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Friday, 27 February 2015

When Will Oil Finally Hit Bottom?

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The sharp decline in oil prices in late 2014 caught market participants by surprise, leaving many wondering whether prices might have extended too far to the downside and when they may recover. However, even though some believe that a pause, and possible turnaround, in the steady decline of oil prices is underway, and despite the fact that companies around the world have indicated they will cut capital spending in 2015 and US drilling rigs are idle, oil prices may not be done falling. (For related reading, see article: What Determines Oil Prices?)

 

Short-term support for oil prices

Apache Corp, a top U.S. shale oil producer, said it would cut capital spending and its rig count in 2015 following the price collapse, keeping its output growth mostly flat. Dow Jones reports that company announcements made so far this year indicate that oil companies that account for around 49% of the global oil and gas spending budget intend to spend 16% less on exploration and production in 2015, according to Barclays estimates. Barclays also says the larger spending cuts are expected among Asian oil companies, with the CAPEX budgets for state-run entities expected to decline by 19% in 2015.

These spending cuts are a logical response to a market in which oil prices are lower, but it remains to be seen if the cutbacks are sufficient to have a lasting impact on global oil prices. More detailed capital expenditure budgets will be disclosed by the world’s major oil companies in the next few weeks as they report 2014 full-year results and update their strategic plans. Analysts are likely to look for clues that support oil prices on the one hand, and that ensure companies don’t fall behind competitors in key project development on the other.

 

Supply Continues Rising

In the meantime, US oil supplies continue to grow, which could be the catalyst for another leg down in oil prices in 2015. Reuters reports that oil is flooding into US storage tanks at an unprecedented rate, and says that storage at Cushing Oklahoma could be full in as little as two months. They go on to report that the build-up in Cushing has made demand look more robust than it actually is, artificially supporting prices. This suggests that once storage at Cushing is full, any marginal supply will spill out into the wider market, potentially driving prices down again. But is that what is likely to happen?

Data from the EIA shows February inventory levels at Cushing are near 43 million barrels, which is 72% of the total working crude oil storage capacity of 60 million barrels. But as the chart below shows, inventory levels have been higher than this in the past, and didn’t automatically produce lower oil prices.

In fact, the evidence suggests that it is price that drives storage levels rather than the other way around. For example, during the financial crisis in 2008, front-end oil prices plunged, sending the futures curve into contagion. This condition prompted traders to put oil into storage to sell at a future date).

In contrast, storage levels at Cushing reached record high levels in late 2012 due to bottlenecks in the transportation system (middle oval) while spot prices remained near the $90 per barrel mark and the future price curve was mostly flat. This suggests high inventory levels are a poor leading oil price indicator. In fact, once the bottleneck problem was resolved, and oil was able to flow out of Cushing, oil prices failed to reach the previous 2008 highs despite similar inventory levels.

 

US Production Not Stopping

A more important determinant of future price is likely to be the pace of US oil production. In its latest Short-term Energy Outlook, the US Energy Information Agency says total US crude oil production averaged an estimated 9.2 million barrels per day (bbl/d) in January. Forecasts indicate that total crude oil production is expected to average 9.3 million bbl/d in 2015 and could reach an average of 9.5 million bbl/d in 2016, close to the highest annual average level of production in U.S. history of 9.6 million bbl/d in 1970.

 

The Bottom Line

Despite plans by oil companies to reduce the amount of oil on the market in an attempt to stabilize, or push up, oil prices, the supply of oil continues to increase, and it is possible that the downward trend of oil prices might not be over, since the prices of oil might be less reactive to changes in storage patterns than storage patterns are responsive to changes in price.

Reference: Andrew Beattie

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