The decline in crude oil prices remains unabated as the fear of supply glut increases into 2015. I must admit that I expected oil to remain above $70 per barrel. The key rationale was a production cut from OPEC and Russia in 2015. With no decision on production cuts, the outlook for oil prices remains uncertain. I will discuss the factors that contribute to the uncertainty later in the article.
Amidst the bearish sentiments, the oil price forecast for 2015 by Morgan Stanley offers more gloomy prospects. According to Morgan Stanley -
Without OPEC intervention, markets risk becoming unbalanced, with peak oversupply likely in the second quarter of 2015. Prices are set up to fall in the first half of 2015...crude prices could average as little as $53 per barrel in 2015, although its base case scenario was for $70... In the worst case scenario, oil could fall as low as $43 in the second quarter of next year, recovering to only $48 in the third quarter...
This article will discuss the most important factor that can take oil to $43 per barrel in the second quarter of 2015.
Before discussing the factor, I would like to make the following points clear -
First, markets have discounted the factor of no production cuts in 2015 by OPEC and Russia.
Second, China is hoarding oil to benefit from lower oil prices and markets have discounted this positive factor.
Third, markets have discounted a potential 550,000 barrels of oil per day supply from Kurdistan region of Iraq with New York Times reporting on December 2, 2014 that a deal has been reached between the Kurds and Iraqi government on sharing of oil revenues.
The Gulf states "don't have a price target, and if prices drop further below $60, it won't be for a long time."
The key conclusion from these four points is that the markets have discounted some of the major supply side factors and OPEC also believes that oil prices can potentially stabilize at $60 per barrel.
In my opinion, there remains just one factor that can take oil to $43 per barrel - A potential recessionary deflation in the Euro-zone.
In one of my earlier articles, I had discussed that massive easing is likely in the Euro-zone with decline in growth and inflation. I had pointed out in the same article that seven Euro-Area members are already in deflation.
I expect the Euro-zone economy to fall into recession in 2015. However, the depth of recession remains uncertain and will be largely determined by how the speed of action by policymakers. With Germany opposing further stimulus, the dispute among member states can delay monetary easing and cause the recession to be deeper.
There are two ways in which a recession in the Euro-zone is strongly linked to oil prices -
First, a deep recession would further lower the demand for oil and result in prices trending down
Second, a deep recession would mean massive policy response. The euro will decline further against the dollar and a stronger dollar is negative for oil. In the last few months, the dollar index has surged and is one of the factors for weaker oil besides the dominant factor of supply glut.
I must add here that I expect the Chinese economy to be weaker in 2015 as compared to 2014. However, the weakness is offset by China's strategy to increase oil imports as strategic reserves.
Therefore, the Euro-zone and the dollar remain the biggest factors that will determine if oil prices are likely to decline further. Oil will remain at around $60 per barrel as mentioned earlier in the article, if OPEC's oil price strategy works.
From an investment perspective, my opinion remains that investors can consider gradual exposure to some attractive names in the oil & gas space. From a long-term perspective, I remain bullish on energy stocks.
It is also interesting to note that as of December 5, 2014 rig count overview (provided by Baker Hughes), the US rig count continues to increase. There are several shale companies that will remains profitable even at $50 per barrel oil. I have discussed few interesting names in my recent articles.
Investors considering broad exposure to the sector can allocate funds to the Vanguard Energy ETF (NYSEARCA:VDE). Among specific names, Cabot Oil & Gas (NYSE:COG) and Encana (NYSE:ECA) are interesting. Both these stocks are well positioned from a leverage and funding perspective. Further, both these companies have the potential to generate robust IRR even at $60 per barrel oil price.
In conclusion, the oil price trend for 2015 will be determined by economic factors and currency factors. I also believe that if oil does fall to $40 or $50 per barrel levels, there will be a certain production cut coming from OPEC and Russia.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.