With WTI on the precipice of breaking below $40/bbl, chatter abounds on just how low oil prices can go from here, with some discussing prices in the low $30s, or potentially lower. While this type of price action is not without possibility, Bentek does not believe this is rooted in fundamentals, but rather, would be a short term phenomenon spurred by speculative trade capitulation and/or a brief storage shock.
In terms of the former, should the paper losses from traders holding long positions in oil become too difficult to bear, the market has the potential for a short term rout if/when there is a liquidation of positioning. With regard to the latter, there remains some concern that this situation could arise in specific places, with the most notable being Cushing, OK, the delivery point for the WTI futures contract. Fears have escalated that a storage shock could occur due to the recent unplanned outage at the Whiting refinery, and the apparent resiliency of U.S. production. A storage shock would result at the point where the marginal buyer of crude at Cushing, or the market participant who has available storage, drops his/her bid for oil because storage has become full. This can potentially lead to dramatic swings in the spot price to reflect that lack of buying interest, and to create incentive for suppliers to try and find an alternate location to send their crude, rather than send it on to Cushing.
While the aforementioned scenario cannot be completely ruled out, current oil prices already dictate that supply should respond in the not too distant future. In other words, the market does not require significantly lower oil prices from current levels to deter future spending on exploration and production, without which, we should see some natural declines in supply. Hedges in place for 2015 are likely one of the largest contributors to U.S. production being maintained. But as we enter 2016 with fewer hedges in place, and with capital becoming more expensive for the E&P sector, in general, it should begin to manifest itself in less production growth, and begin to aid the market in finding balance once more.
A global macro/recessionary shock could place further downside risk on pricing due to implications for demand growth and the impacts of a deflationary cycle. The force of that shock would need to be quite large, however, as it would not only need to result in less demand growth, but likely an actual drop in demand year on year, in order to bring about a situation in which prices would need to fall to a level that dips below cash costs for many global producers.
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