THERE is a tentative and rather fragile belief out there that oil prices have on this occasion finally bottomed in the mid-$35/bbl range.
This is partly based on the production freeze announced by Saudi Arabia and Russia in mid-February.
The US Energy Information Administration also announced that US shale oil production fell in December by 1.8%. This was the first dip in US output in the year-and-half since oil prices first crashed. Last week, US production was also at its lowest level since November 2014.
But scratch the surface of this thinking and it is easy to find many reasons why oil prices may not have bottomed out.
These reasons include most obviously the Chinese economy. Everyone should now have come to terms with the reality that there are going to be no quick fixes to its difficulties.
And of course as China struggles through its reform process, the knock-on effect on other economies is huge. Economic conditions in China, and so the rest of the developing world, will get worse before they get better.
The production freeze that was announced by Saudi Arabia and Russia in February was also only that – a freeze. There as yet has been no agreement to cut production, and geopolitics suggests that such an agreement will be difficult to reach.
And, anyway, as Saudi Oil Minister Ali Ibrahim Al-Naimi said last week in dismissing the prospect of a production cut: ‘Why talk about production cuts when the marginal cost curve will do its job?’
In other words, Saudi Arabia, the lowest cost producer, will continue to pursue its market share battle, armed with the fact that it of course remains the world’s lowest cost producer.
And the freeze in production was something that Iran declined to participate in. Why the Iranian decision is so important is now that sanctions have been lifted, Iran is capable of producing and selling a great deal more oil – and that is exactly what it will do to make up lost ground on economic growth. The chances of it actually cutting production are therefore extremely remote. Further, Iranian production costs are thought to be as low as $1.70/bbl.
The recent slight bounce in oil prices has also enabled shale-oil producers to take out hedges for $45/bbl in future markets. So of course actual oil prices to trade lower than this, the producers have shielded themselves.
What’s also interesting is that because some people think the worst of the oil price collapse is behind us, shale oil companies have been able to sell more equity – and thus improve their financial standing;
Add this the fact that fracking technology improvements have resulted in a 65% or so fall in shale-oil production costs over the last 12 months and you return to this conclusion about US shale oil: The nature of this business means that when oil prices pick up they will very quickly retreat again as US production increases. US shale oil players are the world’s new swing producers.
So if you buy into the idea that oil prices have bottomed out, you are essentially still in denial. Here, in a nutshell, is all you really need to accept about today’s crude and other commodity markets: We are in a world of lingering excess supply and a secular long term decline in demand.
Tomorrow’s price then? Well, of course prices might still rise in the short term on the confidence that we have indeed reached a bottom to the market. And the speculators are again playing their usual games to profit from this argument by going long, thus perpetuating and boosting the rally.
But remember that the long term average price of oil is $26/bbl. There are plenty of reasons to believe that we are returning to this long term average.
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. More