4 Reasons Why Oil Won’t Rise Over the Short Term

Brett Carson, Director of Research, speaks on the oil industry in this U.S. News Article.

Since June 2014, oil has plummeted from a high more than $100 per barrel, dragging energy sector revenues and stock prices along with it. The commodity has tried to bounce back, but there are a number of headwinds that will likely keep the commodity subdued over the short term.

Oil inventories growing, no signs of stopping. As of this writing, there are roughly 3 billion barrels of oil sitting in storage around the world. For context, this is enough to meet all of the United States’ oil consumption needs for more than five months.

While a pullback in production of roughly 1 million barrels per day from the U.S. and Mexico has helped to close the gap between supply and demand, OPEC’s 14-nation producer group has been unable to come to an agreement and many of the nations have increased production.

Iran, free of most economic sanctions, has ramped up its output to 3.85 million barrels per day, a rate the U.S. Energy Information Administration estimated it would not be back to until 2017. What’s more, OPEC juggernaut Saudi Arabia was pumping out a record 10.67 million barrels a day as of the end of July.

There are rumors of a potential agreement to cap production among OPEC member states but with the breakdown in talks earlier in 2016, investors aren’t holding their breath. Indeed, despite Saudi Arabia’s public calls for a cap on output, the country has resisted calls from other member states to curb their own production.

Without Saudi Arabia and Iran, two of OPEC’s largest producers, coming to an agreement, it is unlikely that the markets will see a material difference in production over the near term. All else being equal, this should continue to put downward pressure on the price of oil.

Gasoline inventories near all-time highs. It appears that gasoline inventories, just shy of record levels, continue to weigh on oil as well. Oil traders typically don’t focus on crude byproducts but, given their current levels, they are beginning to take these metrics into account.

According to data released the middle of July, gasoline stockpiles hit 241 million barrels in the U.S. alone, marking an 11 percent increase from last year.

The summer months typically experience the most demand and refineries boost production to keep pace. It turns out that demand was lackluster this summer but refineries produced anyway since they were able to turn a profit on cheaper oil inventories. Indeed, refineries expanded production this summer by roughly 1 percent, blowing away analysts’ expectations and operating near full capacity at 93.3 percent.

However, the oversupply and falling gas prices are starting to hit refineries’ profit margins. The combination should ultimately lead to lower oil demand by refineries.

Slack in production. In addition to the aforementioned headwinds, there is significant slack in production waiting to come online once oil breaks out of the $50- to $60-per-barrel range.

Many drillers are profitable once oil hits $50 per barrel and, assuming demand continues to lag, supply should increase incrementally once oil hits that mark. This effectively puts downward pressure on prices as oil pops into this range.

To add some color around the true amount of potential production waiting to come back online, as of the middle of August the total international rig counts were down 180 to 938 and U.S. rig counts were down 394 to 491.

We would note the wild card here is the timing with which rigs can come back online and begin producing. The longer the rigs are shuttered, the longer it takes to get them back in working order. There is a possibility that, as prices creep into the $50- to $60-per-barrel range, rigs may be slow to respond and prices could rise out of that range.

However, with the significant pent up production, a spike above $60 is likely to be temporary. Indeed, given the current environment, we believe oil should hover around $45 per barrel over the next 12 months.

Strong dollar. Lastly, we would be reticent if we didn’t mention the strong U.S. dollar and its impact on oil. As far as central bank policy goes, the U.S. is debating when to raise rates while other countries’ central banks are pushing out new stimulus or lowering their rates, in some cases below zero. It’s this dichotomy and divergence between yields that has driven general demand for U.S. dollar denominated assets and fueling a stronger dollar.

How does this put downward pressure on oil? Well, crude is priced in U.S. dollars and a stronger dollar makes the commodity more expensive for purchasers in foreign currencies, especially those that have been devalued after years of stimulus and low interest rates. Barring any large changes in central bank policy, the relatively stronger dollar is likely to continue for the near term and contribute to oil’s downward price pressure.

In summary, we see the short-term outlook for oil remaining muted at best. While oversupply has dominated the headlines, there are other structural issues contributing to oil’s price movement.

As noted above, gasoline stockpiles have risen in the face of traditionally high seasonal demand and battered drillers turn the pumps on as soon as they see profits. Furthermore, the existing macroeconomic environment feeding the stronger dollar should only serve to dilute global demand.

Given the current market dynamics and points laid out above, we believe oil prices will remain relatively low over the immediate future.

US News

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