The price collapsed because global supply increased sharply in 2014-15 while demand growth sagged – and more recently even stopped altogether. The Dollar’s super strength played a key role also. In the past 3-6 months, supply growth has been sagging as a direct result of the lower price, but now it looks like a strong bet that supply is actually going to fall, and fall sharply. As a result, the market is likely to come into balance very quickly. As this happens, the price will recover smartly.
Mark Lacey and John Coyle have been reporting how very recently a number of companies have announced further huge reductions in capital spending, lower production guidance or even shut-ins. In 2016 to date, a very small sample of companies have announced a combined cut in production guidance for this year of 160kbpd already, representing a 5-6% drop from last year. In the next few weeks, as the rest of the companies report, we can expect similar announcements. From the initial sample, we can conservatively estimate a combined cut in production globally for 2016 of 1.5-2mbd, especially as the oil price is at least 20% lower than it was when the first companies reported. This reduction should be easily adequate to balance the market.
Anecdotal evidence which points towards production declines is everywhere now. This is especially in the US and Canada but notably in other parts of the world too. India, China, Kazakhstan and Nigeria are all reporting declines. North Sea activity is coming to a standstill. Tanker rates from the Gulf have collapsed recently as there has been a sharp drop in crude cargoes for February loading. Oil is being shipped to the US from far and wide because the US domestic oil price is trading expensively to the rest of the world, but the premium is being maintained. The futures market contango did not worsen at all as spot prices recently swooned and in recent days it has been reduced. US E&P bankruptcies are soaring and the financial tap is being turned off. The evidence is plain that US production is falling faster than the official statistics report and the required oil is being “sucked” in from the rest of the world. This trend is going to accelerate as US production drops precipitously in the next few months.
It’s not difficult to understand why companies are now reducing activity. Remind yourself of the chart below kindly compiled by Citibank in late 2014.
Everyone is losing money now. Producers are much better off leaving it in the ground than selling it for $27, especially as they know that storage facilities everywhere are pretty much full. The market has been rightfully worried about “tank tops” but the price collapse has now, very likely, done its job.
What can make the price fall further?
A collapse in demand. To some extent, this is already happening. Both Chinese and US demand has slowed markedly, and it could continue (likely will, in my opinion). But my view now is that the speed of supply response is overtaking the weakening of demand. We shall see. A sudden surge in Libyan production would also hurt the price; let’s afford that a 25% probability, given the security issues. A further surge in the Dollar would be a problem also, for sure; my view is that the Dollar’s run is now likely fully played out, at least for now, given the renewed turmoil in global stock markets and the weaker trend of US economic data, both of which suggest the Fed will no hike again anytime soon.
As a final note on Fundamentals, what if OPEC acts? This is a scenario completely dismissed by the market currently. Pressure on the Saudis is now immense. Of course the likelihood of the Saudis flinching may indeed be slim but just a suggestion of it today would be enough to send the price up $5-10 at least. Risk in this market is heavily skewed for sure.
I will be writing an updated formal oil report in the next two weeks.
Our official Chart indicators for oil remain bearish, we looked at them closely yesterday. I will argue, however, that from a Pattern point of view a very significant low is very likely in place, or will be within a few days. I believe the sell-off from the mid-2014 high is finishing now, based on wave counts. If this is indeed the case, the first upside target for crude is $38 (+36%), and after that $48 and $57. Strong supporting evidence, I believe, comes from the performance of some of the oil stocks yesterday: they dropped sharply in the morning but then closed very strongly, e.g. WPX was down 34% first thing but closed down only 6%, which left a bullish candlestick. The relative strength of oil stocks versus crude is another indication of a potential turning point. (And by the way, the gas stocks went up yesterday eg Southwestern up 13%; the chart patter non this stock, I believe, is super-bullish. We already has this stock rated as bullish chartwise. 50-100% upside looks easily achieveable.).
On Sentiment, again, our official indicators remain bearish but anecdotally we can now all read the tea leaves. Just listen to any TV or radio commentator or Bloomberg video, or read the papers. Everyone and his dog can now tell you why we are in a “lower for longer” scenario, and I believe it is notable that even CEOs of major oil companies are now saying the price won’t recover until second half 2016, a big change from their position 3 or 6 months ago. The IEA monthly report was widely quoted yesterday; “drowning in oil”, being repeated everywhere. In summary, the big picture sentiment story is bullish; when our shorter-term indicators turn it will be super-bullish.
To conclude, while more volatility can of course be expected, I would bet strongly that oil will finish this month well above $30. I recommend at least a fully neutral position on oil with a strong bias towards equities, which should be increased aggressively if the prices continue to recover. Gas stocks ditto.
Geoff Blanning is Head of Commodities at Schroders and Energy Fund Managerat Schroders.
