The oil price is likely to be substantially higher than current level by the end 2016 Oil is looking very oversold at current levels. While it may fall a little further in the short run, the price will rise in the medium term and we believe the price of oil by the end of the year will be in the region of USD 45-50 per barrel.

The fall in the Oil Price has been one of the major global macro-economic stories of the last two years. As the Bloomberg Chart below shows, prices were at a recent peak of USD 94 per barrel in June 2014 and have fallen by 68% since then to the current level of about USD 29.5.


The decline has been particularly dramatic in the last 5 to 6 months – the price has almost halved over this period, as shown in the Bloomberg six month chart below.


The prices have just fallen (on 18th January 2016) to below USD 29 – a fresh 13 year low.

Prevailing prices are pricing in of a lot of pessimism and the prospect of a higher supply of exports from Iran as a result of the formal lifting of sanctions last weekend.

There are a growing number of signs that the price decline has been overdone due to excessive pessimism.

In recent days analysts have been competing with each other to produce ever lower targets. In 2008, when the oil price was around USD 130, an analyst at a major investment bank forecast that oil would rise to USD 200. The price spiked to USD 140 before falling back sharply to USD 32 two years later. The USD 200 proved to be high water mark forecast which we can see with the benefit of hindsight was actually a good indication that the market was about to fall.

Similarly, as prices have been falling in the last six months, analysts have been coming out with ever lower prices. In early January, a Standard Chartered Analyst forecast USD 10 per barrel.

This is likely to prove to be the opposite of the USD 200 forecast noted above. Such forecasts are often made at moments of markets extremes and are often an indicator that trend of the price is about to turn. We believe that while the price may fall a little lower, the prices will stabilise and recover as 2016 proceeds. At the end of the year, oil is likely to be back in the USD 45-55 per barrel range. Investors should buy out of the money call options which mature at the end of December 2016. These are likely to prove very profitable as oil prices rise from current oversold levels.

The key points are as follows:

  • The current low oil prices will put pressures on supply and a significant reduction in output from high-cost producers. The best solution for low prices is low prices.
  • As prices change from an established level to a new lower level, producers do not change behaviour and cut output immediately in case the price move is temporary. If the new lower prices persist, producers will see increasing revenue pressures. Over time we will see supply reduce as uneconomical capacity is removed. Small firms will go out of business while large companies will cut exploration budgets and then production. Capacity cut will eventually put upward pressures on prices.
  • In the Autumn of 2015, Saudi Arabia triggered the most recent phase of decline of the oil price (from USD 50 per barrel) when OPEC stated that there would be no cuts in output. This was a move aimed at the shale oil producers in the USA who have become a major factor in total US output. The shale producers are relatively small entrepreneurial companies which have high levels of debt. The average break-even cost for these producers is thought to be USD 50-55 per barrel.
  • These producers have been very resilient in the last few months. This reflects two factors. The first is that many of the producers have carried on producing even though it was not profitable, in order to carry on to servicing their debts. However, if lower oil prices persist this is not a sustainable strategy.
  • In addition, many shale producers (along with other mainstream oil producers) hedged their output forward up to the end of 2015 and therefore did not suffer from the decline in oil. However, in 2016, their output is either unhedged or hedged at prices closer to current market levels. This means they will feel the impact of lower prices in 2016.
  • Shale producers will eventually have to reduce output drastically and some will go out of business. What is true for the shale producers is also applicable to conventional oil producers. They have suffered a drastic fall in their total revenues and have been forced to reduce costs. In mid-January 2016, BP announced that they will reduce 4,000 jobs (out of 24,000) in their exploration and production unit. These will not be the last such cuts. There are likely to be a series of cuts in output by major oil companies in the United States, Europe and Asia.
  • The largest producing countries are the United States, Saudi Arabia, Russia and Iran.
  • The lower oil price has put considerable pressure on Russia and Saudi Arabia. Saudi Arabia is financially much stronger than Russia. It has built up strong financial reserves over the years. It can withstand lower oil for prices for two or three years, albeit at the cost of higher budget deficits, increasing indebtedness and increasing pressure on the Riyal Currency Peg. As 2016 proceeds and there is growing evidence of reduction in output. It is not impossible that Saudi Arabia will move to restrict to reduce output within OPEC in 2016 in an effort to counter higher output from Iran and to begin to put upward pressure on prices. Also, as Iran’s sanctions being lifted by the US and EU has been a real prospect for some months, the factor of Iran’s prospective output has largely been priced in to the oil price.
  • A lot of pessimism assuming flat or falling demand, due to slowing economic growth, is a large factor in the current pricing of oil. However, the margin between production and consumption is narrow enough for either a small drop in production or a small growth in consumption to see some upward pressure on prices. The current daily production level for oil is 95 million barrels a day, the current consumption level is 93.5 million barrels a day. The output gap will tighten when production inevitably reduces due to either OPEC reducing target output or through the closure of unprofitable wells.

Summary

We believe the oil price decline is overdone and is being driven lower by financial speculation rather than the end-user market.

Sustained lower oil prices are leading to sharp cuts in expenditures and these will be followed by increasingly significant declines in output. These production cuts will be carried by out by shale producers and conventional oil companies. It is also possible that Saudi Arabia will work within OPEC to reduce output later this year, once there is some unmistakeable evidence of pain and distress in the shale sector in the USA. As a result of these factors, Oil prices by the end of 2016 will rise towards USD 40-55 per barrel. This means that investors could buy call out of the money 12 month call options on oil or some other similar instruments to benefit from this expected price appreciation.



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

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