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Why oil prices will head lower

Oil prices are heading lower and could fall into the $30s before the latest shakeout ends sometime during the fall months.

But analysts say this sell-off is nothing like the one that took West Texas Intermediate crude to $26 earlier this year, and some of the factors behind it are seasonal.

West Texas Intermediate oil futures are down 11 percent so far this month, after rallying above $50 in the spring. WTI was trading settled a half percent lower at $42.92 per barrel Tuesday, after breaking below its 100-day moving average of $44.25 on Monday.

The world remains oversupplied with crude oil, but the fact that it has become very oversupplied with gasoline is currently worrying the market.

"The gasoline inventories are 10 percent above a year ago level, and that's feeding back into crude," said Greg Priddy, director of global energy at Eurasia Group. The real fear is that the demand for crude will drop even further once refineries go offline as they normally do in early fall for routine maintenance ahead of winter fuel refining.

"What refining margins are telling us is there might be some weakness in product demand. I think some of the fears out there are a bit overblown. If I look at product inventories, yeah, they're high, but they've been high for months. Maybe markets are waking up to it. It's not like we've taken a sudden turn for the worse," said Michael Wittner, head of oil research at Societe Generale.

U.S. refineries continue to produce more gasoline than drivers can use. While the U.S. can export fuel, the whole world has plenty of refined product.

Wittner said some refineries on the East Coast have already reduced runs, perhaps signaling an earlier maintenance season than usual because of the gasoline glut. "What people are worried about is there's going to be a sharper than usual cut in runs as we head into the fall," he said.

Priddy agrees that the focus is on the maintenance season. "It's conceivable that it might start a week or two earlier. We're looking at the worst of this as we head into fall," he said.

Analysts say it's possible oil will dip into the $30s, but some say it's not highly likely.

"I think there's a soft floor at around $40," said Wittner, adding it's possible it could go lower. "I don't think we're collapsing. I know it feels ugly out there, but I don't think this is any way a replay of the first quarter. It's very different — that transition from the huge global oversupply to balanced is really important. That's why this is very different." Wittner expects oil to rise into the year end after it troughs.

"I may be tactically very cautious. I'm not turning bearish. I'm not changing my forecast," he said. His forecast is an average of $48 per barrel for the fourth quarter.

Bart Melek, head of commodities strategy at TD Securities, said oil could be heading to its 200-day moving average at around $41 per barrel. "Technicals will seek a level around $40.38, then we'll see ... the fundamental outlook is much, much better than it was six months ago. We're still looking toward $60 for year end," he said. He added that if $40 is broken, the next level would be just above $36.

Oil prices had been supported by disruptions around the world, including a major outage in Canada due to forest fires. But Canada is back on line, and Iran is slowing down its additions of crude to the market. Melek also does not expect much more output from Saudi Arabia or Russia.

U.S. production cuts have been a great re-balancer for the market, now that more than 1 million fewer barrels per day are being produced compared with last year's peak. As a result of higher prices, U.S. producers have also begun to add a few rigs.

"What we're seeing is a reaction to recent Baker Hughes data that showed a fourth consecutive week of drilling activity increases. These rig counts are thought to basically be a precursor to more production. That's probably true, but it's not going to be as fabulous as many people think. For the most part, these companies are in financial impairment and it's difficult to attract capital," Melek said. "Since the peak of October 2014, we've lost 1,291 rigs and what we've gained very recently is 53."

Morgan Stanley analysts, in a note, say these wells could help increase production.

"As oil approached $40-50, a number of producers put on hedges to complete a backlog of uncompleted wells. These wells have the capability to add production in short order without rigs. U.S. rig counts are also rising. In fact, the headline rig count can understate the issue as rigs are being added in the best acreage with greater incremental production," they wrote.

The analysts said oil could bottom in the mid $30s. "Oversupply should return by August, reinforcing a return to the $30-50 oversupply pricing regime, before returning to a balanced market in 2H17," they wrote.

U.S. oil inventory data is expected Wednesday morning from the U.S. Energy Information Administration at 10:30 a.m. EDT.

Platts forecasts a drop in crude stocks of 2.6 million barrels, and a decline in gasoline of 700,000 barrels, a bullish sign. Refineries however, are expected to continue to run at high levels, and distillate stocks are expected to rise by 400,000 barrels.

Wittner said there are a number of things that have aligned against the oil price for now. "We're talking not only fundamentals. Obviously, we're talking market psychology, which is bearish. The technicals are bearish. There's no geopolitics supporting prices," he said. "Bottom line is the global markets are still balanced." He said that compares to last year when the world was overproducing 1.7 million barrels a day.