The Top 6 Reasons Oil Prices are Heading Lower
Investors and speculators can make money in any market no matter which way prices move. In a rising market, you buy and then sell later at a higher price to make profit; in a falling market, you commit to sell and then buy later at a lower price (shorting). The key element on deciding on an investment strategy in crude oil is to work out where prices are heading.
Despite the fact that falling prices can be an incentive to speculate, brokers and traders that live and breathe the oil market tend to prefer rising prices. Everyone loves to back a winner and rising numbers make those in the market feel like they have improved their status. Thus, no matter how clearly factors show prices are going lower, you will still read enthusiastic explanations that oil prices will rise soon.
Some buyers and their agents may have been caught out by long-term futures contracts that commit them to high prices despite the falling spot price. Thus, they will talk up the market to try to square their books and find a pool of gullible outsiders upon whom they can dump their over-priced stock. However, readers at oil-price.net should know by now that the simple rules of supply and demand mean that the crude oil price will continue to hang around or below the $60 mark for some time to come. Here are the top 6 reasons that savvy speculators should continue to short crude oil.
1. Iran Returns
Despite heavy fines by the US authorities against anyone trading in any way with Iran, that country has still managed to continue oil production over the past few years. Sanctions against Iran have existed in various forms since the eighties when religious fundamentalists overthrew the West-friendly Shah of Iran and committed a series of terrorist attacks against Western nationals. However, sanctions ramped up to the point of shutting Iran out of the oil markets in January 2012, when the US insisted that Iran cancel its program of tests of nuclear weapons.
At the beginning of April 2015 Iran signed an agreement to end its nuclear program and let in international inspectors to prove its commitment. Confirmation of Iran's compliance will remove the biting sanctions of 2012 and bring Iranian oil to international markets. Despite being stymied by US and EU sanctions, Iran is still able to produce 2.7 million barrels per day, of which 1 million is exported. The un-exported 1.7 million barrels meet domestic demand, but a large proportion is sent to storage.
The world currently has excess crude oil production of roughly 2 million barrels per day, so a cash-strapped, and slightly embittered Iran could have immediate impact on crude oil prices by putting its estimate 35 million barrels of stored oil on the market the day sanctions are lifted.
The impact of Iran's return to the market greatly depends on how quickly they can ramp up production. Bijan Namdar Zangeneh, Iran's oil minister, claims that the country could easily increase production by 1 million bpd within months of the lifting of sanctions. That worrying figure would increase the world's excess production by 50 per cent, which some analysts claim would push crude oil prices down to $20 per barrel. However, other analysts are skeptical.
Iran's production levels were at 4 million barrels per day in 2011 before the latest round of sanctions hit. Iran's isolation and denial of technology and investment capital means its oil industry has become badly under-invested. Their ability to get back up to former production levels could also be blocked by OPEC, of which Iran is a member. Nevertheless, Iran's return will prevent the world's excess supply from being reduced and so prices will fall.
2. Fracking is Not Going Away
Many believe that the 2014 fall in oil prices was specifically engineered by Saudi Arabia to knock out US oil production through fracking. Industry analysts estimated that heavy start up costs and financing requirements placed the break-even point of a fracking rig at around a $70 per barrel price of crude oil. Many saw the slump in the price of crude down to $60 and then to the $50 mark as a significant factor.
Sure enough, the rig count in the USA plummeted from 1,608 in October 2014 to 747 in April 2015. Seemingly, the lower oil price had squeezed out US oil production in the higher-cost fracking sector. However, the advancement of technology and the agility of fracking producers resulted in higher output from fewer rigs. In October 2014, the USA produced just under 9 million barrels per day. In April 2015, that output had increased to just under 9.5 million barrels per day.
Chinese oil production through fracking has risen to the same extent as USA production, with companies in both countries adopting and improving the same technology. In a world with an excess production of 2 million barrels per day, America's increased production means that oil prices are not about to rise. China's increases compound that situation.
3. OPEC is Idle
Previous oil price falls have been keenly countered by OPEC, the cartel of oil producing nations, centered mainly on Middle Eastern producers. Whenever oil prices fall, OPEC cuts quotas to its members, limiting their production and causing the price to rise through reduced output.
Saudi Arabia is by far the biggest producer in the OPEC club and the opinion of its oil minister, pretty much rules the actions of OPEC. If OPEC members decide to cut their production, but Saudi Arabia refuses to play ball, the resolution to cut would have no impact on oil prices, and thus be a worthless exercise.
Fracking started to provide the USA with a means of achieving energy independence. The country has already become a net exporter of gas, and similar performance in oil production would remove the USA's dependence on the Middle East for its oil supplies. Saudi Arabia's dominance of American oil supply enables them to entice the USA to deploy its military in the Persian Gulf at the direction of Saudi foreign policy. The Saudis want to return to the days of US dependence on Arabian oil and so refuse to cut their production in the face of falling prices.
Despite the apparent failure of the Saudi production tactic, OPEC shows no signs of changing its policy. The Saudis seem to be determined to continue forcing the price of crude down to squeeze out US production, but as fracking gets cheaper, output will continue to expand and the price of crude oil will continue to fall.
4. Russia Produces More
Political analyst point out that oil prices fell dramatically around the time that Russia invaded the Ukraine and the EU dithered over imposing the sanctions that the USA demanded. Although Europe did eventually go along with the policy of punishing Russia through trade restrictions, their reluctance to really hit hard has undermined US strategy.
Eyeing the success of an embargo on oil sales in bringing Iran to the negotiating table, the US administration, the theory goes, decided to depress the price of oil in order to bankrupt Russia and force it to cancel plans to take over the Ukraine. The Russian economy is overwhelmingly dependent on oil and gas exports, because it has little successful industry and is unable to match the West in the development of technology.
Saudi Arabia also has a cause to complain about Vladimir Putin's behavior. The Saudis loathe Bashar Assad, the President of Syria and want to see him overthrown. American and European governments seemed willing to play along with this policy until the Russians threw their support behind Assad and European determination folded. Without any significant allies to share the burden, the USA cancelled their planned invasion of Syria. The infuriated Saudis decided to take matters into their own hands and collapsed the price of oil with the intention of punishing Russia, not US frackers.
Vladimir Putin and his administration have complained loudly and frequently that the oil price fall was deliberately aimed at attacking the Russian economy. However, the steadfast determination of unrealistic quotas haunts the Russian mentality as an overhang of the Communist era. Putin needs money to continue his glorious and domestically popular policy of reassembling the Russian Empire. The Russians refuse to bend to market forces and so have made up the shortfall in their budget caused by falling oil prices by pumping out more oil. The Russian need for income means they are unlikely to make a tactical cut in oil output. Increased production adds to the downward pressure on crude oil prices.
5. ISIL's Days are Numbered
The Islamic State of Iraq and the Levant are said to be causing havoc with oil production in the Middle East. ISIL, originally called "the Islamic State of Iraq and Syria," first came to the world's attention when they threatened takeover of northern Iraq and Syria in the autumn of 2014 – just after the USA declared they would not intervene in Syria to overthrow its president.
Oil analysts talk up the oil price by warnings over ISIL's actions. However, the revolutionaries only managed to grab a small portion of Iraq's oil wells and actually increased production of their new assets in order to fund their cause. The ISIL bogeyman delayed the fall in oil prices by about a month and the havoc they have wrought across the Middle East has since failed to block that overproduction of 2 million bpd.
ISIL's greatest success in wrecking an oil producing country came in Libya, where they apply different tactics to the oil industry. Rather than profiting from Libya's oil wells, ISIL has been destroying them, thus knocking out a major oil producing nation. Simultaneous increases in production in the USA, China and Russia, however, mean that the loss of Libyan output has had no impact on the glut of crude oil in the world. The panic pricing in the oil markets that the group's initial appearance caused has withered away.
Europe's willingness to turn a blind eye to ISIL's activities in Libya came to an abrupt end in mid-April. Deciding to knock out oil production, rather than profit from it, ISIL turned to Libya's other money maker – people smuggling. The short distance between the Libyan coastline and the Italian island of Lampedusa makes the former slave trading ports of Libya ideal routes for illegal immigrants to sneak into the EU. Unfortunately, the greed and carelessness of the smugglers has resulted in overloaded ships sinking in the middle of the Mediterranean.
The death toll through drowning of ISIL's passengers has reached headline-grabbing levels and Europe's major military powers have resolved to put an end to the organization's activities. Although the smuggling gangs are the proposed targets of European airstrikes, the difficulty of identifying those activists means that Europe will have to restore a legitimate government to Libya in order to stop human trafficking.
It is significant that the proposed European strategy is to join Egyptian military efforts. The Egyptians have been routinely bombing ISIL in Libya since February. ISIL is easier to attack than other terrorist groups. With a standing army, rather than a terrorist cell structure, such as that of Al Qaeda, ISIL is more visible, and so can be engaged by a traditional military response. Its system of local governors and administrators require offices and infrastructure that are fixed and easy to bomb. The imminent defeat of ISIL in Libya means the oil industry there will be able to rebuild, the world's oil production excess will increase and crude oil prices will fall further.
6. No Demand
The excess supply in the oil market could easily be mopped up by increased demand. However, there is no great leap in growth expected in the world for the next couple of years. Energy efficiency and investment in renewable energy, such as solar, has permanently reduced demand for oil in most of the developed world.
Both the Federal Reserve and the People's Bank of China have announced they are ending their loose monetary policies. This free money pumped around the world inflated the prices of property, stocks, bonds and commodities. Part of the reason the oil price rose through 2013 and early 2014 was simply that the excessive amount of dollars in circulation had to be invested in something. Now that money has to be paid back, the asset price inflation of the past two years will be reversed.
The BRIC economies have failed to continue their stratospheric growth into 2015. In fact, some developing nations, like Brazil, are now in recession, with tumbling currencies cutting their populations' spending power. World trade is falling and demand for oil will fall with it. With few prospects of increased demand for oil, the chance of its price rising is zero.
The major oil producers have done nothing to cut production since October 2014, and they are unlikely to consider cutting output any time soon. The USA, Russia and Saudi Arabia each have different reasons to continue high output, but all three are just stockpiling oil because they cannot find enough immediate buyers. Add on the inevitable return of Iran and Libya and the prospects of the 2 million bpd excess production in the world reducing can be seen to be impossible.
Monetary tightening will reduce world growth and remove asset price inflation. Lower growth, coupled with lower need for oil through efficiency and environmentalism, means demand for oil is not going to exceed supply for a long time to come. The oil price is not going to rise any time soon.
Published on 2015/05/07 by STEVE AUSTIN
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