With oil prices dipping to new six-year lows and WTI breaking below the $40/bbl threshold, Wall Street seems as polarized as ever when it comes to where oil prices will go from here.
There’s a compelling bull case and bear case to be made for oil, so here’s a breakdown of how oil got to this point and what every trader should know about where oil is headed from here.
Oil was sent crashing to new multi-year lows in the past week following the latest U.S. Energy Information Administration (EIA) weekly commercial crude oil inventories numbers.
U.S. crude inventories had never breached the 400 million barrel level prior to 2015, but the oil glut sent inventory levels skyrocketing to as high as 490.9 million barrels in April of this year. Since that point, inventories have mostly been in decline.
However, this past week’s numbers took a surprising step in the wrong direction. While Wall Street consensus was looking for a decrease of 777,000 barrels, the EIA reported an increase of 2.6 million barrels to 456.2 million. This unexpected inventory increase sent WTI prices crashing.
In addition to the U.S. inventory numbers, the oil market is now entering a tough seasonal period. The latest refinery utilization numbers from the EIA indicate that this year’s seasonal peak in refinery input, which was higher than each of the past three years, has likely come and gone and the seasonal decline in refinery input has begun.
This drop off in refinery input typically coincides with the end of the seasonally high demand for petroleum products during summer driving season. The lull in demand continues until winter fuel demand hits later in the year.
Typically, crude oil stocks are at their highest this time of year, but the massive oil glut has generated stocks that are far beyond anything the industry has seen of late.
The oil market is dictated on a very basic level by simple supply and demand. As the graph from the EIA indicates below, prices started to take a dive in 2014 when global oil production dissociated with global oil demand. That created the huge supply glut the industry is dealing with today.
Bears note the EIA projects that this glut will get worse before it gets better. The EIA is projecting record-high global liquid fuels production in Q3 2015 and a surplus of 2.06 million barrels per day during the quarter.
Even if global production begins to decline after that point (as the EIA predicts), every quarter that production exceeds demand will only continue to enlarge the supply glut and pressure crude prices.
The long-term good news for oil bulls is that, while global demand from China and other major oil-consuming economies may end up being softer than expected in coming years, the EIA is still predicting that demand will continue its steady march higher.
In addition, global oil producers don’t operate charities—they will only continue to produce oil in the long run if they are making money doing so. The precipitous fall in oil prices has already led to the shutdown of about 54 percent of U.S. rigs, and the sub-$40/bbl area becomes critical for many global producers.
Put simply, the cash cost is the cost it takes for an oil producer to continue to produce a barrel of oil from a project that is already up and running.
As this chart shows, the $40/bbl mark is the point at which the price of crude oil starts bumping into the cash costs of some of the major global oil producers, including Venezuela.
While companies can continue producing oil at a loss in the short-term, oil bulls are betting that the cash costs of major global producers in the $30-$40 range will provide long-term support for prices. In an ideal scenario, the market would then work through the current supply glut until growing global demand eventually puts prices back on an upward path.
Since this turnaround story may take years to play out, long-term oil bulls should probably not invest in oil ETFs that are subject to contango, such as the United States Oil ETF (NYSE: USO). Instead, one potential oil pure-play that also provides a degree of diversification protection is the Market Vectors Oil Services ETF (NYSE: OIH).
Disclosure: the author holds no positions in any of the stocks mentioned.
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