Why Oil Could Be Heading Back Below $30

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Gary Bourgeault

Summary

Why oil could easily drop below $30 per barrel.

Fundamentals line up with bear oil market at this time.

Investor momentum drove oil rally - optimism rightly fading.

A production freeze won't alter the fundamentals at all.

Whether or not the worst-case scenario is still in play.

Click to enlarge

source: Stock Photo

Oil investors started to look for a bounce a couple of months ago after oil dropped below $27 per barrel. The general thinking was oil prices at that level weren't sustainable, so it was ready for not only a rebound, but one that had legs. What it didn't take into account were the fundamentals, and the rally was further fueled by the misguided notion a production freeze between some major and minor OPEC and non-Opec producers would provide a bottom for oil prices.

Now that the smoke is clearing and emotions waning, the market is starting to understand the rally was bogus, and primarily fueled by shorts having to cover their positions, along with those taking advantage of what was obviously going to be a short-term upswing in prices. Add to that the already mentioned "verbal intervention" of a proposed production freeze, and you have the basis of what was always going to be a short-term rally.

As I continue to mention, the reason this was a sucker's rally was because the market, overall, has yet to understand or embrace the fact this isn't simply another supply cycle where a move by some of the major producers could quickly support the price of oil, as it has in the past. This is a market disruption as a result of the emergence of the U.S. shale industry. From now on nothing is going to be the same as it has in the past, and the quicker oil and natural gas investors accept this, the more accurate they'll be able to project where the price of oil is headed.

It's why I've been able to accurately project the price movement of oil. I've done it publicly and consistently. I'm not a genius or guru for being accurate, but have embraced and understood the fact we're in a new energy trend as a result of shale oil supplying the market at high levels.

Not only is that the case with U.S. shale, but it will expand in the years ahead as shale production from other countries adds more supply to the market. This won't stop expanding for the next 20 years or so, although U.S. production in and of itself, will probably hit a ceiling within a decade. It will continue at high levels, but will unlikely continue to grow. That assumes more oil isn't discovered or technologically advances make it possible to extract even more oil from existing and upcoming wells.

Worst-case scenario

As for the price of oil, the worst-case scenario for producers will be if inventory at Cushing reaches full capacity. Most of that would be predicated upon gasoline demand slowing down while production remains high.

This would put downward pressure on oil prices because upstream companies would have to move product while looking for alternative storage options. When considering prices closer to $20 per barrel and possibly lower, this is what is being included in the analysis.

Why Cushing is so important and potentially influential is it's the primary refining hub for U.S. shale supply, and there aren't multiple options for what can be done with the crude, as there are with, for example, Gulf refineries. That's why watching gasoline storage levels at Cushing are an indicator of possible extreme pressure on the price of oil.

For now I don't see that playing out because gasoline demand seems to be rising for now. It's why oil prices, while ready to drop further, aren't likely to generate the fear trade that was possible earlier in the year. The price of oil could drop below $30 per barrel, but it's probably not going to drop below $20 per barrel, other than maybe fear driving momentum for a short period of time. That could happen if in the midst of oil prices falling a agreement for a production freeze isn't reached.

It really doesn't matter whether a production freeze is reached or not, as far as the fundamentals go, but it is a psychological catalyst that would have a dramatic impact on investor sentiment, which would drive a negative outcome.

Similar to unwarranted optimism on the bullish side, which drove oil to over $40 per barrel, this could generate a similar response on the bearish side, which could shock the price to the $20 per barrel mark or lower. That wouldn't last for a long period of time in my opinion, but it could linger there for a while until the market sorts out what is going on.

This is why I never liked the idea of floating a production freeze. It created bullish sentiment unrelated to the fundamentals, which without a doubt was going to lead to more volatility. That is happening now because the freeze is understood to be a joke now that Iran and now Libya, have stated they won't participate in the process. If Kuwait and Saudi Arabia follow through with their declarations they won't participate in a freeze if the rest don't, it is obvious it will further underscore the fact this isn't based in reality.
I see that as the case whether Saudi Arabia participates in an agreement or not.

What drove oil rally more than any other factor

I've never liked the short-term fluctuations in the market based upon factors outside of the fundamentals, but that doesn't mean they aren't there. Oil investors need to understand what drove the rally in order to comprehend the price trend going forward.

As usual with the market, emotion drives extremes in responses, and that's what happened once oil dropped below $30 per barrel. Investors starting jumping in like lemmings and once it reached a feverish pitch, the amount of traders shorting the market no longer supported the fundamentals - even on the bearish side.

More than likely we're seeing that happen now on the bullish side. Too many institutional and retail investors hopped on the rally bandwagon, not considering the fact what caused a large bounce in the price of oil because shorts had to cover their positions, can happen on the long side as well. I believe we're already entering that stage.

Fundamentals, while ignored in the short term when fear drives decisions - fear of losing money and fear of losing out on gains - do provide a balancing factor over time, which is where those overloading the play with bearish and bullish extremes can cause a lot of volatility in the market.

As already mentioned, it was into that scenario a proposal for a production freeze caused the price of oil to further rally, as it further pressured shorts to cover their positions. What did that have to do with fundamentals? Absolutely nothing. That's why the price of oil is plunging once again, as it seeks a range based upon actual market conditions.

This is why I despise the so-called "verbal intervention" of the market, because it's being construed as having the potential to guide the price of oil, when it fact the shale revolution has changed that forever.

What are the fundamentals that need to be watched?

Now that we're solidly into the disruption of the oil sector because of the new supply coming from U.S. shale producers, we need to look at what the fundamentals are in the market.

For example, in the past the rig count has been a solid indicator of the oil and gas industry, and it has baffled the market that with over 1,000 rigs shuttered, U.S. production levels remain robust. This is part of the reality of the disruption, and why it's not a supply cycle issue.

Now rig counts don't reflect production and supply levels in the U.S. because shale producers have advanced tech to the point of becoming far more efficient, while also finding ways to extract more oil from their wells. This means lower costs and higher supply from wells already in production, and wells ready to be brought into production.

Next, that has an obvious impact on storage levels, which is of course connected to the rig count assumptions from the past.

As for supply projections, that has been further disrupted because drilled but uncompleted wells are waiting on the sidelines when the market makes it profitable for them to service the market. This is another reason this isn't a supply cycle issue, but a disruption issue. Saudi Arabia has admitted it has no idea how to deal with this new challenge to the oil industry.

While we have to continue to watch oil rig counts and inventory levels, we have to do it differently than in the past. It all has to take into account shale production supply, including its efficiencies, lower costs, and thousands of wells waiting to be added to supply.

Not only that, but on the inventory side, it looks like Saudi Arabia is changing its strategy and selling more oil to the U.S. market at a discount. This, along with improved shale production methods, is why U.S. inventory continues to rise, when the majority of the market believes the fundamentals, which is based on past experience, should drive the price of oil up.

Further, it's why even when demand has been slowly increasing, supply continues to race ahead of the pace. Until that changes, any upswing in oil prices will only be temporary.

What the proposed production freeze is attempting to do is cater to those who believe past intervention methods will work in this disrupted market; it's an attempt to support oil prices in hopes a rebalancing will happen sooner than later.

Taken as a whole, it's not that the fundamentals have changed, it's that most investors aren't fully understanding the impact the U.S. shale revolution is having on those fundamentals, and how they need to be adjusted in how we interpret them.

Nothing has changed in the price of oil being impacted by supply and demand. What has changed is the supply and demand itself, with a new player now part of the overall market, which will be the main driver of global production growth in the years ahead.

Conclusion

The oil price pendulum is swinging back to the bear side once again, as the reasons for a oil rally didn't justify the strength it temporarily enjoyed. Even as the day approaches for a meeting between some oil producers to talk about a freeze, it won't have the effect it has had in the recent past. It will give a little boost to oil prices, but it won't last long.

Inventory levels will continue to climb even as the pace of demand growth shrinks. Add to that the numerous traders going long on oil, and you'll find them running for the exits, just as the shorts had to do.

With momentum to the down side of oil prices increasing, any negative catalysts will once again trigger a sell-off, which could easily drive oil down on momentum based on fears. It won't remain extremely low if that's how it plays out, but it could keep downward pressure on oil through the remainder of 2016 and into the first half of 2017.

The obvious catalyst there would be if a freeze agreement isn't reached, and even if it is, when investors take into account it's really not a freeze when Iran is going to continue to add supply to the market.

Finally, the remaining key factor will be how many drilled but uncompleted wells are brought into service. If it's high, and the production freeze is discounted, that is what would drive the price of oil to very low levels in April. We'll have a clearer picture once earnings reports are in.

With very little in the way of fundamentals propping up the price of oil, I see it dropping much lower, although the depth of that drop and the length of time it remains low will be determined by how the market perceives the upcoming meeting (if it happens at all) and earnings reports which will provide more visibility to the sector.

Further out into the year, after this season of downward pressure, I don't see the market believing an oil rally feint again. We'll come off whatever the lows end up being this time around, but I don't think the market will believe a sustainable move above $40 per barrel in the near future.

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.