No End In Sight For Oil Nightmare

January 12th, 2016 by

Oil futures were pummeled below the $30/barrel mark Monday, before managing to claw their way back above that psychologically important level before the close. This was a small victory, as it still marked the sixth straight session of losses. Both Brent and West Texas Intermediate closed at fresh 12-year lows, while trading down as much as 6% during the day. Brent, down $2 for the day, has posted a loss of 15% for the first six trading days of 2016.

The consensus opinion seems to be that the nightmare isn’t over yet.

Oil futures saw over 500,000 lots traded Monday, for the third day in a row. This is nearly 50% more volume than the 100-Day Moving Average. Prices attempted a meek rebound on short-covering Tuesday, but had soon fallen more than 2% to drag prices back under $31.

Drillers In Denial

Perhaps one of the most shocking of recent developments in the petroleum industry came out of a closed-door meeting between shale fracking companies and investors. Hosted by Goldman Sachs, analysts and investors were dismayed at the extent that shale drillers were ignoring reality. Several companies continue to operate under the assumption of $50 oil, and nearly none were forthcoming on what they were doing now to weather the storm of prices at $35.

oil glutBut reality will come knocking soon, as it is estimated that as many as one third of US oil companies will file for bankruptcy this year. Over 30 oil companies, owing more than $13 billion, have declared bankruptcy in the current bear market. Recent reports that the number of shale drilling rigs in operation fell by 30 wells last week shows that the shakeout in the shale patch is accelerating.

Hedge funds and other speculators are well aware of the dire straits the industry is in. Speculative net longs on crude plunged by 24% last week, as no one is willing to put money on where prices will bottom out.

Pain In The Forecast

bear.Bearish forecasts from the large investment banks keep piling up, with Barclays being the latest. The British mega-bank calls the current oil price rout the worst in 30 years, and has slashed price estimates for 2016. The manager of the $240 billion Guggenheim Partners fund sees oil falling even more in the first quarter, and dragging stocks into a bear market.Goldman Sachs says that weakening oil demand in the US, Europe, and China means that supply will not balance until a price shock under $30 forces more producers out of business.

Strong Dollar Twists The Knife

yuan-vs-dollarShrinking demand and ballooning supply isn’t the only factor in the current free-fall in the oil markets. A stronger dollar is playing a large role as well. The greenback is rising not just because the US economy is faring better than most others. It is also being lifted by Fed interest rate hikes (both actual and expected.) Analysts estimate that for every 5% the dollar gains, oil prices will drop anywhere from 10% to 25%. Morgan Stanley sees $20 oil in the future, as the dollar appreciates.

The dollar isn’t acting in a vacuum, however. China also plays a big role. Not only is falling demand in the Middle Kingdom exacerbating the oil glut, its interventions in international currency markets to devalue the yuan also play a part. If the yuan devalues by 15%, the US dollar gains by 3.2%. This translates into a $2 to $5 a barrel loss for oil.

Bankers Turn Their Backs

Heavily indebted shale companies are finding it almost impossible to roll over their debt. Bonds that were initially floated when oil was triple its current price have seen their ratings fall into junk bond status. Ratings agency Standard & Poors estimates that 50% of oil junk bonds are at risk of default.

Oil drilling and production companies are finding it impossible to raise operating cash, except from hedge funds that gamble on the riskiest debt.

Gulf State’s Scorched Earth Policy

saudi-arabia-653087_640The nightmare for shale and offshore oil companies really began in November 2014. That is when Saudi Arabia decided to defend its rapidly-dwindling market share from US shale and Russian oil by pumping as hard as they could. The other Persian Gulf Arab kingdoms quickly signed on for what was expected a short price war.

14 months later, the war still rages. OPEC greatly underestimated the technological breakthroughs lower prices would spur in the fracking industry, and how far some of the bigger companies could cut expenses. The Middle Eastern members of OPEC have been heavily tapping their cash reserves to maintain social services while running budget deficits. This is a luxury that the African and Latin American OPEC members do not have. When one of these members try to call an emergency meeting to cut production, they are rebuffed by Saudi Arabia. These small producers feel that the oil kingdoms along the Persian Gulf wouldn’t mind seeing them fail. (They’re probably right.)

A new and more vicious phase of the oil price wars is on the horizon, when Saudi Arabia’s deadly enemy Iran has sanctions lifted and can start exporting oil again. The Saudis will be willing to do almost anything to choke off an economic recovery in Iran.

When Will It End?

Many high-expense oil producing companies in the US have already collapsed, or are on the verge. Will the demise of the fracking industry be enough to send prices higher? Even if they are, it will be a short victory for OPEC, as all those wells stand ready to pump again as soon as prices recover.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.