Why The Birth Of A 'New Oil Bull Market' Is Imminent? (Part 1)

| About: iPath S&P (OIL)

Summary

Crude oil prices have become hostage to upgrades and downgrades by major banks and analysts, many of which are now predicting a stronger oil market in 2016.

Will 2016 lead the way to the birth of a "New Oil Bull Market"?

I will attempt to provide an objective view on the fundamentals of oil supply and demand and the reasons why oil prices are heading much higher.

Banks and Analysts are Lining up to Predict a Bottom in Oil Prices in 2016

Crude oil (NYSEARCA:OIL) prices slumped recently below $27 per barrel to levels not seen since 2003. Despite many negative news still surrounding the outlook on crude oil prices including record oversupply, a strong dollar, a weak global economy, and Iranian oil hitting the markets, a wave of Banks and Analysts are lining up to predict a bottom in 2016.

  • Goldman Sachs, who was among the first to postulate that oil prices might fall to the range of $20 per barrel, is forecasting $40 per barrel for the first half of 2016 and says that a new bull market in oil will evolve in late 2016.
  • Societe Generale says "buy oil now as OPEC must cut output to stop bleeding".
  • According to UBS Bank, "There is a recovery story for the second half of 2016".
  • Citigroup is topping all projections with an average Brent price of $41 a barrel in Q3 2015 and $52 before year-end 2016. It has even called that Long Oil from here to be "the trade of the year".

The consensus mean price according to 12 estimates this year compiled by Bloomberg is about $47 for the fourth quarter 2016.

In order to understand why the major banks are upgrading their outlook on crude, we need to have a look at the forces that will drive crude supply and demand in 2016 and the impact that these drivers will have on the price of crude.

Factors Driving Crude Supply and Demand in 2016

Current Levels of Supply and Demand: According to the US Energy Information Administration's (EIA) January 2016 report, the current global crude supply stands at 95.9 million barrel per day (mb/d) while global demand stands at 94.3 mb/d. The oversupply currently is 1.6 mb/d or 1.7% above current demand volumes.

The Impact of new Iranian Oil: With international sanctions lifted, the Iranian government called on its oil industry to open the taps on production, a move that could add to the global glut of crude that has sent prices into a tailspin. Let us examine what is the potential "impact" of this additional source of supply and the extent of its effect on crude prices.

According to the EIA (January 2016 Short-Term Energy Outlook), Iran's production in 2015 stood at 2.8 million barrels per day (mb/d). Iran's capacity to increase production in 2016 seems to be limited as the report forecasts Iran's production in 2016 to average 3.1 mb/d of crude (an increase of 0.3 mb/d in 2016). It may take considerable time for Iran to have larger increases in production volumes as it needs to upgrade its current facilities. "Like an engine that has been switched on after a long time on standby, it does not work like it used to in an instant," said one Iranian shipping executive. "From our banking and payments systems to marketing operations, this will all still take time."

The expected increase in oil production volume coming from Iran in 2016 is a mere 0.3% of the current total global oil output, according to the EIA report. In theory, this should have no material effect on crude prices.

Strain in current storage capacities: One of the short-term factors that can contribute to higher crude prices is the record amount of oil currently in storage, which remains at levels not seen in at least the last 80 years. As oil supplies rise, the strain on capacity becomes an issue. Additional storage capacity solutions are needed which are quite expensive, such as new tanks built or alternative equipment converted to oil storage (ex: pipelines and supertankers being used for storage rather than transport of crude). The EIA estimates that OECD commercial crude oil Inventories totaled 3.06 billion barrels at the end of 2015, the equivalent of roughly 1 month in world consumption.

Supply of Crude Oil:

  • Fall in new investments: The global "oil and gas investments" in 2016 are expected to fall to their lowest level in six years to $522 billion down by 13% in 2016, following a decrease of 22% in 2015. In an attempt to balance their budgets, major integrated oil and gas producers have aggressively slashed their 2016 spending as the current low oil prices continue to strain on earnings. For example, TOTAL (NYSE:TOT), Statoil (NYSE:STO), and BP (NYSE:BP) need $60 oil to balance their budgets.
  • Record bankruptcies: As major oil producing countries such as Saudi Arabia keep pumping oil at record levels in an attempt to gain market share, a wave of bankruptcies is expected to occur in 2016 due to creditors and banks becoming unwilling to extend risky "credit lines" to oil producers forcing many to shut down.

What is the extent of the expected decline in production? The EIA is forecasting crude supply volumes in 2016 to average 95.9 mb/d, basically unchanged from the same levels seen in 2015. The largest oil production declines are to come from US shale producers (0.4 mb/d reduction), effectively absorbing the impact of increased volumes from Iran. Although US shale oil producers have shown resiliency surpassing all expectations following efficiency gains in operations, it seems that it is not enough to stop the bleeding. The break-even price for US shale oil producers has come down from an average $65 a barrel to $50, but is still too high.

Production Cuts by OPEC and Russia: OPEC members and Russia, who account for over 50% of global production volumes, are under economic stress, with some countries, including the largest oil exporter Saudi Arabia, having to raise debt to support their spending. Most of these nations have spending budgets based on oil price of over $75 which are not covered at the current price level. As the bleeding increases, OPEC producers and Russia will likely be forced to agree on production cuts to tackle the oversupply. Saudi Arabia who has refused so far to cooperate is more likely to start showing some flexibility as its primary target to curb US shale production has been achieved.

Demand for Crude Oil: Demand for crude is expected to increase, mainly fueled by lower oil prices. 2015 saw one of the highest volume increases in global oil demand this century. Demand in 2016 is expected to continue higher but at a slower pace. EIA projects 2016 crude consumption to increase by 1.4 mb/d up by 1.5%. The EIA figures were released prior to the European Central Bank and the Bank of Japan signaling their intentions to increase Quantitative Easing last week, which will have a positive impact on oil consumption. Therefore, I expect that the EIA will revise its expected oil consumption figures upwards in its next report.

US Dollar Strength: Federal Reserve is likely to follow suit the European and Japanese central banks by stating concerns about global economic growth and tone down its hawkish calls for higher interest rates. Should this happen, it will likely put a cap on the strengthening of the US dollar and will help support crude oil prices.

Supply and Demand to Balance in 2016: The EIA final report projects that 2016 crude production will exceed demand by 0.7 mb/d on average (or by 0.8% of consumption volumes), with the pace of stock building easing in the second half of the year as supply from non-OPEC producers falls. So basically the EIA report is suggesting a possible balanced supply/demand to happen sometime by the end of 2016, without taking into account any potential production cuts by OPEC and Russia or the effect of further Quantitative Easing (QE) by Japan, China and Europe.

Conclusion

Oil prices are likely to continue to experience periods of heightened volatility in the near term due to economic uncertainties including global growth concerns. However, as we get closer to reach a balance in the crude supply/demand equation later in 2016, which will be evidenced by a reduction in the current levels of stockpiles, the market should start to see signs of recovery back to more normal levels where oil producers can actually make money or at least break-even. The EIA forecasts an average price for WTI crude of $38.54 for 2016, from which we can conclude that the EIA's estimate for WTI to be over $40 at year-end 2016, is in line with the major banks consensus forecasts of between $40 and $50 per barrel by the end of the year. The EIA's 2017 crude price estimate is to average at $47.

In my next article "Why The Birth Of A "New Oil Bull Market" is Imminent? (Part 2)", I will argue why crude oil prices could shoot much higher than the $40-$50 marks. Follow me to receive my latest research relating to crude and commodities outlook.

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Disclosure: I am/we are long AMLP.

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