The price of oil reached a new 2016 high last week - $46. Oil’s steady climb over the past few weeks, coupled with small but continual reductions in U.S. production, has many seeing the light at the end of the tunnel and expecting prices to continue to rise.
However, there are many reasons to doubt the strength and foundation of this oil rally:
At the OPEC/Non-OPEC producers meeting held in Doha, Qatar last month, participants failed to agree on a production ceiling (or freeze). Since then, OPEC production has grown to 32.64 million barrels per day during April. As the hot summer months approach, Saudi Arabia, Kuwait, and other Persian Gulf countries will have to increase their output to meet domestic electricity demand and to continue exporting at current rates. This could lead to historically high production levels over the summer.
Although China is a net oil importer, the country does produce a significant amount of domestically used crude oil. Indications are that Chinese oil production is declining, which will mean that unless demand also falls, China will be looking to import more oil in the future. China’s major partners are Saudi Arabia, Russia, Kuwait, and Iraq – all of whom are eager to expand their markets in China. Iran is another possible source of oil for China, although the Iranian oil industry is coming back online slowly. When major players like OPEC countries or Russia produce more, the global markets take notice much more so than if China decreases production.
Crude oil stockpiles remain at some of the highest recorded levels. The Wall Street Journal reported that 370 million barrels have been put in storage since January 2014. Even with gasoline demand in the United States expected to grow this summer, crude storage levels are so high that it will not be enough to alleviate the glut. Even though oil production in the United States is declining, that decline is not nearly enough to compensate for increases in production elsewhere. For example, U.S. production has been “reducing output by 300,000 barrels since the beginning of the year,” while OPEC production is higher by 30 million barrels per day, just in the month of April. To really make a difference in the global oil glut, American production would have to decline much more significantly.
Since December 2014, U.S. crude production has proven remarkably elastic. Part of this has been producers’ ability to cut costs and drill more efficiency, but even more important is the propensity of lenders to keep the lines of credit open. Some of the weaker producers are going bankrupt or selling off assets, but many small shale oil producers are still struggling along. The problem is that the closer oil gets to $50 a barrel, the more likely producers are to open nearly completed wells and produce more oil. Growing U.S. production could, in turn, send prices into a nosedive.
Oil is not likely to head back down into the $25-$30 range, but neither are prices in the $50-$60 appropriate at this point. Perhaps if more lenders revoke credit lines for more U.S. producers or an environmental or geopolitical incident takes out production in some major producing country, oil could temporarily surge. But absent a serious shock to the market. this oil rally is not likely to hold.
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