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Oil’s capitulation is a reality check

Oil’s capitulation is a reality check
Traders must watch and wait with increasingly white knuckles

You could probably be forgiven for thinking last weekend, as the images from the Saudi embassy in Tehran were beamed around the world, the turmoil would provide be a pick-me-up for the ailing oil price.

After all, Middle East conflict equals greater instability, equals greater risk, equals premium pricing for crude. It is an oft repeated pattern. It is what usually happens.

And indeed it did. Briefly.

But these are not usual times and this is not a usual market.

Having fallen beneath US$33 per barrel at one point this past week, crude prices are now at the lowest for around 12 years.

The fact that escalating problems in the Middle East haven’t lifted prices is the kind of reality check nobody really wanted.

It is, essentially, the same problem the market has faced for about eighteen months now but people have been in denial about it until recently.

Cut away the machinations of the OPEC-vs-US shale price war, the complexities of Middle Eastern politics, and the fact that almost every industrial function in the world relies on some form of hydrocarbon; really it is as simple as there’s too much oil and too little demand to soak it up.

The oversupply, which has now built for more than a year, has now reached a point where international incidents such as last week’s can seemingly be shrugged off by the market.

Experts say there's already enough surplus crude that temporary shocks and disruption hold little fear.

Indeed, US government stats indicate little let up. This week’s inventories showed that although crude stocks reduced by 5mln barrels last week – to leave the stockpile at some 482mln barrels, a lack of demand saw the inventory of gasoline rise by 10mln barrels, which is the biggest weekly increase since the early 1990s.

But, the real risk is that, untethered, the pair of Middle East producers could can leave the oil taps flowing.

As one commentator pointed out Saudi Arabia and Iran are now extremely unlikely to confer, let alone cooperate on measures to reduce production.

Many credit the current oil price crisis to the former’s staunch intentions to hold onto market share. That it has purposely tried to price out the more costly, lower margin producers in places such as the US shale basins.

But, as the OPEC cartel (at least as we currently know it) fractures there may quickly become many more angles to this seemingly chaotic oil price war. And from the Saudis at least the message is things aren’t about to change overnight.

The country’s latest budgets assume an average oil price of just US$38 for 2016, according to London’s Capital Economics.

Under this scenario the pips will be squeaking in the US and Russia. And it doesn’t bode well for the North Sea, probably the most expensive area in the world now to extract oil.

What now for the majors? BP, Shell et al we could see some fairly hefty further cuts to capex, though it seems the biggies are determined to maintain dividends even if it means borrowing to do this.

It is most likely that the recovery will eventually come as a result of natural field decline, which inevitably follows the aggressive and industry-wide reductions in capital investment by oil companies over past months.

The market is very much in capitulation mode - and not just for oil, by the way - so nobody’s yet ready to call the bounce. Some in fact keep calling the price lower and one hedge fund reckons we could touch an US$18 low in 2016.

Capital Economics is not quite so gloomy, though it has downgraded its forecast for the 2016 ‘exit’ price to US$45, from US$55 per barrel.

And it reckons the Brent price can rebound to around US$60 by 2017, and up to US$70 by 2020.

In the meantime traders must watch and wait, with increasingly white knuckles.

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