Oil Heading South

It has been a long time coming, however a deal has finally been concluded between Iran and the P6. It may take another 6 months before another 1.5 million barrels per day hit the market, and the world will have to deal with the consequences of more supply. However, it is a new beginning for the Iranians and the deal is intended to ease the economy from the clutches of trade sanctions which have been in place since the Iranian Revolution in 1979. It’s a big break, not just for Iran but also in the ability of the P6 to come up with a workable plan. In summary, the initial plan releases funds, removes sanctions on metal dealing, the auto market and petro chemicals. On the nuclear program, many see the deal as just another delay and believe Iran will eventually develop weapons anyway. However, if the agreement is policed properly then it will take a long time for this to occur, and why would Iran do this and jeopardize all the good work to date? If it does then it loses its chance to become a part of the global economy and this, we feel, is more important to the new Iranian President then anything else. Through international trade the economy will expand and living standards of its people will increase. Surely this is by far the outcome all Iranians want, so why risk it.  Only time will tell on this. As the market focuses on the deal we get a sense that the bearish picture for the commodity has just been given another bump along. Sentiment in the oil market is already bearish and when faced with the eventual supply of a further 1.5million bpd, it is interesting to see how this will affect buyers of Iranian oil, the market and sentiment.

At the moment there are three major buyers of Iranian oil: China, Japan and India. Although pressure was put on these countries to stop importing oil, the discounts the Iranians offered made it worthwhile. We do feel the price of Iranian oil will slowly come back in line to market prices which may initially annoy Iran's trading partners, however once additional oil hits the market, which is in six months, it may pave the way for greater production which will act as an additional weight on a market that is already soggy. Regardless of this production threat over hanging the oil market, the price managed to bounce back well and we suspect this was just a knee jerk reaction. We continue to see additional supply coming onto the market and we feel that any rally, should it emerge, only presents a better opportunity to sell. When we check out the fundamental picture for oil it still remains dark. The expected supply from Iran in six months only adds to the bearish picture that we are faced with. In addition to Iranian oil coming on tap, a resolution to the Libyan civil war will add more, ongoing builds in inventories provide more pressure, suggesting that global demand remains slack, and imports of oil to the US continue to drop whilst domestic production surges. It doesn’t look inspiring and all, we feel, will to help change the dynamics of the current oil market. Why?

As we looking into the supply side of the market we can see that supply is not an issue, hence the 17.5% drop in the prices. However going forward, without any sign of increased demand via an economic recovery, the more supply that comes on tap the more the price will fall and this is where we see a big change starting to emerge. Oil at US$70.00 is on the cards. Why?

This is where it becomes very interesting as, like OPEC, which is reliant on petro dollars for income, the US will not be able to see the price of crude oil too much lower than US$80.00 a barrel. The main reason for the US to turn up production via oil shale reserves is firstly because America does not want to be dependent on imports of oil, but more importantly the country is blessed with vast tracks of oil shale deposits, in particular in North Dakota. New methods of production such as hydraulic fracturing means that more wells can be drilled and put into production. This is not new news, but perhaps the speed of implementation is and this is what the market needs to look at. The cost of drilling and fracturing is also extremely expensive. As can be seen from the chart below, the costs associated with drilling has increased dramatically. As an example, the cost to put a well into production using fracking in the Woodford Shale of South East Oklahoma has a cost differential of between $3 to 4 million above a traditional operation. This additional cost is okay if the price for crude per barrel remains high. However if it drops, it becomes a problem. We feel that if the price of crude dropped below US$80.00 for any length of time then this would render the practice of “fracking” as not being commercial and, as is the case with OPEC, the possibility of some kind of production cuts become a viable alternatives so as to keep the price from dropping too much a la the natural gas market, where we saw a boom provide a massive shift in the production frontier for the industry and a price drop from US$14.00btu to US$2.5btu. The market is still reeling about this, and the massive amounts of production via the gas boom renders the industry unprofitable until demand can catch up.