Oil Fundamentals Deteriorate, Prices Should Fall Hard

It’s a sign of how bad things are that we feel optimistic about $35 oil.

By Art Berman, Oilprice.com

Oil prices should fall, possibly hard, in coming weeks. That is because fundamentals do not support the present price.

Prices should fall to around $30 once the empty nature of an OPEC-plus-Russia production freeze is understood. A return to the grim reality of over-supply and the weakness of the world economy could push prices well into the $20s.

A Production Freeze Won’t Reduce the Supply Surplus

An OPEC-plus-Russia production cut would be a great step toward re-establishing oil-market balance. I believe that will happen later in 2016 but is not on the table today.

In late February, Saudi oil minister Ali Al-Naimi stated categorically, “There is no sense in wasting our time in seeking production cuts. That will not happen.”

Instead, Russia and Saudi Arabia have apparently agreed to a production freeze. This is meaningless theater but it helped lift oil prices 37 percent from just more than $26 in mid-February to almost $36 per barrel last week. That is a lot of added revenue for Saudi Arabia and Russia but it will do nothing to balance the over-supplied world oil market.

The problem is that neither Saudi Arabia nor Russia has greatly increased production since the oil-price collapse began in 2014 (Figure 1). A freeze by those countries, therefore, will only ensure that the supply surplus will not get worse because of them. It is, moreover, doubtful that Saudi Arabia or Russia have the spare capacity to increase production much beyond present levels making the proposal of a freeze cynical rather than helpful.

Figure 1. Incremental liquids production since January 2014 by the United States plus Canada, Iraq, Saudi Arabia and Russia. Source: EIA & Labyrinth Consulting Services, Inc. (click image to enlarge)

Saudi Arabia and Russia are two of the world’s largest oil-producing countries. Yet in January 2016, Saudi liquids output was only ~110,000 bpd more than in January 2014 and Russia was actually producing ~50,000 bpd less than in January 2014. The present world production surplus is more than 2 mmbpd.

By contrast, the U.S. plus Canada are producing ~1.9 mmbpd more than in January 2014 and Iraq’s crude oil production has increased ~1.7 mmbpd. Also, Iran has potential to increase its production by as much as ~1 mmbpd during 2016. Yet, none of these countries have agreed to the production freeze. Iran, in fact, called the idea “ridiculous.”

Growing Storage Means Lower Oil Prices

U.S. crude oil stocks increased by a remarkable 10.4 mmb in the week ending February 26, the largest addition since early April 2015. That brought inventories to an astonishing 162 mmb more than the 2010-2014 average and 74 mmb above the bloated levels of 2015 (Figure 2).

Figure 2. U.S. crude oil stocks. Source: EIA and Labyrinth Consulting Services, Inc. (click image to enlarge)

The correlation between U.S. crude oil stocks and world oil prices is strong. Tank farms at Cushing, Oklahoma (PADD 2) and storage facilities in the Gulf Coast region (PADD 3) account for almost 70 percent of total U.S. storage and are critical in WTI price formation. When storage exceeds about 80 percent of capacity, oil prices generally fall hard. Current Cushing storage is at 91 percent of capacity, the Gulf Coast is at 87 percent and combined, they are at a whopping 88 percent of capacity (Figure 3).

Figure 3. Cushing and Gulf Coast crude oil storage. Source: EIA and Labyrinth Consulting Services, Inc. (click image to enlarge)

Prices have fallen hard in step with growing storage throughout 2015 and early 2016. Since talk of a production freeze first surfaced, however, intoxicated investors have ignored storage builds and traders are testing new thresholds before they fall again.

The truth is that prices will not increase sustainably until storage volumes fall, and that cannot happen until U.S. production declines by about 1 mmbpd.

Despite extreme reductions in rig count and catastrophic financial losses by E&P companies, production decline has been painfully slow. The latest data from EIA indicates that February 2016 production will fall approximately 100,000 bpd compared to January (Figure 4).

Figure 4. U.S. crude oil production and forecast. Source: EIA STEO, EIA This Week In Petroleum, and Labyrinth Consulting Services, Inc. (click image to enlarge)

That is an improvement over the average 60,000 bpd monthly decline since the April 2015 peak. It is not enough, however, to make a difference in storage and storage controls price.

EIA and IEA will publish updates this week on the world oil market balance and I doubt that the news will be very good. IEA indicated last month that the world over-supply had increased almost 750,000 bpd in the 4th quarter of 2015 compared with the previous quarter. EIA data corroborated those findings and showed that the surplus in January 2016 had increased 650,000 bpd from December 2015.

Oil Prices and The Value of the Dollar

Why, then, have oil prices increased? Partly, it is because of hope for an OPEC production freeze and that sentiment is expressed in the OVX crude oil-price volatility index (Figure 5).

Figure 5. Crude oil volatility index (OVX) and WTI price. Source: EIA, CBOE and Labyrinth Consulting Services, Inc. (click image to enlarge)

The OVX reflects how investors feel about where oil prices are going. It is sometimes called the “fear index.” That suggests that investors are feeling pretty good and less fearful about the oil markets than in the last quarter of 2015 when oil prices fell 47 percent. Since mid-February, prices have increased 37 percent.

But there is more to it than just hope and that may be found in the strength of the U.S. dollar. The negative correlation between the value of the dollar and world oil prices is well-established. The oil-price increase in February was accompanied by a decrease in the trade-weighted value of the dollar (Figure 6).

Figure 6. U.S. Dollar value vs. WTI NYMEX futures price. Source: EIA, U.S. Federal Reserve Bank and Labyrinth Consulting Services, Inc. (click to enlarge)

Now, that trend has reversed. The U.S. jobs report last week was positive, so continued strength of the dollar is reasonable for a while. Assuming the usual correlation, that means that oil prices should fall.

Oil Prices Should Fall Hard

It is a sign of how bad things have gotten in oil markets that we feel optimistic about $35 oil prices. It should also be a warning that the over-supply that got us here has not gone away.

Oil storage volumes continue to grow and that is the surest indication that production has not declined enough yet to make a difference. It is impossible to imagine oil prices rising much beyond present levels until storage starts to fall. In fact, it is difficult to understand $35 per barrel prices based on any measure of oil-market fundamentals.

The OPEC-plus-Russia production freeze is a cynical joke designed to increase their short-term revenues without doing anything about production levels. An output cut would make a difference but a freeze on current Saudi and Russian production levels means nothing. It apparently made some investors feel better but it didn’t do anything for me. Iran got this one right by calling it ridiculous.

No terrible economic news has surfaced in recent weeks but that does not change the profound weakness of a global economy that is burdened with debt and weak demand. The announcement last week by the People’s Bank of China that it sees room for more quantitative easing may have comforted stock markets but it only added to my anxiety about reduced oil consumption and future downward shocks in oil prices.

I hope that oil prices increase but cannot find any substantive reason why they should do anything but fall. As market balance reality re-emerges in investor consciousness and the false euphoria of a production freeze recedes, prices should correct to around $30. A little bad economic or political news could send prices much lower. By Art Berman, Oilprice.com

And there are the “negative ripple effects.” Read…  Dallas Fed Unplugs Oil Bulls, Warns of Liquidity Crunch, Contagion

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  19 comments for “Oil Fundamentals Deteriorate, Prices Should Fall Hard

  1. Palo says:


    • alexaisback says:

      Chevron Corp.’s $54 billion Gorgon liquefied natural gas project,
      whose partners include Royal Dutch Shell Plc and Exxon Mobil Corp., reportedly starting to ship next week ( 3/14/16).

      Initially estimated cost of $37 billion came in at 54 Billion.

      Imagine they have to get that money back somehow ?

      Sell Sell Sell price is irrelevant must sell product to get income regardless of price…………

      ====== Yes prices must decline, for this reason and also for say Argentina oil ( and others ) which has no choice but to borrow from China to increase production and sell sell sell to support the economy or face civil war……
      . Finally we all know Iran will not cooperate with Russia and Saudi to limit production at this time they are just starting to produce oil and legally sell oil why would they limit it….. they would not, no one would..
      Just many reasons oil should stay low for long time Saudi’s too do not want eat all the Sovereign funds they Must produce and sell. Every one has to produce and sell- Sell – SELL.

      • DV says:

        You forget that with Gorgon the operating costs are sometimes higher than what they can get in the market. Of course, Chevron needs the cash flow, but the project may be loss-making at these prices even at the operational level, not geneating, but burning cash.

        As to Saudies, at $30 Brent they will be spending close to $20 bln a month to sustain their budget spending. That is well over $200 bln on annualized basis. How long do you think they can withstand such pain?

        And people forget that many smaller producers such as Mexico and Venezuela have been actually losing production. China’s production (forth largest) will be down too.

        Then the summer is coming the the Middle East will have to burn a lot of oil to keep air conditioners running, SA alone burns 400 mln barrels per day to geneate electricity. So most likely the oil will actually rebound to about 50 by May or even earlier. It is likely then to fall toward the year end, unless there is a production cut deal.

  2. Mad Max says:

    IMO the strength of the Dollar comes down to the divergence between U.S. monetary policy and the rest of the world. Every other major economy is cutting, or devaluing. The Fed is not. The Fed will meet next week and we will know what they are planning.

    If you expect the Fed to remain ‘tight’, you should expect the Dollar to strengthen and oil to weaken.
    They have no excuse not to tighten (rallying stocks, good jobs print, etc…) So if they don’t tighten, the top is probably in on the dollar and the bottom on oil, as I suspect they won’t get another chance to raise.

  3. Chicken says:

    I have to try filtering the old news from the new news, then add to that future news as it becomes available but it seems there’s a bit of short profit taking going on.

    Notice the FED was happy with a falling SPX/NASDAQ/.DOW, all that was acceptable until banks began selling off as well then they changed their tune, lol.

  4. Chicken says:

    Ease up, it’s time for banks to feast on secondary offerings and besides, prices don’t move in a straight line.

    “PDCE today announced that it has priced and upsized a public offering from 4,000,000 to 5,150,000 shares of its common stock for total gross proceeds (before underwriters’ compensation and estimated expenses) of approximately $262.7 million. BofA Merrill Lynch and J.P. Morgan are acting as joint book-running managers”

  5. Shawn says:

    I thought the reason why oil is going up right now is because of an epic shot squeeze.

    • Wolf Richter says:

      Yes, correct. But something has to cause or trigger a short squeeze.

    • MC says:

      I prefer the term “forced rally”, meaning a rally that goes against every single fundamental we have available.
      Yes, oil probably hit its bottom at $26/bbl but a 37% jump in less than one month in face of unchanged fundamentals (Cushing and ARA are not going to empty all by themselves and Saudi Arabia has another half million barrels a day capacity coming into line over the next months) hints at the fact this rally is not driven by fundamentals but by financial factors.
      A +5% would have been more than reasonable. A +10% jump acceptable… but 37% is just asking for troubles.
      It means instead of that slow but steady adjustment upwards as demand and supply rebalance we’ll get a short term peak followed by yet another decline, that may well take oil back to $30/bbl in a matter of days.
      I suspect the reason is twofold.
      Yesterday iron ore, one of the most thrashed commodities in the world, jumped well over 10% in face of unchanged fundamentals for no discernible reason at all. That pretty much confirmed my suspicions: somebody (meaning a lot of funds and other large istitutional investors) is betting on yet another round of stimulus spending originating from China. The Party Congress is presently ongoing and there are insanely high expectations about it, albeit it’s very likely Beijing will seriously disappoint anybody hoping for a repetition of the 2009-2012 excesses. The Party seems presently more focused on reducing overcapacity and dealing with that mountain of debt its export miracle is built upon: building new railroads and skyscrapers will have to take a back seat.
      As an added bonus, this miraculous rally has allowed energy outfits cut off from the bond market by “punishing” rates to sell mountains of equities to raise fresh capital. Somebody is going to get rich by shorting those equities when oil prices will adjust again.

      Again: this an extremely dangerous game that, as with other pieces of financial engineering, may last longer than anybody would like with any extra day adding to the dangers.

  6. Ptb says:

    This little bounce in oil does seem like the cat hitting the patio

  7. LG says:

    China trade is crashing for the 8 month straight! Just saying.

  8. David D says:

    The strength of the dollar is based on other CB’s continuing to debase their already massively debased currencies. It is based very little by what the U.S. Fed will or won’t do to further tighten or loosen monetary policy. Money is leaving other global economies in mass droves and coming to the U.S. The dollar will continue to get stronger and stronger in the future until it finally also gets to it’s point of implosion. Then precious metals will be the way forward.

  9. CameronS says:

    About 1/3 of the tank cars used to transport shale oil are now being used to warehouse the oil. The cost for leasing a 700 barrel capacity tank car is $1500-$1700 per month, so if the warehousing period lasts for six months, the barrel price has to increase by about 50 percent to make this exercise in market-timing fruitful. It seems not all speculators aren’t good with numbers.

    • Jungle Jim says:

      I just did an unscientific, back-of-an-envelop, run on your numbers. Ohhhh…….ugly. But isn’t the same thing true of VLCCs just on a larger scale ? Somebody must be paying through the nose for them.

  10. Juergen says:

    You’re stating “the correlation between U.S. crude oil stocks and world oil prices is strong”. Please have a look at those graphs: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCESTUS1&f=W and https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rwtc&f=w and it will be hard to prove you’re right on this. If you have a look at EIA’s historical data you will find that we have (in the US) the highest amount of stocks since 1925 – 1930! I am no Dr. Doom but somebody better watches out for the market movers.

  11. Nicko says:

    So when do the musical chairs stop moving? I’m guessing sometime around the US POTUS elections?

  12. orion says:

    question again about the floating storage on ships. wolf last time u said there were 50 tankers docked in one city Rotterdam. do they know how many of these there and what the storage levels are everywhere else it is being stored? until all this get oil get offloaded there will be no clearing any of this up. I was reading something and these tankers can hold a heck of a lot of oil. depending on size.

  13. Patrick Wilson says:

    20$/bbl oil the natural progression of a manipulated inflation cycle. Energy is plentiful and must be cost effective if you want real growth. Put all the lipstick on it you want, recent calls for (hopes for) inflation to improve prices only benefit the political (criminal class)

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