Oil Prices Should Fall, Possibly Hard

Posted in The Petroleum Truth Report on March 7, 2016

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.

Saudi Arabia's Minister of Petroleum & Mineral Resources Ali Al-Naimi speaks at the annual IHS CERAWeek global energy conference Tuesday, Feb. 23, 2016, in Houston. (AP Photo/Pat Sullivan)

Saudi Arabia’s Minister of Petroleum & Mineral Resources Ali Al-Naimi speaks at the annual IHS CERAWeek global energy conference Tuesday, Feb. 23, 2016, in Houston. (AP Photo/Pat Sullivan)

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% 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.

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.

Chart-US-RUSSIA-SAUDI Incremental Prod MAR 2016

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).

Crude Oil Stocks_5-Year AVG MIN MAX 6 FEB 2016

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% of total U.S. storage and are critical in WTI price formation. When storage exceeds about 80% of capacity, oil prices generally fall hard. Current Cushing storage is at 91% of capacity, the Gulf Coast is at 87% and combined, they are at a whopping 88% of capacity (Figure 3).

Cushing & Gulf Coast Inventory & Utilization 6 Feb 2016

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.

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).

U.S. Production Forecast MAR 2016

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).

VIX & WTI 5 MARCH 2016

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%. Since mid-February, prices have increased 37%.

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).

Chart_DEC-MAR USD-WTI

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 awhile. 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.

_______________________________________________________________________

I have no short positions in oil or in any other investments. 

_______________________________________________________________________

I have no short positions in oil or in any other investments. 


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36 comments on this entry


  1. Look forward to meeting you sometime, or talking by phone when convenient for you – appreciate your commentary.


  2. Richard,

    Likewise and thanks for your comments. Go to the “Contact” area of my website and send me your contact information please.

    All the best,

    Art


  3. Art, you are a brave man making forecasts 😉 I’m disappointed the way things have panned out to date. I stopped drinking for two weeks and mortgaged my dogs to raise funds to have a flutter on WTI (not Brent) below $20. And it hasn’t happened (YET). Chart wise we have a double bottom at $26 which can portend a lasting recovery. But like you I simply don’t see the fundamentals for it.

    Saudi and Russia are both pumping flat out and so promising to not pump any more flatter out – big deal! Over supply will hang over the market all this year. Sure, the shale industry is beginning to collapse, but still 1000 wells drilled and not completed? And a gazillion bbls in storage and weak demand. I think the oil bulls may burn – soon.

    http://euanmearns.com/oil-production-vital-statistics-february-2016/


  4. Euan,

    It frightens me when a Scot gives up drinking if only for two weeks! Making the call that oil prices are too high also frightens me but that’s what the data tells me–perhaps we are the only ones who see it that way!

    Right now, it’s all about short covering. Unless Saudi and Russia have something to deliver, it’s hard for me to see support for $41 Brent and $38 WTI, but it was hard to understand $39 Brent and $36 WTI last Friday.

    I heard that some survey indicated lower OPEC production. Then, there are the usual suspects–lower rig count, a few shale players who say they won’t complete any wells this year–as if any of that made a difference in the last year or so.

    Thanks for the comments,

    Art


  5. I’m always eagerly awaiting your next comment and because I’m only a naive reader I’m restraining from publishing a comment, but not this time. There is a big influence on the price formation by the traders expecially the big guys, but they are not alone. Today central banks do act on the markets directly, so if they think that oil prices and stocks are now correlated and they believe that propping up the markets or at least avoiding a hard fall is worth any effort thay can manipulate the futures more broadly than anyone; also only a naive more naive than me could think that the big boys are not working in tandem with central banks everytime is needed expecially now when distressed loans are on the verge of a 2008 like explosion.


  6. Frank,

    You make an interesting point that I had not considered although it makes sense with credit re-determinations coming in April. The last round of re-determinations essentially gave energy companies a pass but this time, that will not be an acceptable outcome.

    I must admit that this rally stands out as having no tangible foundation. The stated reasons other than the obviously stupid reason of a Saudi-Russia production freeze–falling rig count and falling U.S. production–are nothing new. Falling rig count was a bad reason a year ago and hasn’t gotten better with age. The February production drop is the biggest since July 2015 (but not nearly as great as drops in May and June 2015) so I suppose that is a somewhat substantive reason for hope but I haven’t heard much emphasis on that data point.

    Many thanks for your comments,

    Art


  7. Art-
    You mention in the post you believe that OPEC will likely cut production later in 2016 but is not on the table today. Why do you think OPEC will cut production and what is the reasoning for the timing of the cut?

    thank you


  8. Jeff,

    Thanks for your question.

    OPEC is not a unified group and never has been. Saudi Arabia, Kuwait, the UAE and Qatar are sunni monarchies, control more than half of OPEC production and are rich in comparison with the rest of OPEC. Iran and Iraq are shi’a republics, are relatively poorer than their sunni neighbors, and control about 20% of OPEC production. The rest of OPEC are economic desperadoes.

    Despite their dysfunction, it is important for Saudi to present an illusion of unity to the world. It is becoming increasingly difficult to hold that face of unity together because of the dire economic straits of many members and the wealthy members are having trouble coping with low oil prices as well.

    Russia and the U.S. are the other big oil powers. If Russia would have agreed to a production cut earlier in the oil-price collapse, I think that Saudi and friends might have cut but Russia didn’t. Russia has supported Assad in Syria, another shi’a republic and is, therefore, aligned with Iran and Iraq and against Saudi and Gulf States interests. Russia is also desperate for cash from oil.

    What the freeze demonstrates is that there has been some movement toward agreement between Russia, Saudi and the Gulf States. Venezuela, Nigeria et al want a cut. Iran won’t have any part of it because they basically traded their nuclear program for the ability to sell oil. Iraq is probably not able to cut production because of their desperate economic condition and vassal state status with Iran.

    The collapse of funding for the oil sands and deep water is reasonably complete. After a few more nails in the tight oil coffin, I think Saudi Arabia will be ready to acquiesce to a production cut as long as Russia joins. My guess is that will happen at the June OPEC meeting but it could happen sooner or later depending on the flow of events.

    I have no inside knowledge but, since you asked, this is what I think.

    All the best,

    Art


  9. With depressed oil prices lately, one would thing there would be talk of increasing the US oil strategic reserves. I haven’t heard a word on that. Our government is so dumb.
    _aleph_


  10. Thomas,

    Figure 3 shows that storage is routinely increased. The dumb thing is that companies continue to produce more oil than is needed and destroy the price in the process.

    Thanks for your comment,

    Art


  11. I very much enjoy reading your posts. My question: If the oil markets lately seem to be trading more on sentiment, positive or negative, than on fundamentals, how can you determine what the price of oil should be? If $37/Bbl is still substantially less than breakeven for the shale plays, can’t you just attribute the $26/Bbl price to market pessimism and the recent rise just an adjustment to the recognition that $26/Bbl is an unsubstainably low price that even Saudi Arabia doesn’t want to see?


  12. Paul,

    There is no correct price for oil. The market shorts the price based on a combination of factors but comparative inventory (year-over-year storage) is a big one. Market balance–supply and demand–is another but is largely accounted for in storage. Then there are sentiment-based issues.

    I am not trying to make a case for what oil price should be nor am I saying that $38 or $40 per barrel is too high. All I am saying is that the market expectation has been around $30 for several months and I see nothing that should have caused that expectation to increase $8/barrel except sentiment because fundamentals have not improved and may have gotten worse.

    All the best,

    Art


  13. Now that oil is back near 40, I imagine that there is no reason for the shale operaters to cut production significantly because they still have hope. Cushing is near full capacity so ironically this recent rebound will result in production not declining as quickly as it should….. Do you agree? I have still not seen many bankruptcies in the sector…. And companies like Continental Resources say they will bring oil production back on line if we get into the 40’s again. It reminds me of the last time oil ran up in 2015 about 40% plus only to come back down again as you pointed out ( and ignorantly did not think so, and rightly got burned as a result) its De ja vu all over again.


  14. Rushabh,

    Forecasting oil prices is impossible. That’s why I don’t do it. What I did last May and earlier this week was to point out that there was no basis in fundamentals to justify the price rally.

    Some people mis-understood me to mean that $30 is the right price and $40 is the wrong price. The market generally bets long or short on price depending on storage, the link between supply and demand that is more readily measured than those two factors.

    The Spring 2015 price rally was weird. It began in late March at $44 and reached $55 in mid-April 2015 as comparative inventories were rising. It was based on sentiment that falling rig counts would result in falling production. Then in late April, inventories fell and prices rose to $60 per barrel. That was seen as cause-and-effect and maintained the price rally through mid-June although prices did not go above $60. In my May post, I pointed out that the world production surplus had never been worse since the price collapse began and that an as-yet-unseen production drop in the U.S. did not warrant a 40% price rally. I was apparently right and price fell to $38 per barrel.

    Now, I think the situation is more straight-forward. Cushing inventories are at an all-time high and 4th quarter IEA and January 2016 EIA data showed that the world surplus had risen to the highest level since May 2015. The latest EIA data shows a big drop in February to a mere 1.12 mmb of surplus and Cushing comparative inventory fell very slightly this week, both data points since I posted on Monday. Now, U.S. production is clearly falling but not by enough to lower storage–that has to happen before a sustainable rally is possible and we’re just not there yet.

    So this rally is almost all about sentiment. Based on the amplitude and frequency of price cycles in 2015 and 2016, short-term cycles are about a month and longer-term cycles are 2-3 months. So, if OPEC and Russia bomb on results, this rally is over in a week. Again, I’m not trying to predict prices but just showing that there is little to no basis for the price rise that we’ve seen from $28 to $38 WTI.

    All the best,

    Art


  15. I would like to elaborate on the last comment that I ignorantly did not think so but you were right I was DEAD WRONG. That’s why this recent rebound reminds me of that spike in 2015. I was one of those hopeful idiots pilling in thinking it was the bottom…… that’s what appears to be happening again.


  16. Hi Art-
    Any idea what is behind all the short covering (presumably) today in oil? It seems the EIA report was bearish. Gasoline futures also rallied today (7 cents at one point). Is the fundamental picture for gasoline as bearish as oil prices in your opinion? Gasoline supplies decreased but there is no shortage in feedstock for refineries with the brimming oil supplies.
    thank you


  17. Jeff,

    Short covering has been driving this entire price rally since it began in mid-February. I believe that’s what oil traders do–they “follow the tape.” If prices are falling, they test the lower resistance; if prices are rising, they test the upper resistance. Whenever, there is momentum in any direction, there are buyers on the other side of the trade. When the momentum slows, traders must cover their previous bets. That’s the way that I understand it–I’m not an oil trader.

    When oil prices increase, refiners cut gasoline production because their margins shrink. That leaves more oil in storage but gasoline inventories fall. More oil in storage lowers oil price and refiners start buying oil again to produce more gasoline. The only way to end the cycle is to increase gasoline prices as oil prices rise. Apparently, current demand for gasoline is predicated on super-cheap prices and that says something about the weakness of the overall economy. Again, that’s how I understand it–I’m not a chemical engineer.

    All the best,

    Art


  18. Art,

    The unanswered question is what is the cost of oil storage, including transport to the storage. This would have many variables. For instance, what would be the cost of transporting oil from Cushing to a salt cavern. The cost of building new tanks is ? etc, etc.

    There are many trillions of investible dollars that have no home, hence negative interest rates in Europe and zero in the US. You are calling for a pull back to $16 yet the majors cancelled projects stating they needed $115 to break even.

    My bet is someone is buying this oil and physically storing it, who and where is unknown. As you have said oil will go way up at some point. There is no substitute for transportation fuel excepting CNG. Electric is bit player even with subsidies. The true cost of a Tesla is $150,000.

    Art said in one presentation ‘peak oil is batting 1000’. New oil exploration needs $100-$115. It takes 35 years to double you money at 2%. Makes more sense to buy it at $40 and store it, if the storage is cheap enough.

    Jim


  19. Jim,

    Cushing storage is ~$0.65 per barrel per month although it can be as high as $1. There is also an ~$0.25 per barrel fee to re-enter the pipeline. Pipeline costs for light oil from Alberta to Cushing are ~$3.75/barrel and Cushing to Houston, ~$2.75/barrel.

    Estimates of floating storage are ~100 million barrels.

    I imagine there are people buying physical oil but, other than countries, I don’t know if it is enough to make a material difference in U.S. or world balance. I mean, 100 mmbo is just a little more than a day of world consumption. It’s a lot of oil but not in the larger picture. I could be very wrong about this–I just don’t know and I don’t think that anyone does.

    Peak oil is about the end of cheap oil. That’s not just my interpretation. I spent a few days with Colin Campbell and Jean La Herrere who wrote the seminal 1998 paper on peak oil and that is certainly their view.

    Those who deny peak oil simply misunderstand it mostly because they don’t want to face its implications. It’s like saying that old age is a false idea because medical advances keep increasing life expectancies. Fair enough, but we still die and those advanced treatments and procedures cost a bunch of money.

    Thanks for your comments,

    Art


  20. http://wallstreetonparade.com/2016/01/did-wall-street-banks-create-the-oil-crash/


  21. Hi Art,

    Given last week’s data from EIA and IEA, and Iran’s response to production freeze, which was “no freeze before 4 million barrels a day are reached,” change your assumptions on demand/supply or crude oil price in your analysis?

    Thanks for seeking and sharing knowledge!


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  28. Carefull, the day you can’t fill your tank is when the economy as we know stops!


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