There was never any fundamental reason why oil prices should have doubled between January and June this year. There were no physical shortages of product, or long-term outages at key producers. But of course, there was never any fundamental reason for prices to treble between 2009 - 2011 in the Stimulus rally, or to jump nearly 50% between January - May last year.
- Instead, prices once again rose because financial players expected the US$ to decline
- They realised this meant they could make money by buying oil on the futures market as a "store of value"
- Now, as the US$ has started to recover, they are selling off these positions
- And so oil prices are falling again
The problem is that the financial volumes swamp the physical market - they were 7x physical volume at their 2011 peak- and so they destroy the oil market's key role of price discovery based on the fundamentals of supply and demand.
And so, once again, oil prices have been in a bull market along with prices for other major commodities such as iron ore and copper, as well as Emerging Market equities and bonds. In turn, this forced companies to buy raw materials at unrealistically high prices, as the rally coincided with the seasonally strong Q2 period.
Now, as Reuters reports, the funds have already "slashed positive bets on US crude oil to a 4-month low", and are leaving chaos behind them. Companies are finding that they "bought high and will have to sell low", as they need to work off high-priced inventory in the seasonally weak Q3. Adding to the change in mood:
- Russia has confirmed the myth of an OPEC/Russia oil production freeze is now officially dead
- US oil and product inventories have hit an all-time high of almost 1.39bn barrels
- China's gasoline exports have doubled over the past year, and its diesel exports tripled in H1
- Saudi Arabia's Oil Minister has warned "There are still excess stocks on the market - hundreds of millions of barrels of surplus oil. It will take a long time to reduce this inventory overhang"
Even worse is that the world is now running out of places to store all this unwanted product, as Reuters reported earlier this month:
"Storage tanks for diesel and heating oil are already so full in Germany, Europe's largest diesel consumer, that barges looking to discharge their oil product cargoes along the Rhine are being delayed".
Similarly, the International Energy Agency has reported a major backup of gasoline tankers at New York harbor, due to storage being full, whilst Reuters added that tankers are being diverted to Florida and the US Gulf Coast to discharge.
Plus, of course, the recent rally has proved a lifeline for hard-pressed oil producers, who have been able to hedge their output at $50/bbl into 2017. As a result, companies have started to increase their drilling activity again, and are expected to open up many of the 4000 "untapped wells" - where the well has been drilled, but was waiting for higher prices before it was sold.
Yet wishful thinking still dominates oil price forecasts, with the consensus still believing that $50/bbl is a sustainable price. Yet even in February this year, only 3.5% of global oil production was cash-negative at $35/bbl - just 3.4mbd. Today's figure is likely even lower, as costs continue to tumble.
And in the real world, oil prices have already fallen more than 10% from their $50/bbl peak. Unless the US$ starts to fall sharply again, it seems highly likely that prices will now revisit the $30/bbl level seen earlier this year. Given the immense supply glut that has now developed, logic would suggest they will need to go much lower before the currently supply overhang starts to rebalance.
Disclosure: I am/we are long SOIL.L.
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.