Below $30 a barrel what is the outlook for oil?

Today we have seen the price of oil falling decisively below $30. This psychological support level seemed to be holding (despite an intraday spike below earlier this week) but this price has been blown out of the water today with a 5% decline on WTI and a 4% fall in the Brent Crude price. So what is the outlook for oil now this $30 a barrel level has been breached? 

oil world

The Brent premium dissipates

The differences between the two oil prices have been down to their “API gravity”. The American Petroleum Institute has a viscosity scale and anything above 10 floats on water, with anything less than 10 sinks in water. Both West Texas Intermediate (WTI) and Brent Crude have API levels above 10 but WTI is “lighter”. Not only that, the WTI oil is also considered to be “sweeter” having less sulphur content (which is therefore less expensive to purify). Hence why WTI is referred to as “light, sweet oil”.

The lighter and sweeter that oil is the more prized it is and this is why historically WTI has traded as a small premium to Brent Crude (up until the mid-2000s). However recent supply of WTI has soared, not least of all due to the shale oil boom in the States, meaning that in conjunction with supply issues of Brent Crude in the Middle East (Libya and Iran) have meant that Brent has been trading at a sometime significant premium to WTI. However, with Libya and Iran supply constraints being resolved, the price premium of Brent Crude has fallen away and it is now basically zero.

oil spread

Recent supply issues

Iranian oil supplies could be about to increase, leading to further imbalances between global supply and demand. The supply sanctions on Iran could be coming to an end as soon as this weekend. “Implementation Day” (the day Iran can start providing oil to global markets) may be about to be announced. If the International Atomic Energy Agency verifies that Iran has fulfilled its obligations under the nuclear agreement, this would trigger IMPLEMENTATION DAY. The IAEA expected to report findings today.

Iran world’s 4 largest oil reserves. It currently produces 2.8m barrels per day but some reports suggest this could increase by as much as another 2m more barrels. The expectation of the speed of the increase in supply suggest it could be up by around 500,000 to 600,000 barrels per day by the end of 2016. This would further skew the global demand/supply imbalance which in Q4 was around 0.5m barrels and act as further downside pressure on oil.

Oil turned lower again on Wednesday on the back of the weekly US Energy Information Administration report. US inventories grew again last week by 0.2m barrels which was lower than the 2.5m expected, but elsewhere in the report it noted that reserves of oil derivative products increased massively, with gasoline stockpiles increasing by 8.4m barrels following 10.6m last week. This means that for 9 weeks in a row there has been a build of petroleum derivatives in the US.


The demand side of the equation remains weak

There are ongoing concerns over the slowdown in China impacting on global demand. Not only that the depreciation (or should that be devaluation of the yuan) is expected to continue, with concerns that China is playing a currency war which will impact on emerging markets demand. Anyone who exports into China will be finding their demand hit. These are often countries that are also have large US denominated debt exposure, with the strengthening dollar meaning that the servicing of this debt is getting ever more expensive – again something to negatively impact on demand. The strong dollar is also likely to be a feature of this US earnings season too, with corporates likely to warn of the strength of the greenback impacting negatively on their business. This is all negative for the demand for oil.

The price continues to fall

Brent Crude down 8 days in a row and there is a technical downside target of $27 on Brent Crude. This is a 100% Fibonacci projection target of the June to August sell-off projected lower from the October high. There is a similar downside projection target is $27.15 on WTI. The concern from a technical perspective is that the next Fibonacci projection level beyond 100% and $27 is the 161.8% Fibonacci which is around $10. The next big low is the 2002 low around $17.

oil fib

What are the brokers saying?

Brokers have been queuing up to put out huge downside targets. Morgan Stanley has gone for $20, Royal Bank of Scotland has gone for $16, whilst Standard Chartered believes $10 could be seen. The contrarian in me starts to get interested when huge targets get published (remember Goldman Sachs and $200 oil?). Just as an aside, at $10 oil price, the RAC in the UK expects petrol to cost around 86p which would be less than cost of supermarket bottled water – the average price is currently around 103p per litre.

What could signal a bottom?

Perhaps a trigger for a bottom would be:

  • A big oil major going bust?
  • A swathe of dividend cuts?
  • Or maybe even these huge broker forecasts may mean we are close to the bottom?

Economic Impact of falling oil

The petrol price cut is a pseudo tax cut for consumers. But there is also the other angle of it that it impacts on employment too. BP 4000 jobs losses in its upstream exploration and production (Including 600 in the North Sea). This has cut BP’s exploration and production E&P workforce by around 17% from 24000 to 20000. There are also capital expenditure issues. The largest oil major, US company Exxon Mobil saw that capex was around 16% lower, whilst around the world, the number of exploration wells drilled or planned in 2015 was lower by around 25%. Smaller companies would be even more impacted, with UK listed Tullow Oil cutting its exploration budget by 80% last year.

However, on the flip-side the more canny companies out there may be able to take advantage of cheaper drilling and services costs. And they may also be able to pick up licenses or assets on the cheap. For example, Cairn Energy said last year that its deep water services costs were down by 40%.

So where does it go from here?

The big issue is whether the increase in the Iranian supplies have been priced in fully yet. If so then perhaps the bearish outlook may begin to slow. However, perhaps the demand side will of the equation will also need to improve. This will involve an improvement in Chinese economic data which at the moment certainly does not seem to be happening for now.

I think that for now there is further downside potential in this break lower and the “trend is your friend” on oil. However with seemingly the whole market bearish, the bottom may not be far in coming. In the least, there is likely to be a technical rally to unwind some near term oversold momentum. Whether the bulls back up this rally with some serious buying rather than simply short covering will be key.