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Short term outlook for oil remain negative

Many commentators have suggested that the oil price would rise in the first quarter. Well here we are the start of the second quarter and the oil price is still below $50. Whatsmore any trader will tell you that from a technical point of the chart looks pretty ugly with oil caught in a downward trend; which however is not surprise when you consider the recent US data (April 1) which shows US crude oil stocks at all time highs (471.4m barrels) which implies that supply is still greater than demand.

The good news is that US oil production fell for the week ending March 27 to 9.386m barrels down slightly below the 9.422m barrels from the previous week. Oil prices reacted positive to the news seeing it as sign that US production was peaking. Maybe, but US oil production is up 1.1m barrels a day over the last 12 months and the Saudi’s are also increasing production. Saudi production is estimated to be 10m barrels in March which would be the highest level in many years and well above the 9.5m barrels average from last year. So how can oil prices go up when we are in a weak demand environment and the world’s two largest producers are still increasing oil production?

To add to this, there is likely to be an extra 1m barrels of oil coming on the market in the second half of this year in the form of Iran and Libya which could add between them 0.5m barrels with another 0.5m barrels coming to market in 2015. But the biggest upside to oil production is Iran. The recent nuclear agreement with Iran paves the way for a lifting of the oil embargo on the country. And let’s not forget that Iran’s oil and gas production have declined substantially in recent years. In 2008 Iran produced 4.4m barrels a day. In 2014 it was 3.6m so there is lots of upside. Whatsmore Iran holds the world’s fourth-largest proved crude oil reserves and the world’s second-largest natural gas reserves. It means another 500 thousand barrels a day on the market in the second half of this year and this will likely increase by the same margin next year and in 2017.

This leaves two big supply questions. Will US production fall significantly in the second half of the year? And will OPEC reach an agreement to cut production when they meet in June?

Let’s start with the latter. The answer is most unlikely given that Saudi Arabia and Iran both seem to be focussed on increasing rather than curtailing production, and Saudi is constantly telling the market that they have no intention of “intervening” in the oil market. But the behind the doors pressure is growing and if Saudi and Iran can come to some form of output agreement and take together the lead in OPEC, then anything is possible.

As to the US this seems to be the most likely route to a decrease in production given the higher cost structure of a large amount of the US oil. The reason this has not happened to date is that most of the US producers have forward sold their production at agreed prices or else have used financial derivatives to hedge their production. An analysis by the EIA shows that for 32 listed US oil producers oil revenues fell by 22% from $10.9 billion in third-quarter 2014 to $8.6 billion in fourth-quarter 2014. But because of $1.3 billion income from hedging activities, the total revenue figure only fell by $1.1 billion. Each company tends to have different hedging strategies so the big question now is how long companies have hedged forward. The answer is up to 18 months ahead.

My bet is that most have hedged 12 months ahead which means that as the hedges come off production will be cut….that puts me in August of this year.

What’s it all mean. Oil buyers are going to remain very happy in the second quarter as they were in the first quarter.

This post first appeared in the Energy Carbon Blog