Are oil prices bottoming out or is there worse to come?

Oil prices have plunged roughly 50 percent since the summer last year, amid a glut of supply and slowing demand. Brent crude, the international benchmark, has been trading around $55 a barrel, well below the level of about $110 a barrel in June 2014.

In the view of some traders, the recent spike in prices and increase in volatility offer further evidence that oil markets are approaching a trough.

They predict that Brent futures are projected to fall to a low of $38 in March and then climb to $58 in the fourth quarter. Brent for April delivery fell 1.9% to $56.37.

The cause of the price decline was a case study in elementary economics: The supply of oil rose dramatically due to prodigious production in the United States and OPEC, while sluggish economies, particularly in Europe and China, depressed demand. Now there is a glut, North American drilling is being curtailed and energy companies are slashing spending.

The situation was made worse when OPEC, led by Saudi Arabia, decided in November to maintain production at the 3-year-old limit of 30 million barrels a day. The idea, confirmed by Saudi Oil Minister Ali al-Naimi, was to drive oil prices to the point where expensive oil extraction from shale in the United States would cease to be profitable.

All markets have cycles and crude oil is no exception. But this collapse is different from other crashes. However, the magnitude and volatility of price declines since last summer have been extraordinary and associated historically with recessions or even greater supply surges.

For instance, the 60% drop in crude prices has not benefited the global economy in the way expected with growth forecasts lower, the absence of inflation and in some cases fears about deflation, has prompted central banks to take a more accommodative stance.

Oil companies are now finding that their investments are either not viable or not worth as much as they had estimated when oil prices were higher.

In a recent forecast experts expect that the world’s oil supply will grow by just 860,000 barrels a day by 2020, less than half the increase of 1.8 million barrels a day seen in 2014.

While a lot of excess oil has been held in storage, it could be released in the middle of this year as US production declines. But elementary economics will put upward pressure on the price of oil, prompting renewed production of US shale oil because extracting it will be profitable again.

What of OPEC? Did its price-war strategy work? The 12-member cartel may have recovered some market share lost to US producers, but it is unlikely to return to the heights it enjoyed before the global financial crisis in 2008.

And that’s all to do with the flexibility of shale oil. This unusual response to lower prices is just one more example of how shale oil has changed the market. OPEC’s move to let the market re-balance itself is a reflection of that fact.

However, a recent rally saw prices move upwards on the back of currency volatility and OPEC’s move to reduce quotas. Unfortunately the rally was unsustainable and prices have come off the boil.

So oil prices will get a heck of a lot worse before they get better!

Author. Martin Rawlings

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