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Arthur Berman

Arthur Berman

Arthur E. Berman is a petroleum geologist with 36 years of oil and gas industry experience. He is an expert on U.S. shale plays and…

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Oil Fundamentals Could Cause Oil Prices To Fall, Fast.

Oil Fundamentals Could Cause Oil Prices To Fall, Fast.

Oil prices should fall, possibly hard, in coming weeks. That is because fundamentals do not support the present price.

Prices should fall to around $30 once the empty nature of an OPEC-plus-Russia production freeze is understood. A return to the grim reality of over-supply and the weakness of the world economy could push prices well into the $20s.

A Production Freeze Will Not Reduce The Supply Surplus

An OPEC-plus-Russia production cut would be a great step toward re-establishing oil-market balance. I believe that will happen later in 2016 but is not on the table today.

In late February, Saudi oil minister Ali Al-Naimi stated categorically, “There is no sense in wasting our time in seeking production cuts. That will not happen.”

Instead, Russia and Saudi Arabia have apparently agreed to a production freeze. This is meaningless theater but it helped lift oil prices 37 percent from just more than $26 in mid-February to almost $36 per barrel last week. That is a lot of added revenue for Saudi Arabia and Russia but it will do nothing to balance the over-supplied world oil market.

Related: Big Oil Eyes Upcoming Auction In Iran

The problem is that neither Saudi Arabia nor Russia has greatly increased production since the oil-price collapse began in 2014 (Figure 1). A freeze by those countries, therefore, will only ensure that the supply surplus will not get worse because of them. It is, moreover, doubtful that Saudi Arabia or Russia have the spare capacity to increase production much beyond present levels making the proposal of a freeze cynical rather than helpful.

(Click to enlarge)

Figure 1. Incremental liquids production since January 2014 by the United States plus Canada, Iraq, Saudi Arabia and Russia. Source: EIA & Labyrinth Consulting Services, Inc. (click image to enlarge)

Saudi Arabia and Russia are two of the world’s largest oil-producing countries. Yet in January 2016, Saudi liquids output was only ~110,000 bpd more than in January 2014 and Russia was actually producing ~50,000 bpd less than in January 2014. The present world production surplus is more than 2 mmbpd.

By contrast, the U.S. plus Canada are producing ~1.9 mmbpd more than in January 2014 and Iraq’s crude oil production has increased ~1.7 mmbpd. Also, Iran has potential to increase its production by as much as ~1 mmbpd during 2016. Yet, none of these countries have agreed to the production freeze. Iran, in fact, called the idea “ridiculous.”

Growing Storage Means Lower Oil Prices

U.S. crude oil stocks increased by a remarkable 10.4 mmb in the week ending February 26, the largest addition since early April 2015. That brought inventories to an astonishing 162 mmb more than the 2010-2014 average and 74 mmb above the bloated levels of 2015 (Figure 2).

(Click to enlarge)

Figure 2. U.S. crude oil stocks. Source: EIA and Labyrinth Consulting Services, Inc. (click image to enlarge)

The correlation between U.S. crude oil stocks and world oil prices is strong. Tank farms at Cushing, Oklahoma (PADD 2) and storage facilities in the Gulf Coast region (PADD 3) account for almost 70 percent of total U.S. storage and are critical in WTI price formation. When storage exceeds about 80 percent of capacity, oil prices generally fall hard. Current Cushing storage is at 91 percent of capacity, the Gulf Coast is at 87 percent and combined, they are at a whopping 88 percent of capacity (Figure 3).

(Click to enlarge)

Figure 3. Cushing and Gulf Coast crude oil storage. Source: EIA and Labyrinth Consulting Services, Inc. (click image to enlarge)

Prices have fallen hard in step with growing storage throughout 2015 and early 2016. Since talk of a production freeze first surfaced, however, intoxicated investors have ignored storage builds and traders are testing new thresholds before they fall again.

Related: Climate Action Could Save $250 Billion Per Year In 2030

The truth is that prices will not increase sustainably until storage volumes fall, and that cannot happen until U.S. production declines by about 1 mmbpd.

Despite extreme reductions in rig count and catastrophic financial losses by E&P companies, production decline has been painfully slow. The latest data from EIA indicates that February 2016 production will fall approximately 100,000 bpd compared to January (Figure 4).

(Click to enlarge)

Figure 4. U.S. crude oil production and forecast. Source: EIA STEO, EIA This Week In Petroleum, and Labyrinth Consulting Services, Inc. (click image to enlarge)

That is an improvement over the average 60,000 bpd monthly decline since the April 2015 peak. It is not enough, however, to make a difference in storage and storage controls price.

EIA and IEA will publish updates this week on the world oil market balance and I doubt that the news will be very good. IEA indicated last month that the world over-supply had increased almost 750,000 bpd in the 4th quarter of 2015 compared with the previous quarter. EIA data corroborated those findings and showed that the surplus in January 2016 had increased 650,000 bpd from December 2015.

Oil Prices and The Value of the Dollar

Why, then, have oil prices increased? Partly, it is because of hope for an OPEC production freeze and that sentiment is expressed in the OVX crude oil-price volatility index (Figure 5).

(Click to enlarge)

Figure 5. Crude oil volatility index (OVX) and WTI price. Source: EIA, CBOE and Labyrinth Consulting Services, Inc. (click image to enlarge)

The OVX reflects how investors feel about where oil prices are going. It is sometimes called the “fear index.” That suggests that investors are feeling pretty good and less fearful about the oil markets than in the last quarter of 2015 when oil prices fell 47 percent. Since mid-February, prices have increased 37 percent.

Related: 3 Metrics on Picking Stocks in a Low-Growth Environment

But there is more to it than just hope and that may be found in the strength of the U.S. dollar. The negative correlation between the value of the dollar and world oil prices is well-established. The oil-price increase in February was accompanied by a decrease in the trade-weighted value of the dollar (Figure 6).

(Click to enlarge)

Figure 6. U.S. Dollar value vs. WTI NYMEX futures price. Source: EIA, U.S. Federal Reserve Bank and Labyrinth Consulting Services, Inc. (click to enlarge)

Now, that trend has reversed. The U.S. jobs report last week was positive so continued strength of the dollar is reasonable for a while. Assuming the usual correlation, that means that oil prices should fall.

Oil Prices Should Fall Hard

It is a sign of how bad things have gotten in oil markets that we feel optimistic about $35 oil prices. It should also be a warning that the over-supply that got us here has not gone away.

Oil storage volumes continue to grow and that is the surest indication that production has not declined enough yet to make a difference. It is impossible to imagine oil prices rising much beyond present levels until storage starts to fall. In fact, it is difficult to understand $35 per barrel prices based on any measure of oil-market fundamentals.

The OPEC-plus-Russia production freeze is a cynical joke designed to increase their short-term revenues without doing anything about production levels. An output cut would make a difference but a freeze on current Saudi and Russian production levels means nothing. It apparently made some investors feel better but it didn’t do anything for me. Iran got this one right by calling it ridiculous.

No terrible economic news has surfaced in recent weeks but that does not change the profound weakness of a global economy that is burdened with debt and weak demand. The announcement last week by the People’s Bank of China that it sees room for more quantitative easing may have comforted stock markets but it only added to my anxiety about reduced oil consumption and future downward shocks in oil prices.

I hope that oil prices increase but cannot find any substantive reason why they should do anything but fall. As market balance reality re-emerges in investor consciousness and the false euphoria of a production freeze recedes, prices should correct to around $30. A little bad economic or political news could send prices much lower.

By Art Berman for Oilprice.com

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  • R H Blackmon on March 07 2016 said:
    There is only a 1% difference between global oil supply and demand .Further, global oil demand is growing at 1% a year. So oil prices are naturally drifting higher.
  • Michael H on March 07 2016 said:
    The 'could' qualification is always handy.
    Rising inventory tells me that the storage operators see value in holding the product and so in itself is a contradictory signal supporting the positive regarding prices.
  • sb on March 07 2016 said:
    Lol attempt so that the author can buy more stocks at lower prices
  • J DeCaen on March 07 2016 said:
    This kind of sober assessment is reassuring. It shows that not everyone has lost their marbles.
  • Greg on March 07 2016 said:
    Bit concerned about the terminology being used here (and in the mainstream media). It belies the true nature of the problem. A supply surplus implies we are supplying more. A practical impossibility in a world of dwindling and harder to get oil resources. If anything we are supplying less. It is in fact demand contraction brought on by debt limits. Essentially we have the limits to everything and the first red flag would always be oil. It gets worse, a lot worse from here on out.
  • Asad on March 08 2016 said:
    oil aint comin up any time soon, let iran enter the market in May 2016 after auctions of its oil resources, then we will see how the prices tumble to the low 20s. Cant believe no one is weighing that in...
  • aphp on March 08 2016 said:
    Interesting and well substantiated view on the current situation. Probably the market has become to positive.

    Regarding the oil production decline, what I noticed is a major difference between the oil production levels within the Gulf Coast and the shale area's. In December the production decline in shale was for a bigger part offset by the growth in the Gulf Coast (+ 100k b/d). Apparently the production in the shale area's is still coming down rapidly.

    It will be interesting to learn what the shale E&P companies will do following the recent oil price spike. Will they ramp up production (like October last year) or just sit still and wait for better prices?
  • zi on March 08 2016 said:
    In March 2009, US crude stocks were 185 Mb above the 5 year average, more than today. The oil price doubled in the following 12 months.
  • steve on March 08 2016 said:
    Asad; they are auctioning off concessions... Once you win a concession, then you do seismic, then then you study that seismic for a year or two, then you start considering maybe drilling a well... These Concessions that are being auctioned off are at least 5 years away from producing any meaningful oil...
  • avenger 426 on March 08 2016 said:
    If oil rises, shale will kick up rigs. High oil destroys economies.
  • Gray Mewburn on March 12 2016 said:
    Art, I think intervention drove the price up, not fundamentals
    cheers
    Gray
    OIL WATCH Group
    G+
  • GregSS on March 17 2016 said:
    Art, I came to the same conclusion as you and scratch my head everyday that prices continue to go up. I think we are due for another pull back, possibly into the $20's again. From there we might finally see a long gradual climb back to $50

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