Why oil prices could stay lower for longer

Published Thu, Aug 6 20156:00 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

The oil market is setting up for a prolonged period of low prices, unless there's a dramatic shift in strategy by producers. Those producers range from Saudi Arabia and Iraq, to the upstart shale drillers of Texas and North Dakota whose surprising success initially set off a market share battle with the world's largest oil exporters. "What you're seeing now is the price crisis some had expected last winter. Just a few weeks ago, confidence was coming back and people were saying, '$70 was the new $100.' Reality intruded," said Daniel Yergin, vice chairman of IHS. Yergin believes the world is awash in even more oil than expected because of increases in output from Saudi Arabia, Iraq and the U.S. since the beginning of the year. Both Saudi Arabia and Iraq have been producing at record high levels, and U.S. producers, contributing 600,000 more barrels a day since January, are currently holding production steady at roughly 9.5 million barrels a day. On top of that, Iran's nuclear agreement with the U.S. and five other countries would end sanctions against the country, allowing it to sell more crude on the world market. "That 2 million barrels surge from three countries is unprecedented. That's just since the beginning of the year," Yergin emphasized. "There's several things going on right now. The Saudis are seeking market share. They're seeking to hold onto markets and not give it away to Iran, and a big question for the market is what kind of strategy is Iran going to pursue when it comes back into the market. Is it going to try to regain its market? Is it offering price incentives, or is it going to do it more slowly and not undercut prices further?" Source: FactSet Oil has been under intense pressure as the oversupply concerns collide with fears of weaker demand from China. Futures slumped again Wednesday, with West Texas Intermediate crude futures trading in the $45 range—about $3 per barrel above the March low. WTI was about 7.5 percent lower in the last five sessions while Brent futures, the international bench mark, were trading just under the key $50 level. Saudi Arabia and OPEC changed the dynamic in the oil world when they opted to leave production targets unchanged last fall, and instead allow the market set prices. Read More Retail investors try to pick oil bottom and fail On the news, already declining prices fell even more, but then stabilized and rose into the second quarter of this year. "You could well see prices for a period in the low $40s. That's the type of price that would really start to lead to a cutback in U.S. production," said Yergin. One advantage U.S. producers have, according to Yergin, is that they've found efficiencies to allow them to extract more crude from wells even as the industry cut back on rigs. John Kilduff, partner with Again Capital, says a day of reckoning could be on the horizon. "The market is in the process of forcing action by some element of the market. Whether it's that these guys in the shale space implode, or whether the Saudis blink," he said. While some analysts see no shift in OPEC's strategy, Kilduff believes major changes typically come when they're not expected. According to Kilduff and other investors, oil could dive into the $30s before moving back to higher levels. A wild card is what level of pain U.S. producers can take and at what level some of their funding would be impacted, putting the brakes on production. One big concern for the U.S. market last spring had been the huge supply in storage at Cushing, Oklahoma, the physical storage point for NYMEX crude. That situation became less critical as demand from U.S. refiners increased and they processed record amounts of oil this summer. Refiners were still running at a record high of more than 17 million barrels a day last week, but that level isn't expected to be sustained for much longer. "Cushing inventories have not really moved a lot since April, and here we are about to embark on refinery maintenance season," said Andrew Lipow, president of Lipow Oil Associates. "Where is the world going to put all this stuff that continues to come out of Iraq and Saudi Arabia." The theory is if Cushing and other storage locations run out of space that producers will flood the market with oil, undermining the price even further.

A worker pauses while drilling for oil on a derrick in the Bakken shale formation outside Watford City, North Dakota.

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The oil market is setting up for a prolonged period of low prices, unless there's a dramatic shift in strategy by producers.

Those producers range from Saudi Arabia and Iraq, to the upstart shale drillers of Texas and North Dakota whose surprising success initially set off a market share battle with the world's largest oil exporters.

"What you're seeing now is the price crisis some had expected last winter. Just a few weeks ago, confidence was coming back and people were saying, '$70 was the new $100.' Reality intruded," said Daniel Yergin, vice chairman of IHS.