Oil's Turbulent New Year

by: The Financialist

oil 2016 The beginning of a new year is supposed to be a time to start afresh, but for oil markets, 2016 has brought only fresh troubles. On January 6, the U.S. Energy Information Administration (EIA) announced that at 482.3 million barrels, U.S. crude oil inventories are close to an 80-year high for this time of year. As if that weren't enough, concerns about global economic growth, sparked by another month of weak Chinese manufacturing data, triggered a widespread sell-off in the global financial markets last week. Oil certainly wasn't exempt from the rout. Brent crude oil prices closed at $34.38 a barrel on January 6, past a key threshold of $34.55, which means prices could soon fall into the $20s - the lowest since 2003 - say Credit Suisse's technical analysts. The prices have since dipped below $32 a barrel.

Even at $34 a barrel, oil prices were plumbing depths last seen in 2008. Whether $25 or $35, the real question is how long can prices stay extraordinarily low? Credit Suisse's base-case forecast is that oil prices will begin to recover this year.

The stage for the world's current supply glut was set several years ago, when the shale revolution led to a huge increase in U.S. oil production and set the stage for Saudi Arabia to abdicate its role as the world's swing producer in order to protect market share. Credit Suisse believes the Saudis will keep production levels flat this year, as the kingdom is already producing as much oil as it can without further investment, to the best of Credit Suisse's knowledge - however, the bank's analysts continue to monitor rig counts and official selling prices, since a production increase poses a downside risk to their forecast. If Saudi Arabia does ramp up production from its July 2015 peak of 10.5 million barrels per day, it would likely prevent oil prices from rising significantly in 2016.

Other countries also have an important part to play on the supply side of the oil equation. Iraqi production soared 23 percent in 2015, while U.S. supply grew 6.8 percent in 2015. Looking forward, Credit Suisse analysts believe Iran will ramp up production by 500,000 barrels per day once the sanctions on crude exports are lifted.

If Iranian oil is the only significant new supply to hit the markets in 2016 and demand stays on track, Credit Suisse expects oil prices to inflect up later in the year. The bank's analysts believe Iraqi production has little room to grow further, given infrastructure constraints, the threat from ISIS, and oil companies cutting investments for 2016. They also note that U.S. production began to fall in the second quarter of 2015, and declines are likely to continue in the first two quarters of 2016. Non-OPEC countries outside the United States are likely to experience declining output as well.

If Credit Suisse's supply forecasts are correct, rising demand for oil should eventually force a draw on inventories, putting upward pressure on prices. Healthy consumer demand trends in the U.S. and Europe should make up for weakening global industrial production, unless a collapse in Chinese investment or an unforeseen disaster prompts a global recession. If global growth improves slightly this year, however, as currently forecasted, Credit Suisse believes Brent crude prices will hit $64 a barrel by the end of 2016.

The oil price trajectory has implications far beyond the commodities complex. The performance of emerging market bonds, currencies, and equities are highly correlated with oil prices. Low energy prices also depress headline inflation numbers, and inflation is the key indicator that officials at both the Federal Reserve and European Central Bank are watching to determine future monetary policy.

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