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The Surge Is Over- Why $50pb Oil Is Now More Likely Than $100

Proshare

Monday, June 18, 2018 07:41 AM /FDC 

Hedge funds convinced them-selves that they understood market fundamentals better than the professional. The spring fever is passing. After three months on the rise, the oil market has turned. In a single day, on Friday (May 25) the price of a barrel of Brent crude fell by 2.5% while the US benchmark crude — West Texas Intermediate — was down by 4.5%. The market is now set for a further fall as the hype and speculation that led to the increase is replaced by a cold return to fundamentals. 

A Martian watching the oil market from outer space during the past few months will have noticed one thing above all else. There is no shortage of supply and no imbalance of supply and demand. Any shortfalls in production from places such as Venezuela have been easily covered by production from elsewhere, not least the US where output continues to grow month by month; thanks to the continuing shale revolution. The run-up in prices was driven by politics. 

Some traders came to the conclusion that supplies were going to be disrupted by war in the Middle East between Saudi Arabia and Iran or between Israel and Iran. This was fuelled by rhetoric on both sides and by President Donald Trump’s disavowal of his predecessor’s deal with Iran over its nuclear ambitions. The traders began to speculate on what they thought might hap-pen next and the price rose. 

Another Middle East war would indeed be devastating but is it really likely to happen? Israel will continue to use its superior firepower to limit the threat posed by Iranian activity in Syria and Lebanon but that is very different to launching an all-out conflict. Mr Trump is an unconventional president but I do not believe he wants to take America to war in the Middle East again. He wants Iran to give way and waves a big stick. So far the big stick is the threat of yet more sanctions. That would be disruptive for Iran and for western companies doing business there but does anyone seriously think that Russia and China and India are going to obey the sanctions or stop buying Iranian oil? 

They have not done so before and there is no obvious reason why they should now. Speculation got ahead of the reality. At the same time reality moved in the opposite direction. The rise in prices has helped bring on more production — not least in the US. Across the world, producers have pushed production up to take advantage of a price surge which they believe is temporary. OPEC — and in particular Saudi Arabia — have decided that the surge has gone too far. Last week they began to indicate that they do not want to see oil prices rising to the point where demand is choked off.

So the tide turns. How far out will it go? 

On the supply side there is more production due on stream this year from Iraq and the US and a continuing gradual increase in demand that so far has only been modestly tempered by the recent price rise. Supply and demand re-main in balance. Since there is no physical shortage the answer is that instead of rising to a $100 as some commentators have suggested, the price is more likely to fall towards $50 per barrel. This seems to be the level at which some US shale production becomes un-economic. If it gets too low the Saudis and others will try to reassert their production quotas and so a reasonable bet on where the market balances would be around $50 to $60.

That, not by chance, is the expectation of several of the major oil companies that have never embraced the spring speculation and continue to plan on a baseline price around $50. They have enjoyed the surge in prices but continue to focus on control-ling costs and imposing discipline on new investments. The losers in all this are the hedge funds that have managed to convince themselves they understood the market better than the professionals. Their fingers are badly burnt but no doubt they will lick their wounds and then return — trying to trade the price down to $5 or some other unrealistic level. It is hard to feel too much sympathy for them. 

Another Middle East war would indeed be devastating but is it really likely to happen? Israel will continue to use its superior firepower to limit the threat posed by Iranian activity in Syria and Lebanon but that is very different to launching an all-out conflict. Mr Trump is an unconventional president but I do not believe he wants to take America to war in the Middle East again. He wants Iran to give way and waves a big stick. So far the big stick is the threat of yet more sanctions. 

That would be disruptive for Iran and for western companies doing business there but does anyone seriously think that Russia and China and India are going to obey the sanctions or stop buying Iranian oil? They have not done so before and there is no obvious reason why they should now. Speculation got ahead of the reality. At the same time reality moved in the opposite direction. The rise in prices has helped bring on more production — not least in the US. Across the world, producers have pushed production up to take advantage of a price surge which they believe is temporary. OPEC — and in particular Saudi Arabia — have decided that the surge has gone too far. Last week they began to indicate that they do not want to see oil prices rising to the point where demand is choked off. 

So the tide turns. How far out will it go? 

On the supply side there is more production due on stream this year from Iraq and the US and a continuing gradual increase in demand that so far has only been modestly tempered by the recent price rise. Supply and demand remain in balance. Since there is no physical shortage the answer is that instead of rising to a $100 as some commentators have suggested, the price is more likely to fall towards $50 per barrel. This seems to be the level at which some US shale production becomes un-economic. If it gets too low the Saudis and others will try to reassert their production quotas and so a reasonable bet on where the market balances would be around $50 to $60. 

That, not by chance, is the expectation of several of the major oil companies that have never embraced the spring speculation and continue to plan on a baseline price around $50. They have enjoyed the surge in prices but continue to focus on controlling costs and imposing discipline on new investments. The losers in all this are the hedge funds that have managed to convince themselves they understood the market better than the professionals. Their fingers are badly burnt but no doubt they will lick their wounds and then return—trying to trade the price down to $5 or some other unrealistic level. It is hard to feel too much sympathy for them.

 

Proshare Nigeria Pvt. Ltd.

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