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Why Another Oil Price Downturn Is A Distinct Possibility

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In June 2015, oil prices surged to $60 per barrel, raising hopes that the oil price downturn would have been brief and the recovery swift. But by July, oil prices were heading back down, the beginning of a deeper slump that would continue for months.

A year later, a similar pattern could be playing out, or at least, that is what oil producers are fearing. After hitting a low point in February of this year, oil prices began a four-month rally, rising from $26 to $51 per barrel by June, the third year in a row in which the month of June saw a relative peak for oil prices. Now, July could once again mark a renewed nose-dive.

This time around, an array of oil producers are not taking any chances. According to Bloomberg, more and more E&Ps are hedging their production, protecting themselves against a crash in prices. Earlier this month, Laredo Petroleum Inc., for instance, hedged more than 2 million barrels of its 2017 production. “The producers have sold the hell out of this rally,” Stephen Schork, president of Schork Group Inc., told Bloomberg. “The companies that did survive, they’ve been hedging into this rally. And they’re counting their blessings.”

Hedging even began before prices rallied. Reuters surveyed shale firms earlier this month, finding that 17 out of 30 had increased their hedging in the first quarter when oil prices were at a low point. Even though they locked in at low prices, doing so offered some stability and certainty in their revenue projections.

But it was also an indication of the level of anxiety with which E&Ps were approaching 2016. The rally since February has buoyed spirits, but with oil prices back to $45 per barrel, negative sentiment once again pervades the market. For the week ending on July 12, oil traders increased their short bets by 1.6 percent, the third week in a row that shorts climbed.

The logic is straightforward. Production is falling but global supplies are still elevated. Worse, inventories are only coming down slowly from record highs. Then there is the possibility of new drilling – the rig count rose again last week, with the industry adding 6 oil rigs and 1 natural gas rig, according to Baker Hughes. On the other hand, although drillers could get back to work, the markets are likely overestimating the impact of a few dozen rigs coming back into operation. Related: Big Oil Begins To Worry About Trump’s Wall

Meanwhile, the botched coup attempt in Turkey barely registered in oil. Supply disruptions through the Bosporus, where 3 percent of global crude travels, were certainly plausible, but the straits were reopened only hours after the overthrow failed. "The market is looking past the coup," Ric Spooner, chief market analyst at Sydney's CMC Markets, told Reuters.

At this point, the very large overhang of refined products weighing on the market is one of the most important indicators to watch, a glut that will take time to work through. The rapid buildup in storage levels of gasoline and diesel this year have taken the markets by surprise, and could ultimately delay what everyone thought would be a rebalance in the next few months.

“The rising inventories of gasoline have got the markets’ attention,” John Kilduff, partner at Again Capital LLC, said in an interview with Bloomberg. “The oil market is getting ready to break.” Related: Is Oil Going Back Under $40?

The one bullish factor for oil prices is India, which has taken over from China as the main driver of demand growth. India just grew at its fastest three-month period in the past decade, the most recent data shows. "We think India is roaring right now and will be a key driver of demand," Helima Croft, managing director and Global Head of Commodity Strategy at RBC Capital Markets, told CNBC's "Futures Now” in a recent interview. Despite all the negative factors pointing to ongoing oversupply, RBC still thinks that crude prices could close out the year in the mid$50s per barrel, largely because of India.

But another downturn in prices is also a distinct possibility, and one that looks a bit more likely than it did a month ago. At the very least, it will take quite a bit of time before a serious price rally arrives. "Fundamental headwinds are growing, supply-demand rebalancing is likely still a mid-2017 event, but tail risks are admittedly large in both directions, as geopolitics add to uncertainty," Morgan Stanley concluded in a recent report.

By Nick Cunningham of Oilprice.com

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  • Bob on July 18 2016 said:
    The apparent confusion in the oil market feels like a possibly great investing opportunity. The bearish view has seemingly gone from a legitimate oil supply and demand argument in 2015 to, in my opinion, the much more flimsy basis of product supply, hedging, and miniscule rig count additions.

    While product supplies are elevated, they appear close enough to expected to not be much of a long term worry. At least in the US. For instance, US gasoline is maybe a few percent higher than I would like but not bad given gasoline imports are roughly 5.5% higher over the last 4 weeks versus 2015 and 50% higher than 2014.

    Fuel oil supplies significantly over stocked after the warm winter also appear to be being worked down and should be more normalized with an average winter season.

    I'd guess, as long as the world economy keeps growing good enough, oil bears might not have much anecdotal support for their view in six months or so.
  • adec on July 18 2016 said:
    anecdotal support is the right word to describe the bears.
  • Travis on July 19 2016 said:
    Another Nigerian Oil pipeline bombed as of yesterday morning. Article this morning on this website. Fracking is harming people with asthma. Wonder how long it will take for the this government to use this info. against the frackers. Soon i bet, very soon. The argument for oil going lower is getting weaker by the day.
  • John Brown on July 19 2016 said:
    The world is still awash in oil. Its still being stored in rail cars and ships. Supply is dropping slowly in the USA, but can turn around at lower prices and much faster than in the past, but right now there is no need because you have supply coming available from multiple other sources like Iran. There is really no reason for oil not to be at $30 per barrel except everybody in the industry want it higher and latch onto any excuse to drive it higher or at least keep it from dropping. Sooner or later the reality of supply and demand will drop the price, and likely sooner than later. Everybody knows it that's why they are hedging.

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