How low can crude go?

Perhaps lower

Just a few short weeks ago the consensus was that crude oil could not break below $75. Then it changed $64 and to $50. After seven consecutive weeks of falling oil prices, WTI dropped below $47 and Brent seems under pressure to trade below $50, a significant psychological level. The talking heads on TV continue to focus on the prospect of stabilizing oil prices, but I am not buying it. It’s never a good idea to attempt to catch a falling knife; and the current oil market seems more akin to a falling axe. In my view, the 50% move lower in crude oil that we’ve seen recently was driven by a glut of supply coupled with weakening demand, and I don’t think that situation has significantly changed or looks to change in the near term.

The North American energy revolution is a main catalyst for the excess supply as new shale technology has allowed drillers access to previously untapped oil reserves. Oil bulls are pointing to a drop in U.S. rig counts as evidence we may have seen a bottom. They are not wrong in the fact rig counts are dropping. Rig counts were down 6% this week alone, bringing the count to 1,755, the lowest figure since November, 2013. However, rigs already in operation show no signs of being shuttered and production in the United States continues to increase. The lower rig count will have an effect on the market in the long run but I am looking for production forecasts to remain unchanged in 2015.

OPEC once provided stability to the oil markets by lowering/adding production when needed. However today’s environment is different and Saudi Arabia, the biggest player in the cartel, has made it crystal clear that they will not cut production in a fight to protect market share. Iraq is producing at record levels as their oil exports are at their highest since December, 1980. Russia has dealt with sanctions by doing the only thing they can - pump more oil! 2014 saw Russia produce a post-Soviet era high of an average of 10.58 million barrels per day.

On the flip side, Chinese and European demand is slipping. China has been buying oil to add to their reserves but with stockpiles nearing capacity, this buying fever may dry up soon. Greece is bringing down Eurozone demand as an election in late January could result in them leaving the euro currency bloc.  As oil-producing countries play this game of chicken, consumers are the real winners as gasoline prices at the pump have reached an average of $2.16 in the United States according to gasbuddy.com. From a fundamental analysis point of view, crude continues to show weakness and unless something changes substantially, we could be heading for sub $40 prices soon.

About the Author

Jack Malone is a Futures and Options Advisor at RCM Asset Management with a focus on the metals and energy markets. Jack can be reached at jmalone@rcmam.com