Commodities | Jun 02 2017
The downside risks to the oil price are stacking up, according to one analyst.
– OPEC disappoints
– US production rising
– Currency a threat
By Greg Peel
Two factors have surprised oil sector analysts over the past twelve months. One is that OPEC-Russia not only agreed to cut production, they have (so far) stuck to that agreement and extended its timing. That’s rare for OPEC. The other is that the resurgence in US shale production, thanks to subsequent higher oil prices, has been swifter than previously assumed.
The US shale rebound is the predominant reason the WTI oil price has not managed to return to at least the high fifties, if not US$60/bbl, as analysts had previously forecast. Most analysts still believe such prices will be regained, but more likely down the track as demand slowly rises.
In the past week the oil price has suffered a tumble again, mostly because while OPEC-Russia did agree to extend their production cuts, they didn’t deepen those cuts as hoped. Meanwhile, the US rig count continues to grow steadily.
Bearish Developments
Ian Bezek, associate analyst with Value Investor’ Edge, and research provider to Seeking Alpha, is bullish oil. In the long term. While Bezek has suggested the oil price could eventually return one day to triple digits, he does not expect the path to be a direct one. Developments in 2017 to date, notes Bezek, have been net bearish.
Oil did not make it back to US$60/bbl as initially expected when OPEC cuts were flagged, and that has proven disappointing. That is why the market assumed OPEC-Russia would not only extend the time period, but also cut further. The fact this did not happen added to the disappointment.
In order to appease all OPEC members and reach an agreement, production cut requirements were tailored dependent upon each member’s circumstance (such as Iran only just having export sanctions lifted), while others were exempted altogether. To that end, this week’s production numbers have shown Libya and Nigeria are making the most of their exemptions and producing as much as possible.
Another issue to consider, Bezek points out, is the US dollar effect. Being US dollar-denominated, the oil price should be negatively correlated to the currency, all things being equal. The Trump reflation trade initially pushed the US dollar higher post election and inauguration. The oil price also rallied, but the US dollar acted as a headwind.
The Trump reflation trade has since given way to a realisation Rome won’t be built in a day, and while Wall Street hangs in limbo, the US dollar has fallen back again. Yet this retracement has not provided a kicker for the oil price, which has failed to hold over US$50/bbl.
If the reflation trade reignites due to, for example, US tax reform progress, the US dollar should duly rise once more. With the oil price threatening to return to pre-OPEC cut levels, a stronger US dollar would only exacerbate the downside.
Short Term Problems
Bezek further points out that contrary to recent years, US energy stocks are “massively” underperforming the oil price. Not so the giants like Exxon Mobil, who offer attractive dividend yields, but across the wider sector. Since the beginning of the year, the SPDR oil & gas producers & explorers ETF has fallen -25% in a virtual straight line, despite the oil price being range-bound over the period.
There appears little market faith in oil. This devaluation does have an ultimate benefit however, Bezek notes. The oil price has been held back by rapidly rising US shale production. Lower share prices will lead to les access to capital, in turn leading to fewer new wells being drilled. The faster the energy sector cuts capex, the better the longer term prospects for the oil price.
On the flipside of this is the ever falling cost of shale production, thanks to technological advances and subsequent efficiencies. This is one reason why rigs have come back on line faster than expected, and at a lower oil price than expected. It was also assumed, Bezek notes, that more costly offshore production would be, let’s say, dead in the water at US$50/bbl. Yet offshore is still attracting capital, and Gulf of Mexico production has surged since late 2016.
From a technical perspective, the oil price looks weak, marking lower highs and lower lows since February. WTI has been range-bound for many months now, and experience suggests lengthy periods of range-trading usually end with an explosive move out of that range, either up or down. This would imply either US$40/bbl or US$60/bbl.
The way things are stacking up leads Bezek to believe the risk is to the downside.
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