Interactive Investor

Oil price to sink back to $30 a barrel

1st August 2016 12:15

Paul Hodges from ii contributor

There was never any fundamental reason why oil prices should have doubled between January and June this year. There were no physical shortages of product, or long-term outages at key producers.

But, of course, there was never any fundamental reason for prices to treble between 2009-2011 in the stimulus rally, or to jump nearly 50% between January and May last year.

Instead, prices once again rose because financial players expected the US dollar to decline. Market participants realised this meant they could make money by buying oil on the futures market as a 'store of value'. But now, as the US dollar has started to recover, they are selling off these positions. And so oil prices are falling again.

The problem is that the financial volumes swamp the physical market - they were seven times physical volume at their 2011 peak - and so they destroy the oil market's key role of price discovery based on the fundamentals of supply and demand.


And so, once again, oil prices have been in a bull market along with prices for other major commodities such as iron ore and copper, as well as emerging market equities and bonds.

In turn, this forced companies to buy raw materials at unrealistically high prices, as the rally coincided with the seasonally strong second-quarter period.

Now, as Reuters reports, the funds have already "slashed positive bets on US crude oil to a four-month low", and are leaving chaos behind them.

Companies are finding that they "bought high and will have to sell low", as they need to work off high-priced inventory in the seasonally weak third quarter.

Adding to the change in mood; Russia has confirmed the myth of an OPEC/Russia oil production freeze is now officially dead, US oil and product inventories have hit an all-time high of almost 1.39 billion barrels, while China's gasoline exports have doubled over the past year, and its diesel exports tripled in the first half of 2016.

Even worse is that the world is now running out of places to store all this unwanted product. Similarly, the International Energy Agency has reported a major backup of gasoline tankers at New York harbour, due to storage being full.

Wishful thinking

Plus, of course, the recent rally has proved a lifeline for hard-pressed oil producers, who have been able to hedge their output at $50 per barrel into 2017.

As a result, companies have started to increase their drilling activity again, and are expected to open up many of the 4,000 'untapped wells' - where the well has been drilled, but was waiting for higher prices before it was sold.

Yet wishful thinking still dominates oil price forecasts, with the consensus still believing that $50 is a sustainable price. Yet even in February this year, only 3.5% of global oil production was cash-negative at $35. Today's figure is likely even lower, as costs continue to tumble.

And in the real world, oil prices have already fallen more than 10% from their $50 peak. Unless the US dollar starts to fall sharply again, it seems highly likely that prices will now revisit the $30 level seen earlier this year.

Given the immense supply glut that has now developed, logic would suggest they will need to go much lower before the currently supply overhang starts to rebalance.

Paul Hodges is chairman of International EChem, commercial advisers to the global chemical industry.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.