Three Reasons Oil Prices Can Still Go Lower

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Three Reasons Oil Prices Can Still Go Lower

January 22, 2016

Although many analysts are and have been calling for a bottom in oil prices, there are three key reasons why oil can continue to fall substantially further from current levels near $30 per barrel:

Bankruptcies Do Not Necessarily Mean Lower Production and Higher Prices

At least nine U.S. oil and gas companies, accounting for more than $2 billion in debt, filed for bankruptcy in Q4 2015.  This brought quarterly bankruptcies for the sector in line with levels last seen in the depths of the Great Recession.  And although it is estimated that there are more than five times as many oil and gas loans in danger of default as there were a year ago at current prices, we must consider what bankruptcy means for future production and prices. Counterintuitively, growing bankruptcies in the sector do not necessarily lead to lower production and higher prices. In fact, this process could very likely lead to lower breakeven costs, which would make lower prices even more sustainable in the coming years.  This is a simple function of the fact that Chapter 11 bankruptcy does not destroy oil producing assets or infrastructure, it simply lowers the breakeven cost of production by allowing this capital to be reacquired and reengaged at lower prices.  Private equity firms and other investors will use this opportunity of rampant bankruptcies to buy up oil and gas fields and their producing assets at greatly discounted prices once the prior owner’s debts are wiped clean.  Through this process, an oil well that just weeks ago had breakeven costs of $40 per barrel can nearly instantly have a breakeven cost of $20 or $30 per barrel.

Macroeconomics and Monetary Policy

With oil prices falling by over 50% you would assume that demand would increase substantially and you would be right, as demand rose by the most this century in 2015.  However, there is little reason to believe that this rate of demand growth will be sustained. In recent weeks, stock markets and crude have plummeted as global markets are hit with multiple fronts of bearish developments – from the World Bank cutting global growth forecasts once again over fears in emerging markets, to central banks in developed nations around the world losing their wars on deflation. Prior to December, the five-year correlation between the S&P 500 and Brent crude oil was a negative 72%, but since December that correlation has jumped to a positive 91.4%.  Meaning, for years there was an inverse relationship between oil prices and the stock market, but since December they have moved in near lockstep. It is no coincidence that this correlation developed as the Federal Reserve ended a near decade-long policy of zero percent interest rates with their December interest rate hike announcement. As a result, the Federal Reserve’s monetary base and the velocity of money have continued to contract, leaving fewer dollars in circulation in the economy to bid up oil prices and other assets. With uncertainty growing in Brazil, China, the Middle East, and Russia, and a strengthening U.S. dollar that increases crude prices in local currencies, this is unlikely to lead to another year of surging oil demand.

Global Markets Are Expected to Remain Oversupplied Into 2017

Although the story of global oversupply has been repeated to the point of redundancy, it is still important to consider how the relative changes in expectations for oversupply have evolved over the past month.  Just last week, Iran met the final terms of its international nuclear deal commitment, which allowed the country to once again begin competing for global market share in the crude market.   As the International Energy Agency (IEA) recently pointed out, although many analysts would say that Iran’s exports are already “priced in” to the market, there are many unknowns yet as to the quantity and quality of oil that Iran will offer on the marketplace, which means that this event cannot yet truly be fully priced in.  In its first Oil Market Report for 2016, the IEA concludes that, “The oil market faces the prospect of a third successive year when supply will exceed demand by 1.0 mb/d and there will be enormous strain on the ability of the oil system to absorb it efficiently.” And as it relates to Iran, “In a scenario whereby Iran adds 600 kb/d to the market by mid-year and other members maintain current output, global oil supply could exceed demand by 1.5 mb/d in the first half of 2016”. These are not forecasts that portend well for a bullish reversal in oil prices.

Reprinted from

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