Latest Oil Rally Another 'False Dawn' As Global Supply Glut Worsens

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Financial Markets Wizard

Investors hoping to see a recovery in the oil markets will have to wait a lot longer, according to a forecast by the International Energy Agency (IEA). The Paris-based organization representing 29 countries announced in February that the oil surplus will likely swell to 1.75 million barrels per day through the first half of 2016, higher than the previous estimates of 1.5 million.[1] This will no doubt exacerbate the oil collapse and put to rest any optimism that the price rally of late January could be sustained.

In fact, the IEA described the latest rebound as another "false dawn"[2] in a market that has seen its prospects dashed over a 20-month price shock. Over that period, the price of West Texas Intermediate (WTI) crude has declined a staggering 75%.

Understanding the Price Collapse

A perfect storm of factors came together to create one of the worst oil shocks since the market's epic collapse in 1986. Waning international demand, peak OPEC production and a US shale boom have caused a severe imbalance in the oil market where supply far outweighs demand. International demand has been blunted mainly by a slowing Chinese economy, which is undertaking a painful transition away from exports and investment toward consumption. China's economy expanded 6.9% in 2015, the slowest rate in 25 years[3] and just below Beijing's official target of 7%. As the world's largest energy consumer, China is seen as a major demand-driver of crude and natural gas.

Instead of cutting production to help support prices, the Organization of the Petroleum Exporting Countries (OPEC) - a 12-nation oil cartel headed by Saudi Arabia - has effectively waged a price war against global producers. The cartel has kept production well above 30 million barrels per day, effectively flooding the global market with oil. While non-OPEC producers reduced their output levels by around half a million barrels per day in January, the cartel increased its output by 280,000 barrels per day.[4] Despite rumors being floated that Russia and OPEC were planning to coordinate a production cut, Saudi Arabia quickly dismissed that possibility.[5]

Where Do Prices Go From Here?

It's important to remember that the underlying forces behind the supply-demand imbalance haven't changed very much over the past year-and-a-half. And while it's reasonable to assume that demand will rise, spending on new oil projects will continue to decline and equity prices will remain low, there's very little indication that a supply drop is in the cards. If anything, OPEC has made it abundantly clear that it is prepared to raise production levels to maintain market share. This says nothing about Iran's plans to increase output following the removal of international sanctions.

Goldman Sachs reflected on these market dynamics in a recent forecast, where it said oil prices could fall below $20 a barrel as the market attempts to rebalance.

"Once you breach storage capacity, prices have to spike below cash costs because you have to shut in production almost immediately," Goldman's head of commodities research Jeff Currie told Bloomberg News in a television interview on February 9.

Currie added that he "wouldn't be surprised if this market goes into the teens."[6]

Investors may recall that Goldman Sachs was one of the first to float the idea of $20 oil last September when prices were hovering around $45 a barrel.

The US Energy Information Administration (EIA) estimates that crude prices will average above $37 a barrel in 2016,[7] which is more optimistic than the latest forecast put out by Morgan Stanley. The US-based financial services company slashed its 2016 oil forecast from above $50 a barrel to below $30.[8]

While forecasts vary, analysts are nearly unanimous about the oil market over the short term. In fact, most estimates don't see oil trading above $70 any time in the next two years.

[1] Grant Smith (February 9, 2016). "IEA Raises Estimate of Suplus Oil Supply on Higher OPEC Output." Bloomberg Business.

[2] The Week UK (February 10, 2016). "Oil price rally another 'false dawn', says global energy watchdog. The Week UK.

[3] Mark Magnier (January 19, 2016). "China's Economic Growth in 2015 Is Slowest in 25 Years." The Wall Street Journal.

[4] Grant Smith (February 9, 2016). "IEA Raises Estimate of Suplus Oil Supply on Higher OPEC Output."

[5] Grant Smith (January 28, 2016). "OPEC States Say No Meeting Planned as Russia Floats Talks." Bloomberg Business.

[6] Grant Smith and Jonathan Ferro (February 9, 2016). "Goldman Sees Risk of Oil Below $20." Bloomberg Business.

[7] US Energy Information Administration (February 9, 2016). Short-Term Energy Outlook.

[8] Ben Mashinsky (February 9, 2016). "MORGAN STANLEY: We're slashing our oil price forecast by 50%." Business Insider UK.