COMMENT: This is why oil prices won't go up much more

COMMENT: This is why oil prices won't go up much more
For a variety of factors, oil prices won't go up much more.
By Kim Iskyan of Truewealth Publishing April 14, 2016

When the price of an asset increases by nearly 60% in a matter of weeks, it’s usually a good time to sell. That’s true for oil right now – regardless of high hopes for an oil production freeze when Opec members meet in Doha at the weekend. And that’s bad news for Russia.

Since the middle of February, WTI (or, West Texas Intermediate, a grade of oil whose price is used as a global benchmark) has rallied from around $26 per barrel to stand at around $41 per barrel as of April 14. But that’s still down 65% from 2014 highs.

As we said back in December, the oil price collapsed for the same reason that prices fall for anything else: there was more supply than demand. And the group of oil-producing countries that controls a lot of the world’s oil production, Opec, hasn’t cut production at all. In fact, it has intentionally kept pumping out crude at near-record levels to keep its market share.

It’s been an expensive lesson in ‘Economics 101’. Russia, which if an Opec member would be its second-largest producer, saw its economy shrink by 3.8% last year as real disposable income fell 6.5%. And Saudi Arabia, which is even more dependent on oil than Russia, posted a budget deficit for 2015 of 15% of its GDP.

Right now there is about 2mn barrels per day (b/d) of extra supply, in part because Iran, the world’s eighth-biggest oil producer, has been increasing the amount of oil that it’s producing. As we previously said, Iran’s increasing oil production means it will take even longer for global supply to match demand. Iran is trying to make up for all the oil it couldn’t export when it was dealing with economic sanctions, and is aiming to increase production by one-third, to 4mn b/d.

Part of the recent recovery in oil prices stems from an anticipated Opec meeting on April 17. A recent bump in in the oil price has been in part because traders anticipate that Russia and Saudi Arabia could discuss an output freeze. But both countries have been producing at near-record levels, and keeping production at the same level isn’t going to help relieve the supply glut. Growth in Iran’s oil production will anyway offset the minimal help of any production freeze by Opec and Russia.

A potentially bigger problem is that some of the oil that Iran has produced hasn’t even hit the market yet. It’s having problems finding companies to insure its oil cargoes, so in February it had about 40mn barrels of oil in storage waiting to be shipped. That’s about six weeks of production by Iran. Once that does come available, it will put more pressure on the price of oil.

Meanwhile, in the US, now the world’s largest oil producer, one report estimated that 35% of public oil exploration and production companies around the world are very likely to go bankrupt this year, including many US shale producers. That there’s less oil production in the US is a good thing for oil prices, but that doesn’t mean that the extra supply that’s pressuring prices is going away anytime soon.

Oil prices peaked last year at around $60 per barrel, because at that level a lot of US shale oil became profitable (it was unprofitable below that level). Since then, though, the US shale industry has been getting more efficient. Instead of needing a breakeven price of around $60 per barrel, it’s dropped for many shale producers to $40-45.

This means that shortly after the oil price moves up to that level, there will be more production from shale producers. And as we’ve already seen, in the oil market – as in other markets – a small amount of extra supply can have a big effect on prices.

There’s a “just right” price that benefits the global economy and strikes a balance between oil producers and consumers. As we recently said, this Goldilocks price is probably higher than where oil is now. But oil companies (and Opec members) don’t care about what’s best for the global economy – they’re focused on their own profits. So the price of oil probably won’t move up much more this year.

That means oil companies – Russia’s and around the world – aren’t a great investment, especially after share prices have increased in recent weeks. And markets where the recovery in the price of oil has helped – like Russia – are probably in for some disappointment.

Kim Iskyan, a former Russian securities analyst and hedge fund manager, is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in the your in box every day, for free.