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Why I think $60 is the ceiling on the oil price into 2016

The fall in the oil price from $60 to below $53 over the last two weeks is a clear indicator that the market believes that the global oil market will stay over supplied for a longer period that most market participants have anticipated. And the facts seem to back up this view. We are not seeing reductions in oil production from any of the the major global producers; in fact, quite the contrary; in June, Saudi Arabia, Iraq, the United Arab Emirates and the United States all set production records.

What this means is that we are still producing too much oil across the world to the tune of 1.5m barrels a day and this can be clearly seen in the inventory data from the IEA in the United States which showed, for the week ending 3rd July, US stocks of crude oil and other liquid oils at an all-time high of 1,962 million barrels. The big question on everyone’s lips is when will we see a balanced oil market again?

This could happen because of an increase in demand for oil or a decrease in production. However, both are not likely to happen this year. On the demand side while there may be some growth in demand in Europe and North America the reality is we have probably seen peak demand for oil in these regions.  Demand growth is going to come from Asia and in particular China and India. We would need to see demand growth of 2.5mbd till the end of 2016 for the market to rebalance around current production levels. Is this likely? Probably not.

The fastest growing oil market is China, which saw oil demand in June grow by 360,000 barrels compared to the same month last year.  However, the Chinese economy is showing signs of slowing and it is also important to note that the government is very much focused on curbing the growth in oil demand by forcing very expensive automobile registration charges in cities like Shanghai as well as pushing electrification of transport in the form of trains and scooters. These measures are already having an impact and China’s automakers association is now expecting new car sales to grow by 3% this year as opposed to the 6-7% they had expected at the start of the year.To add to this China is very much focused on pushing electric vehicles (EVs) in the next years which could also have an impact on oil demand.  And as other countries move electric, the almost continual growth in oil demand we have seen for the last hundred years may come to an end. In a nutshell, demand for oil is likely to remain weak in years to come.

On the supply side, major oil producers within OPEC such as Saudi Arabia and Iraq are not cutting production.  In fact, they are very much focused on not just protecting but gaining market share in the oil market. To add to this the nuclear agreement between the G5+1 and Iran sets the stage for further gains in OPEC oil production. This could be as much as an extra 1m barrels of oil over the next 12-18 months which is close to the 1.2m barrels in extra demand the IEA is predicting for next year. If this scenario does happen then we will see oil prices at best at $60 until the end of 2016.

The wildcard in all of this is US oil production. Production growth has already slowed significantly as E&P firms have cut investments. However, we are still seeing production at all time highs and the question is if and when production in the US will fall. The general view is that 1-2m barrels per day of US production is not economically viable at current oil prices which begs the question why they are still producing. They are doing so because of two reasons: one, because they are “hoping” that the oil price will rise again and two, they have hedged their oil production meaning they have used financial derivatives such as futures to guarantee the price that the oil can be sold at. So for instance, Chesapeake Energy Corporation (NYSE:CHK), one of the leading US oil and gas producers, has, according to their latest SEC fillings, downside price protection on approximately 43% of their projected remaining 2015 oil production at an average price of $93.48 per barrel. This of course begs the question: what happens next year? Hedging will prove to be very expensive at current oil prices so what you are likely to see is a reduction in production as producers make a decision to close unprofitable production. This is what the Saudi Arabia is banking on and my guess is that we will begin to see this happening in Q1 of next year.Until then oil is not likely to go above the $60 mark.

This post was originally published on the Energy and Carbon Blog

$60 is the ceiling on the oil price into 2016