Citi Sees $20 Oil Prices (Here’s Why They’re Wrong)
Despite a 20% jump in oil prices, some pundits continue to predict more pain.
In fact, just yesterday, Citigroup analyst Ed Morse came out with his most bearish forecast yet.
According to Morse, oil prices could fall another 60% to $20 a barrel. As for the recent rebound, Morse thinks it looks more like a “head-fake” than a sustainable turning point.
The market, of course, promptly reacted to Morse’s latest missive: oil prices continued to climb.
Nonetheless, that hasn’t stopped similar calls from others pushing their own doom-and-gloom forecasts.
There’s just one problem with all of this bearish analysis. And it’s a big one…
Oil Prices Have Already Begun to Stabilize
As I’ve previously discussed, the nearly 60% plunge in oil prices resulted in an abnormally oversold market, driven largely by the shorts. And without an actual pronounced decline on the demand side, there is very little likelihood of a price “Armageddon” happening anytime soon.
In fact, the oil picture has already begun to stabilize.
Now admittedly, absent a major geopolitical crisis, we are not going back to triple-digit oil prices anytime soon.
But the trajectory now clearly indicates a new medium-term floor in the mid $50s in New York and about $60 in London. By the fourth quarter of this year, oil prices will likely trade even higher, somewhere in the $70s.
Fueled by the onslaught of huge reserves in U.S. unconventional (shale and tight) oil, the oil picture is rapidly changing. Scarcity has suddenly been replaced with abundance.
Today, we’re facing a supply-side squeeze that will continue to influence oil prices – especially as the “shale revolution” goes global.
As for demand, it continues to climb globally – where the actual pricing dynamics take place. Just yesterday, OPEC revised its near-term demand projections higher, while cutting expected production from non-cartel nations. According to the cartel, demand for OPEC oil will average 29.21 million barrels per day (bpd) in 2015, up 430,000 bpd from its previous forecast.
OPEC determines its monthly production quota by estimating worldwide demand, then deducting non-OPEC production, resulting in what is referred to as “the call on OPEC.”
But as I noted last week, this long time market barometer is undergoing a significant revision, and it’s not in OPEC’s favor. Now U.S. production is determining the price. Or as Morse puts it, “the call on OPEC” has been replaced by “the call on shale.”
Now, the Paris-based International Energy Agency (IEA) expects global growth in oil demand to accelerate to 1.13 million bpd in 2016 from 910,000 bpd in 2015. Some of this is the simple reaction to lower prices – people use more oil when it costs less, especially in developing parts of the world where the use of diesel and other oil products is needed to generate essential electricity.
And there is another factor these “sky is falling” soothsayers fail to recognize. Despite a price decline of nearly 60% (most of that coming in the last quarter of 2014), we still ended up with the highest daily demand figure in history.
What makes this price decline different from all the others is the cause. Despite increasing global demand, the supply available to meet it has been rising even faster. That has put the brakes on the normal spikes in price that would result from any perceived interruption of the oil flow from world events or a rise in demand.
The Rig Count Falls As the Market “Self-Corrects”
Of course, the ability to accurately estimate the available supply has become the mantra of the profession. However, two fundamental mistakes are being made in the process.
Both arise from trying to use traditional yardsticks to a measure a “non-traditional” market.
First, the talking heads have been incessantly harping on shale and tight oil reserves available for uplift. However, just because reserves are extractable does not mean they will be produced. Because this potential has recently emerged, shale reserves have created an overhang on the market, and the cost-side triggers required to cut production are still unknown.
Nonetheless, the reaction to the price decline in the U.S. has been pronounced. The rig count has fallen dramatically to levels not witnessed in over a decade. In addition, operating companies are mothballing more expensive projects and trimming capital expenses.
Yet the doomsayers respond that there is still considerable volume available from ongoing existing projects. That is true. But, as usual, they miss the governing factor. The continuing volume from existing projects is already factored into a market where demand is not collapsing.
As for the stockpiles at places like Cushing, OK, these surpluses have been weighing on the pricing spread between WTI and Brent for some time now. But they are hardly a major factor moving forward.
New sections of the Keystone Pipeline system (located within the U.S. and not needing approval) are already draining oil from Cushing to the Gulf Coast refineries. What’s more, the decisions to reverse the flow in other pipelines – away from Cushing to the coast – are doing the same.
That makes the concern over an expanding glut at Cushing completely unwarranted, especially in an environment where domestic production is about to be reduced.
And what is underway among American producers is already taking place in Russia – the other primary non-OPEC producer. In Moscow, a central budget dependent on much higher oil prices has prompted a move to offset costs by delaying projects and reducing production.
That leaves the second overarching concern. This morning, the IEA reported that it may take some time to rebalance the oil market. Some pundits are already making bearish waves on the IEA statement, as much to offer an enticement to the next short play on oil as anything else.
Here’s the problem. We don’t need a perfectly balanced oil market, never have. That’s what trading arbitrage is all about, as future contracts expire and collide with the actual consignments of oil.
So long as there is a trading range, the system works quite nicely. According to just about any matrix, the market has not been balanced for much of the last decade. There are pricing changes in both directions, but the lack of a textbook balance has no appreciable impact.
It’s just another red herring.
Yes, this is a “brave new world” of oil. Yes, the factors colliding are operating in new ways. But it’s still the trade in oil that determines the price.
The sky is simply not falling… and we are going to continue to see fantastic profit-making opportunities in the months ahead.