Oil Price Prospects

March 17, 2016

Crude oil prices have fallen from $100+ two years ago to around $37 today, after going under $30 briefly last month. Not surprisingly, there are differing views on the direction of prices going forward.

Let’s look at where we are now.

The Shale Boom has catapulted the US to the top world producer spot, surpassing Saudi Arabia. This has greatly reduced US imports of oil and is a major contributor to the price break we’ve seen. As an aside, the US Balance of Payments has been much reduced by US Shale Oil production, even though the Deficit once again is running at over $500 Billion a year.

But, there are other factors greatly affecting the supply-demand balance for oil.

Production of oil from wells in the Gulf of Mexico is soaring. Adding this US produced supply also reduces the US need to import foreign produced oil, helping to keep the Balance of Payments from being even larger than it is, and greatly increasing the world supply. More supply means lower prices, as we’ve seen these last two years.

Then there is the US-Iran deal which ended sanctions on Iran. During the sanctions, Iran still produced oil, but only a small amount was able to reach world markets. Iran used tanker ships to store this oil, and now that sanctions are over, these oil-filled tankers are goosing world supply, forcing prices even lower. And, new Iranian production and exports will do likewise.

Not to be outdone, especially since their domestic budgets depend largely on exported oil, the Saudis and the Russians are maintaining very high production rates. Need I say that this is pushing down the price of oil? BTW, don’t let a recent oil producer agreement to meet next month to discuss freezing production at current rates confuse the issue for you. A production freeze does NOT cause production (supply) to go down, so no effect on prices ought to result.

As all this oil has come to market around the world, it has exceeded the demand for refined products. The resulting surplus needs to be stored somewhere, and we’ve seen oil tanks – and oil tankers – filling up. The current low prices for a product, which eventually will be demanded, has encouraged this oil inventory buildup, but eventually you run out of places to put the oil. You can’t just store it by putting it onto the ground, as you could do with copper or some other solid material.

I’ve read estimates of 95+% of capacity utilization, which means that many areas already are at 100%. Cushing, OK is one oil storage hub in the US, and they are running out of storage. Even at current low prices, if you have no place to store oil, you just won’t buy it. Lower demand puts downward pressure on oil prices.

One fact of life with any security, especially a commodity, is that it anticipates future conditions. All the factors noted so far already are known, including the expectation of continuous large surpluses of supply over demand. Expected continuous, large surpluses, together with diminished places to store the oil, have helped push prices lower than the might be otherwise.

The Oil Institute publishes reports regularly on industry conditions. For the previous week, it had forecast a surplus which turned out to be significantly lower than predicted. Expectations matter short term. While still in surplus, the smaller than expected number helped the price go up 20% to the current $37 per barrel. So long as the surplus continues though, don’t expect the price rise to survive for long.

Now, the demand for oil goes through seasonal patterns. The oil is refined into gasoline and into home heating oil, with the refining process favoring home heating oil during the winter months and gasoline during the summer.

As winter ends in the springtime, less heating oil is needed. But, the travel season demand for gasoline hasn’t begun as yet, and this happens year after year. The refinery process changeover, together with reduced product demand, is the perfect time for the refineries to perform regular, scheduled maintenance.

Refinery closures (or rolling closures) for maintenance mean that the refineries will demand even less crude oil during this time. Reduced demand, once again will boost the imbalance between supply and demand, and it will act to lower prices.

I would not be surprised to see oil go back to $30 or lower very soon.

The surplus will not go on forever. A few marginal producers will go bankrupt, as we’ve seen already. Some other producers, as their long-term contracts (at higher prices) expire, will cut back their higher cost wells. Some production drilling projects will be delayed, waiting for higher prices.

On the demand side, cheap prices will encourage construction of additional oil tanks to store the current surplus. Cheap prices also will encourage some industrial users to expand.

For example, mining uses a tremendous amount of oil, so a low oil price would encourage adding additional shifts to be run. Lower jet fuel prices, through competition, will afford lower air fares and increased air travel. Lower gasoline prices will encourage more driving vacations and more purchases of gas guzzlers.

Storage space will rise. Supply will come down. Demand will go up. As this happens, the surplus could turn into deficit, and the price of oil will go up. Now, all this is basic Economics 101, and it really does go on.

For now though, expect stable and lower prices, with higher prices resuming only a few years from now. The non-oil part of the US Economy (the lion’s share) will get a big boost from the low oil prices while they last. GDP will grow faster than it would otherwise (or it will shrink much less than otherwise).

The next President and Congress will have a tremendous tailwind helping the image of the results they achieve. Voters in 2018 and 2020 need to be aware of this and consider only the non-oil effects of the incoming officials’ policies. Fat chance! 

Robert (Bob)  Shapiro is self-taught in Austrian Economics and has consulted briefly for the governments of Mexico, Greece, Portugal and Spain. He has traded Gold & Silver and their stocks since 1970. Bob Shapiro’s blog is http://us-issues.com

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