What Will Save Oil? (And When?)

Rumors of an OPEC production cut have been rampant, but Saudi Arabia has been pumping oil at a relentless rate in order to put pressure on U.S. frackers, which would then lead to market share gains for Saudi Arabia – a country highly reliant on oil. Even if Saudi Arabia wanted to involve itself in a coordinated production cut, Iran wouldn’t participate because Saudi Arabia is its largest enemy in the region and potentially on the verge of bankruptcy, which Iran would love to see as it would increase its power.

All information below as of Feb. 24, 2016.

Supply & Demand

Regarding supply, the IEA recently reported that supply and demand for oil won’t re-balance until 2017. The IEA released the following statement: “At the risk of tempting fate, we must say that today’s oil market conditions do not suggest that prices can recover sharply in the immediate future – unless, of course, there is a major geopolitical event.”

Also according to the IEA, supply outstripped demand by an average of 2 million barrels in 2015. Looking ahead, supply is expected to outstrip demand by an average of 1.1 million barrels in 2016. Looking a little deeper into the future, supply is expected to exceed demand by an average of 100,000 barrels in 2017. But what about the long haul?

According to the IEA, demand will exceed supply by an average of 400,000 barrels in 2018. This uptrend is expected to continue, with demand exceeding supply by an average of 700,000 in 2019 and 1 million barrels in 2020. Record-high inventories aren’t expected to drop until 2018.

Another interesting note is that OPEC revenues were $500 billion last year. That’s a big number, but nothing compared to the $1.2 trillion in OPEC revenue generated in 2012. The IEA believes that OPEC revenue could move as low as $320 billion in 2016 if oil prices remain low.

For those who are speculating on oil, consider the following statement by the Executive Director of the IEA Fatih Biro: “It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall: the historic investment cuts we are seeing raise the odds of unpleasant oil-security surprises in the not-too-distant future.”

All of the above is certainly possible as the IEA is known as a reliable source. At the same time, the IEA didn’t expect the current oil crash to be as devastating and long-lasting as it has proven to be. Therefore, if they’re incorrect this time around, then what else could lead to a recovery in oil prices?

Oil Price Catalyst

The most logical scenario for oil price appreciation is failure. The fracking industry has been capable of a run-up in production for one reason: debt. This debt was made available by record low interest rates. However, now that oil prices are falling, most frackers can’t turn a profit. And when their futures contracts expire, lenders won’t exactly be knocking on the door, which will lead to bankruptcies.

As these frackers fail, oil supply is reduced and market share shifts to the companies with staying power. But focus on the first point. This is exactly what Saudi Arabia wants to see happen, and it’s not a positive for the United States as layoffs will occur and the people working for frackers will find themselves in difficult fiscal situations. No American wants to see this happen. Unfortunately, the failure of overleveraged frackers is the only way for oil to rebound based on reduced supply. Many analysts believe that at least 50% of frackers could go out of business.

The Bottom Line

It’s possible that the supply and demand picture evens out by 2018 as OPEC expects, but that would require a strong global economic rebound, which is far from certain, and not from a production cut, which is probably wishful thinking. A more likely scenario is that overleveraged frackers go bankrupt due to the inability to turn a profit at low oil prices, which will then lead to the inability to find lenders. This has the potential to lead to a rebound in oil prices, but it still wouldn’t be a significant rebound due to global economy conditions.

Dan Moskowitz does not have any positions in oil.

Read more: What Will Save Oil? (And When?) | Investopedia

— Investopedia

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