Energy Economy

Could Oil Still Drop to $20?

124668669
Source: Thinkstock
Last week analysts at Citigroup slashed their forecast for crude oil to $20 a barrel before prices begin to recover. They see prices dropping to that point by the end of the first quarter or the beginning of the second quarter. The forecast is based on two points: the amount of crude oil in storage and the end of OPEC’s role as the so-called swing supplier.

West Texas Intermediate (WTI) crude oil for March delivery closed at around $44 a barrel on January 29 and at $52.65 this past Friday, about where it traded before Citi’s forecast was published. Crude dipped to around $49 last Wednesday before climbing back up on Thursday and Friday.

U.S. crude in storage remains at an 80-year high, and there have been reports that foreign producers have been leasing tankers to sail around in circles with cargoes of crude waiting for the price to rise. No one, apparently, wants to be the first to cut production, preferring instead to take a “wait-and-see” approach.

In the U.S. shale drillers have been cutting back on rigs at a pace of more than 80 a week for the past several weeks. But the cuts to rigs are not being accompanied by cuts in production. Apache Corp. said last week that it expects to cut its rig count from an average of 85 rigs in 2014 to just 12 to 14 rigs in 2015 while maintaining equal production.

ALSO READ: 4 Clean Energy Stocks to Buy as Huge Growth Continues

OPEC’s influence on oil markets has been diminishing since the mid-1980s, and the so-far imputed ability of U.S. shale producers to replace the cartel as the world’s swing producer may soon be tested. There is nothing OPEC can do short of cutting production to meet the challenge of shale oil production, and the cartel has said it will not do that. The important point here is that OPEC — and in particular Saudi Arabia, Kuwait and the UAE — have declined to fill their traditional role of balancing the oil market by turning the spigot on and off.

OPEC has made a clear break and decided to let the market set the price of crude. We noted last week that the Bank for International Settlements (BIS) lay the responsibility for the oil price decline squarely at the feet of OPEC. Perhaps, but certainly not entirely.

Even though the price of crude has risen in recent weeks, that rise is based on future U.S. production from fewer and fewer rigs operating in the main U.S. shale plays. In the here-and-now, however, storage tanks are brimming and the beginning of the seasonal maintenance and turnaround at U.S. refineries is likely to slow demand even further.

Until demand can sop up the extraordinary supply, prices should remain low but are unlikely to fall to $20 a barrel. There is a caveat, though: should producers be unable to find swaps dealers willing to hedge future production, prices could go much lower than they are today. These intermediaries require counterparties willing to take the long side of the bet before they will write the insurance policies (hedges) that producers need.

In the Commodity Futures Trading Commission’s (CFTC) Commitments of Traders report for February 10, among market participants long positions for WTI on the NYMEX fell by 1,796 while short positions fell by 12,568. Swaps dealers added 8,361 long positions and 19,560 shorts. Market participants are more optimistic about futures prices than swaps dealers, but as long as shorts vastly outnumber longs among the swaps dealers, producers will have difficulty hedging future production. Rig counts will continue to fall and production eventually will fall with the rig counts. What is unlikely, though, is that another $30 a barrel will be lopped off the price of crude.

ALSO READ: The Cities Where No One Wants to Drive