) much greater for the companies that remain. As such, the more fields that are shut down, the greater the pressure on existing operators to leave the region as well. The British government has tried to help the industry through lower taxes, but it may not be enough. More companies are clamoring for the exits. Royal Dutch Shell (NYSE: RDS.A) announced this summer that it would shrink its footprint in the North Sea. Total (NYSE: TOT) announced in August that it would sell $900 million worth of North Sea assets in order to raise cash. Greater cooperation between companies could slow the decline, an industry trade group says. For example, companies could share data on dry wells. However, such cooperation is foreign to operators who are so used to competing, and salvaging the region as a major source of oil and gas production appears increasingly difficult.

With that said, the North Sea could see its highest level of oil production since 2012, as new projects that were planned years ago finally come online, according to Bloomberg. Shipments of several North Sea blends could hit 2.1 million barrels per day, and the elevated production could exacerbate the global supply glut. The uptick in output does not alter the long-term picture of decline for the North Sea, but it will keep oil prices low in the near-term. Moreover, Nigeria and Angola are producing at high levels, leading to a surplus of supplies in the Atlantic basin. This could push oil prices downward in the coming weeks. Related: U.S. Gasoline Prices Could Stay Low For The Time Being

Moreover, to make matters worse, there are several other short-term trends that could keep oil prices from rallying. First, peak driving season in the United States has now ended, which could cause demand to flatten out a bit. Also, U.S. refiners are entering maintenance season, which could reduce demand for crude oil.

The physical market for crude oil continues to show weakness, but in the financial markets, prices continue to experience extreme volatility. Oil traders shifted their positions significantly in recent weeks, covering their short positions after oil prices tanked to six year lows. According to the U.S. Commodity Futures Trading Commission, oil traders slashed short positions by 21,009 contracts last week, or 13 percent. That is the sharpest cut in short positions since May, and a sign that speculators think the selloff went far enough.

However, there are still a large preponderance of short positions left in the market, which suggests a few things. First, money managers are still pessimistic about oil markets, and as mentioned above, there are good reasons to come to that conclusion. On the other hand, a stronger rally could be in order if more short positions are liquidated in the weeks and months ahead. Traders covering their short positions was the main cause of the massive three-day rally at the end of August. With a large degree of short positions still outstanding, there is more room for oil prices on the upside. Related: Two Big Oil And Gas Finds In Unexpected Places

But a lot of damage to the oil industry has been done. For some of the least efficient drillers, cash flows never covered expenditures, even when oil prices were high. With oil prices much lower, deficits have ballooned across the industry. According to the FT, the U.S. shale industry ran a $32 billion deficit in the first half of 2015, more or less equal to the total for the entire year of 2014. Earlier this year bond and equity markets remained opened for indebted companies, allowing them to stay alive and wait out the bear market. However, with oil prices failing to rebound, the generosity from the financial markets has waned, and new debt and equity issuance has slowed.

In fact, the next few weeks could be decisive for several indebted shale companies in the United States. Credit reevaluations will get underway this month and by October, some of the weakest firms could see their credit lines cut. That could spark a shortage of liquidity for some companies and potentially set off a wave of bankruptcies. Of course, as Citigroup’s Ed Morse recently noted, the shakeout in the sector is necessary for oil markets to rebalance. Although we have spent the past year debating about when the adjustment would occur, this quarter could prove to be a turning point.

Finally, in a bit of LNG news, a new study from Wood Mackenzie finds that most U.S. LNG projects continue to move forward even though a huge volume of capacity is slated to create a glut of export capacity around the world. There is 60 million tonnes of LNG export capacity (mtpa) under construction in the United States, and a total of about 140 mtpa under construction around the world. Worse yet, another 100 mtpa could enter construction over the next year and a half. That stands in stark contrast to existing export capacity of 250 mtpa – and it points to a coming glut and bust in prices. In all likelihood, many of those project could be scrapped before they get off the drawing board.

By Evan Kelly Of Oilprice.com

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