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Midweek Sector Update: As China Disappoints All Eyes Are Turning To Riyadh

The worldwide stock market crash on August 24 – dubbed “Meltdown Monday” – was the worst sell off for many indices in years. The turmoil was led by China, whose Shanghai Composite sank 8.5 percent on August 24, followed by an additional 7.6 percent loss the next day. Stock markets across Asia, Europe, and the United States were thrown into a panic on Monday, before stabilizing somewhat on Tuesday.

We have spent quite a bit of time talking about China’s fragile economy this summer, ever since the stock market started crashing in June. After a few weeks of relative calm, the currency devaluation earlier this month set off a new round of trouble. China’s problems are far from over.

The meltdown could not come at a worse time for the oil markets. Already suffering from too much supply, Chinese demand is no longer a given. Demand had already been slowing, but it could slow even further now that the economy is showing some serious cracks. And if that causes contagion in other countries, oil prices could stay low for a much longer period of time than many anticipated.

Low oil prices have the world turning their eyes once again towards Riyadh. Saudi Arabia holds the only keys to higher oil prices, if it chooses to cut back on production. But it has shown a dogged determination to continue to pursue market share. However, Saudi Arabia is suffering just like everyone else. The Saudi government is reportedly conferring with advisers on how to make deeper cuts to government spending in order to stop the hemorrhaging. Saudi Arabia’s budget deficit is expected to balloon to 20 percent of GDP this year. According to Bloomberg, Saudi Arabia may shave off 10 percent of the $102 billion it had planned on spending on infrastructure and other investments. Related: OPEC’s $900 Billion Mistake

Saudi Arabia is not the only oil giant looking to husband its shrinking pile of money. Russia revised its GDP forecast lower, expecting its economy to contract by 3.3 percent this year. That is down from the negative 2.8 percent growth rate that it had expected in an earlier forecast. More pessimistic forecasts could yet be forthcoming, depending on the trajectory of oil prices. The ruble is deteriorating to near multiyear lows and could yet worsen.

That has the Russian government a bit more cautious than it has been in the past. The FT reports that the state-owned oil firm Rosneft has been rebuffed by the government for new funding. Rosneft sought money from the state’s sovereign wealth fund for new drilling plans, but the Russian government rejected four out of the five proposed projects. Just a few weeks ago, Rosneft’s Igor Sechin said that his company would focus on boosting production at existing fields, widely read as a chastened tone and an admission that the Russian government would not be hugely generous with new spending.

Kurdistan continues to ramp up oil exports on its own, in defiance of Iraq’s central government in Baghdad. After the government stopped transferring funds to the semiautonomous Kurdistan Regional Government (KRG), the northern Iraqi region had no choice but to go on its own. The FT reports that the KRG has earned $1.5 billion by selling oil over the past two months, badly needed revenue for Kurdistan, which has not only failed to reimburse private oil companies operating within its borders, but Kurdish soldiers fighting ISIS have also seen some of their salaries cut off. Kurdistan is still in a legal limbo when it comes to international oil sales, but an increasing number of oil traders have decided to do business with the region. Related: Scuttled Iran Nuclear Deal Could Be Catalyst For Oil Price Rebound

Such a development has created a fledgling economy independent of the Iraqi state. Last year, the KRG tried to sell oil from a tanker that sailed to U.S. waters, but was turned back after Baghdad used the U.S. legal system to block a sale. This year is different. One of the KRG’s largest buyers has been Israel, which has sourced three-quarters of its imported oil from Kurdistan in recent months. But other countries have shown a willingness to buy Kurdish oil, including Italy, France, and Greece, among others. Those deals have been secret, but are possible because large oil traders like Vitol and Trafigura have decided to work with the KRG. With oil prices hitting new lows, Baghdad’s financial position is deteriorating, although Iraq has boosted exports in recent months. The Iraqi government will probably not be able to stop the KRG from exporting oil for the foreseeable future.

Meanwhile, another explosion struck a natural gas pipeline in Turkey, with Turkish officials pinning the blame on Kurdish militants. The gas pipeline runs from the massive Shah Deniz gas field in the Caspian Sea, sending gas from Azerbaijan to Turkey. The explosion is merely the latest in a string of pipeline attacks, allegedly conducted by PKK rebels. The event will worsen already violent relations between the Kurds in Turkey’s southeastern territory and the Turkish government. Related: Does Arctic Drilling Have A Future With Sub $50 Oil?

Moody’s has downgraded Canadian Oil Sands Ltd (TSE: COS), pushing the company down to one notch above speculative status. The move is emblematic of the deep troubles facing Canada’s oil industry. Canada’s oil sands trade at a discount to WTI, a discount that has widened in recent weeks after the unexpected closure of BP’s (NYSE: BP) huge Whiting refinery in the Chicago area. Canada’s oil sands are much higher cost to boot. Moody’s gave Canadian Oil Sands a credit rating of Baa3 along with a “negative” outlook due to the company’s “elevated leverage.” Another downgrade into junk status is possible. Unfortunately for Alberta producers, Canadian Oil Sands may not be the only company with such grim prospects to look forward to.

Amid all the pessimism surrounding oil prices, there is one contrarian voice arguing that oil prices should rise. Morgan Stanley argues that oil prices are oversold. “While oil fundamentals aren’t strong, physical markets do not corroborate the substantial weakness in flat price,” Morgan Stanley analyst Adam Longson wrote in an August 24 report, arguing that the “latest oil pricing pressure appears more financial than physical.” Morgan Stanley goes on to argue that the global economy is stronger than it may appear, and Chinese demand will continue to rise as it fills up its strategic petroleum reserve. That suggests prices could come around.

By Evan Kelly of Oilprice.com

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  • Brian on August 26 2015 said:
    This latest oil crash has been pure speculation based on the Iran deal. The fundamentals are gaining strength, NOT weakening. Production here in the U.S. rolled over in May/June of this year, and have been going down ever since, and demand has been higher then ever, and there are no signs that Chinese demand is going to shrink. All of the fears of Chinese demand falling are just nonsense. On top of that, the EIA estimates that worldwide demand will increase in 2016 by 1.4 million barrels per day, more than enough to offset 500,000+ increase in Iranian production, and not to mention that by the middle of 2016 U.S. production will have decreased by around 1 million+ barrels per day. All of this is very bullish for oil. Needless to say, this latest crash was caused by short selling bets right after the Iran agreement was signed (http://seekingalpha.com/article/3455646-dont-buy-the-hype-oil-prices-are-down-due-to-short-sellers?ifp=0)

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