Hopes Of A 2016 Oil Price Recovery Fading

|
Includes: OIL, USO
by: Gary Bourgeault

Summary

Why the downturn in the price of oil is more than a cycle.

Catalysts for the support of oil are nowhere to be found.

Shale oil production has changed the market for decades - the past market is no longer the future market.

(click to enlarge) source: bidnessetc Click to enlarge

Financial news outlets are running out of potential catalysts to report on concerning an upturn in the price of oil for 2016, as they've exhausted most of the possibilities associated with the support of oil. It's far past time for this to happen, as it has given the false sense that this is simply a temporary downturn as has been the case in the cyclical past for oil.

One of the last catalysts to bite the dust has been the idea Iran wouldn't have much of an impact on the outlook for oil for some time into the future, because it may not be able to meet its asserted estimates of immediately increasing supply by about 500,000 barrels a day, and by the end of 2016, increasing it to about 1 billion barrels a day. This would be primarily directed toward the export market.

While we don't know the timing of Iran's supply boost, no one believes it isn't going to come. That is now being priced into oil, which is one of the reasons it continues to plummet.

The other catalysts that some were hanging their hats on was the idea because oil at this price was unsustainable, it would force companies to change their output to rebalance the industry. That hasn't happened. It reminds me of coal and iron ore, which have experienced the same type of conditions.

In the midst of bankruptcies and falling revenue and earnings, production continues on. I think this is what is going to happen with oil as well. We're in uncharted territory for oil here, and competitors show no sign of a willingness to cut back in supply outside of the U.S. shale industry.

Some companies with exposure to Canadian sands and offshore rigs have cut back some, but that isn't representative of the amount of oil brought to market by U.S. shale producers.

Any chance of OPEC cutting back?

Over the years OPEC has evolved into more of a loosely connected cartel, rather than the more cohesive amalgamation it had once been. This is having a dramatic impact on policy decisions, as each country essentially is only watching out for itself. There isn't even much of an attempt to give the appearance of unity any longer.

Now that Saudi Arabia and Iran are fighting a proxy war in Yemen, and have had tensions increase when Saudi Arabia imposed and carried out the death penalty on a Shiite cleric, the chances of any type of agreement to cut oil supply between the two is zero.

My belief is not only is that true, but it could result in an extension of the war on the economic front, with Iran never backing down from boosting production, even though it has publicly stated it has no intention of trying to drive down the price of oil.

Iran may not have the intention, and the reason for boosting supply may not be for that purpose alone, but it knows it can hurt Saudi Arabia and is Sunni allies by keeping the oil spigots running. It of course wants to increase its own revenue to not only fund its domestic projects, but to have the capital to wage its proxy war in Yemen and on other fronts in the region.

With Saudi Arabia, it has also shown it has little or no interest in the smaller member states of the cartel, as repeated requests for a cut in supply has went unheeded, as have requests for more meetings to discuss the matter. There is no interest in cutting production, and that will continue on for a long time.

I've even read some reports trying to resurrect the tired idea that Russia is going to get together and come to an agreement with OPEC to lower production. It's not going to happen. Only the low price of oil may force that, but no agreement will.

The catch-22 investors must understand

It's hard to discuss the implications of the price of oil on individual countries and companies because each one as a different breakeven point; what is profitable for one won't be profitable for another. With that in mind, what we need to consider is what happens to significant competitors if the price of oil moves up.

Another factor that makes it complex is the profit point can differ from well to well - whether offshore, onshore or shale. This is why the U.S. shale industry, for example, has been more resilient than expected. With new knowledge and technology, it has been able to tap into some of the more productive wells, which has allowed it to ride out the low-price storm much longer than believed.

As for the catch-22, if the price of oil does rise to levels that benefit many competitors because it makes it profitable to boost production, it will immediately have an impact on the price of oil, which will provide a ceiling for it. We have yet to discover what this new ceiling will be, which is part of the reason there is such a lack of future visibility. Everyone knows if OPEC continues to oversupply the market the price will fall, or at best remain level. Once it stops, it is totally unclear what the new price levels will be. This is why the market is totally different since shale has become an important part of supply.

A majority of financial media outlets (and analysts) continue to regurgitate the idea the price of oil will significantly rebound once producers are forced to cut back on, or stop production of many rigs, altogether. What they fail to take into account is the fact shale oil companies can very quickly resume or launch production, which again, puts a ceiling on where the price of oil can rise to. This is the catch-22 that didn't exist to this extent in the past.

Is this another cycle for oil?

Another idea that has been hard to lay to rest is this isn't much more than typical cyclical movement of the price of oil. The thought is it'll simply rebalance as it has in the past. This idea is wrong.

This is much more than a cyclical event, it's the total upheaval of the industry. The transformation is because of the introduction of shale as a new, major competitive force in oil, and we're only at the early stages of exploration and production, as represented by the U.S. Based upon U.S. formations, the amount of shale oil estimated to be recoverable in the world stands at about 419 billion barrels.

The price of oil is dropping not because a few OPEC countries are cheating on their agreed upon supply levels, but because an industry able to put out as much or more than Russia or Saudi Arabia has emerged, and that's only a reference to what the U.S. can bring to the market. Obviously this is the entirety of U.S. oil production - not only shale. But the bulk of the growth in U.S. oil supply comes from shale deposits.

One of the major reasons the market and financial media continue to be dumbfounded by oil is they're primarily identifying it as another cycle - a difficult cycle, but a cycle nonetheless. Since that's the incorrect way to understand and analyze the situation, they continue to get it wrong on the general price movement and hopes a near-term recovery.

This is not another cycle, this is a disruption of the oil market that will change the industry for a long time into the future.

Conclusion

In all of my research I haven't been able to come up with one catalyst that could support the price of oil over the next year. Expectations were demand would offset the increase in supply, but that isn't going to happen, as demand has been downwardly revised for 2016, and even if it rose to prior estimates, it would at best rebalance without any new supply coming to market.

With Iranian oil coming and demand estimates falling, this isn't going to be a factor in 2016. A low price may boost demand a little, but I don't see it having any impact in the next 12 months. The oversupply is too high to be overcome by a slight increase in demand because of low prices, if it comes at all.

What could be interesting for 2017 would be the depth of the cutbacks in supply from U.S. shale producers if the price of doesn't come back at all. I'm thinking in the $40 to $45 range here, which is far from being a guarantee.

In that case a sustainable increase in demand, along with lower production may support the price of oil temporarily, but as I mentioned, once it finds support and prices rise, shale producers can ramp up production and weaken the price momentum, resulting in it not being able to maintain the price level.

The change in the oil industry is systemic, not cyclical. Only soaring demand could sustainably push the price of oil up, with the exception of a geopolitical event.

With the global economy sputtering, there is nothing to suggest demand for oil will increase at projected levels. They will likely decrease. This means a long, painful season for the industry, as it works to figure out how to move forward on under competitive conditions it has never faced before.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.