Hang On! Oil Supply Will Get Worse Before It Gets Better - More Pain Ahead

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Includes: OIL, USO
by: Gary Bourgeault

Summary

Why ETF inflows have nothing to do with the fundamentals at this time.

Too much oil will be the ongoing catalyst.

Supply and demand won't rebalance in 2016.

Downward pressure will continue on oil prices.

Investors should be wary of the many attempts to prop up the oil market using media as the means of influence. Oversupply will continue to be the main metric to watch, and evidence continues to mount it's going to get worse before it starts to reverse direction, and that means the price of oil should move in conjunction with it.

The latest report from the International Energy Agency reinforces the thesis, saying too much oil on the market will only increase in volume, as the outlook for global oil demand growth falls below the recent pace of growth.

Not only that, but production from OPEC is projected to climb more in 2016, contrary to the dubious and unbelievable reports there will be an agreement between Russia and OPEC to cut supply. Russia already called that bluff, and as I mentioned recently, Saudi Arabia quickly folded.

My goal is to keep oil investors focused on supply and demand rather than the seemingly endless number of scenarios coming out of the media, implying something else will trigger a rise in oil prices.

source: Telegraph

ETF inflows

One of them is the increase in investment in ETFs with strong oil exposure. The conclusion is because there has been huge inflows into the ETFs, it points to the price of oil changing direction. Why would it mean that? It only means some institutional investors are getting in at a fairly low price and will hold on for the long term. At least that's my view of it.

To suggest money flows to investment vehicles trumps the fundamentals is nonsensical. Of course if the money flow is based upon the fundamentals, that's different. At this time it isn't. Institutional investors are getting in, believing oil has either hit a bottom, or is close to it. That's not necessarily a bad strategy, but it has nothing to do with supply and demand. Only supply and demand determines the sustainability of the price of oil, and at this time the outlook is dismal over the next year, and probably longer.

The other thing is it will tie up capital for a long time if the price doesn't start to rise. Again, for those with a long-term investment time frame, that's not a bad thing. It's only that the pressure on oil prices could be of a much longer duration than the market thinks. If that's the case, it would either result in a level investment result at best, or force investors to sell at a loss if they're not in it for the long haul.

Oil demand growth in 2016

In 2015 demand for oil climbed to a five-year high of 1.6 million barrels per day, according to the IEA, with expectations that's going to drop to 1.2 million barrels per day in 2016. Most of that is from the decline in demand in the major oil markets, including the U.S., China and Europe.

When considering the rapidly declining global economy, this could quite likely be an optimistic outlook, even with the approximate 400,000 per day decline in the pace of growth for the demand for oil.

While oil supply slightly declined in January by about 200,000 barrels per day to 96.5 million barrels per day, it had no impact on the price because the market was looking at the reintroduction of Iranian oil into the market after sanctions were lifted. Iran reports it has already added about 300,000 barrels to the market, and it has the short-term goal of increasing exports by 500,000 barrels per day. Further out it wants to double that number. Before the sanctions it was supplying the global market with about 3 million barrels per day; dropping to 1 million barrels per day at the time the sanctions were lifted.

For the year, the amount of oil supplied outside of OPEC is projected to drop by about 600,000 barrels per day, coming in at about 57.1 million barrels per day on average. When combining the drop in demand growth and the boost in OPEC supply, it will continue to pour more oil into the market than demand justifies.

If some of the U.S. shale oil companies follow through with their asserted strategy of bringing their DUC wells into production, it would further flood the global market. At this time there are about 4,000 drilled but completed wells in the U.S., representing an estimated 300,000 barrels per day in supply.

Expectations are U.S. oil inventory will continue to rise, as will global inventory.

Rebalancing will take longer than believed

Saudi Arabia has been consistent on its assertion the oil market will rebalance in 2016, which will support the price of oil. It's wrong.

Eventually there will be a rebalancing of the market, as increased demand will finally overcome oversupply. The question is when that will happen. I'm very bearish on that happening in the near term, by which I mean in the next couple of years. There are too many elements now working against it to change direction during that period of time.

By the time demand finally catches up with supply, it will in fact support the price of oil, but the problem quickly becomes what happens when other producers bring more supply to the market at that time. That's especially true with shale producers, because they can prepare the wells and wait to bring more supply to market in a very short time. To offset that, demand will have to be a lot higher than it is today.

Since most oil companies have already cut back on development, there could be a period of time when that results in an inability to meet global demand, which would move prices up significantly. That is probably going to take at least five years before we see it happen. There is also the remaining shale-producing countries that are in the early stages of exploration and development. That will become a major contributor to supply over the next decade, which at this time is an unknown as to how it will have an effect on the global market.

Because we're in a period of a major disruption of the oil market, we don't have a map we can rely on from the past. Shale oil is the reason for that, and until we get a clearer picture on how it will impact the rebalancing of the market, we won't have as much visibility as we have had.

Even in a low-price oil market, the slowing global economy won't be enough to rebalance the market in the near term, underscoring how much of an oil glut there is.

Conclusion

When taking in the disparate data in reference to oil, the best thing to do is anchor ourselves in the larger supply and demand scenario being played out. The rest is ancillary and can be confusing to investors if we dive too deep into minutia. There's nothing wrong with looking at various areas of the oil market, but it is reflected in the macro data in a way that takes in most of the secondary and smaller data points.

It makes more sense to do that in a bull oil market where something missed by most investors could get us in at a good price point. In a bear oil market all ships are getting hit by the storm, and momentum, for now, is overriding everything else. Minute details can't and won't overcome that.

Oil supply will continue to exceed demand, putting more downward pressure on the price. The share price of companies with significant exposure to the upstream will follow the price of oil down. Even the downstream is weakening because of shrinking margins.

We're in for a rough and long ride. Resist the temptation to move off the fundamentals associated with supply and demand. That is by far the most important data to take in to analyze the oil market.

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.