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Why Oil Prices Will Likely Drop Below $40 Soon

Why Oil Prices Will Likely Drop Below $40 Soon

The 70 percent rise in crude oil prices from the lows of $27.1 per barrel to a high of above $46/b in a matter of three months is being driven by speculative activity—make no mistake about it. The speculators have latched on to every bit of rumour and news to bid prices higher, and this has nothing to do with the real fundamentals.

However, speculation can boost prices only to a certain extent in the short-term. After this, the fundamentals take over. The extent of speculation is enormous, though the daily production of oil in the U.S. is around 9 million b/d, the WTI crude oil contract trades more than 100 times the produced quantity, as highlighted in this January 2016 post.

The trading volume is generated by the algo traders, day traders, and scalpers who are in and out of their positions many times a day. Due to their enormous volume, they set the direction of prices in the short-term.

However, these traders are neither involved in the production nor do they take physical delivery of oil; they are usually active only in the near-term contracts until expiry; after which the users of oil take deliveries. Related: Lets Stop Pretending Nuclear Power Is Commercially Viable

The oil producers have used the sharp rise to hedge part of their production for 2016 and 2017 as reported by The Wall Street Journal.

(Click to enlarge)

However, Citi Research points out that the oil producers have hedged only 36 percent of their estimated production for 2016, compared to 50 percent in the previous years.

If prices creep up further, the producers will not only hedge more, they are likely to increase production to mend their balance sheet.

Pioneer Natural Resources has hedged 50 percent of its expected 2017 output and has conveyed its intention to add five to ten horizontal drilling rigs if prices recover to $50/b, with a positive outlook for oil fundamentals. Earlier on, too many U.S. shale oil drillers had indicated that they will be back at around $50/b levels. Related: Oil Prices Fall Back as Rally Hits a Ceiling

Though the bulls have latched on to the largest U.S. rig count drop in the past six weeks, their bullishness might be short-lived because if prices reach above $50/b, we might see an increase in the oil rig count, reversing the current trend.

The short-term trend changed with the idea of a production freeze by Russia and OPEC, but the Doha meeting turned out to be a non-event.

The chart below by Yardeni Research, a provider of independent investment and economics research, shows that in 2016, the oil inventories continue to rise, confirming that the supply glut continues.

(Click to enlarge)

The U.S. Energy Information Administration’s (EIA) STEO report expects the supply glut to reduce in the second half of the year; however, if prices remain high, production might increase adding to the supply glut. Related: Weak Data, Strong Dollar Pressure Crude Lower

Though Nigeria, Kuwait, and Venezuela’s production has been hit hard due to various reasons, OPEC’s production of 32.64 million b/d is very close to its highest level of 32.65 million b/d recorded in January 2016, according to Reuters survey records since 1997.

"The market is massively oversupplied," said Eugen Weinberg, analyst at Commerzbank in Frankfurt. "This rally doesn't have strong legs," reports Reuters.

There isn’t much by way of fundamentals to rely upon for the rally to continue. Closer to $50/b, additional supply will start trickling in and buyers will be wary to buy at higher prices. With no excuses at hand, the speculators will find it difficult to prop prices higher.

The short-term speculative pop in crude is about to end and the long-term fundamentals will take over. Prices should drop closer to $36 to $38/b in the near future.

By Rakesh Upadhyay for Oilprice.com

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  • Darcy on May 03 2016 said:
    Ya right!!! You must be shorting oil!!!
  • kamakiri on May 04 2016 said:
    Short and Distort. Plain and simple.
  • adec on May 04 2016 said:
    I think the author is either clueless and just speaking on behalf of the shorts
  • SallyW on May 04 2016 said:
    LOL! All the other posters must be longies! See no glut, see no glut, see no glut.
    And a slowing global economy. China about to do their 2008.
  • Brandon orlando on May 05 2016 said:
    I think the author is off a bit. I have a oil and gas rental company in the midland area and the eagleford . I know for a fact the wells in the eagleford have about 9 months to a year of solid production and then it drops off 400-500%. We will not be producing 9mil bbls/per day for much longer and I would be suprise did it hasn't dropped off a good bit presently. Going from 2300 plus rigs in North America to under 500 with the drop over 1.5 yrs ago and because worse each month cannot support the 9 mil per day much longer. We have bottomed out for sure
  • Oeconomia on May 05 2016 said:
    Noticing a trend over the last few months. There are several authors on this site that write for the "U.S.-based Divergente LLC consulting firm". And every one of them seems to be writing over and over for short positions.
  • Brad Beago on May 07 2016 said:
    It continually amazes me that people believe the industry turns on and off production like a switch. Was is in place today - a contraction in CAPEX for two consecutive years, will take at least two years to reverse. In the meantime - based on OPEC and IEA numbers, supply and demand will be balanced in 3Q 2016 or 4Q 2016. In the meantime, global non-opec production, app. 52 million barrels per day, is dropping monthly due to natural declines and insufficient investment. When the industry begins to increase investment, it will do so slowly at first. In the meantime, production WILL continue to decline. To just bring the Eagle Ford to flat from declining will require some triplling of current CAPEX based on my estimates. The bottom line is at best, production could STOP declining by this time next year, and register real growth in another 6 months.

    It is also noteable that the author's only reference to real fundamntals is a vague "massively oversupplied" comment...Where are the numbers? How do you tell Iranian production from the sale of stockpiled barrrels? In all likelihood, they are producing flat out and will required hundreds of billions and years of work to add the kind of incremental volumes that have been thrown around in the press. Think about this - worldide, it costs around $30,000 to add a flowing barrel of oil. No money = no oil. Oh, and by the way, bear case global demand growth is 1.2 mmbbl/d...U.S. alone is running nearly half of that.
  • Nessrookie on May 08 2016 said:
    OIlsands production losses are now up to 1.5 million barrels per day now that syncrude is shut down. Even with the wild fires moving north east winds can shift at any moment and the air quality is the biggest concern now
    Re starting these OIlsands facilities is not like turning a switch back on either. It will be a slow process
  • jess on May 23 2016 said:
    Dear Mr. Rakesh Upadhyay how come you work for a US-based Divergente LLC consulting firm when you are anti U.S. oil? Don't know these articles are unethical even though you could be stating facts? Couldn't you have written something with a positive outlook for U.S. oil? It seems the whole world wants to destroy U.S. oil.
  • Nicolas Dragon on June 30 2016 said:
    But according to other estimates the price of oil can be $150-180 just in 2016-2017. And I believe that it is not far off the mark as the Venezuelan crisis, quantifiable drop in US shale oil production and Brexit become major factors for it now. Furthermore, Chinese oil demand keeps its growth. It is expected to slow in 2016 to as low as 2% (maybe), but it's still growth!

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