Market Insider

Why oil decline could get ugly again

Futures Now: Will oil bounce back?
Futures Now: Will oil bounce back?

Still drilling at four-decade highs, the U.S. oil industry could help drive another price collapse in crude this spring.

OPEC Secretary General Abdalla Salem el-Badri told a conference this past weekend that the cartel's policy has hurt the U.S. shale oil industry and triggered a global reduction in capital spending that could ultimately lead to a shortage—and higher prices.

The U.S. industry, however, has not slowed its high levels of oil production, despite OPEC's best efforts to curb drilling with lower prices. The U.S. has pumped more than 9 million barrels a day since early November, and last week it produced a multidecade high of 9.32 million barrels. Industry output has not been at such a level on a sustained basis since the 1970s.

Oil analysts say the strong production in the U.S. should ultimately wind down, as the output of some wells in operation declines and more wells are shut in. But for now, as seasonal factors like refinery maintenance affect demand, U.S. production could be a catalyst for even lower prices and a new bottom for crude.

"You could touch a surprisingly low price sometime in the next month or two," said Citigroup energy analyst Eric Lee. "As we get into summer, refineries come back from maintenance. Demand could pickup stronger than it was before the rig cuts and capex cuts, and globally there will be capex cuts starting to have an effect."

Lee and other analysts said West Texas Intermediate crude, at $50 per barrel Monday, could easily head toward $40 a barrel. The strong dollar is also a factor in oil's weakness.

"WTI could take another leg down," said Lee. "If there's enough distress, if imports into the U.S. don't budge, which they wont ... if exports don't rise quickly enough, which is a wild card, then producers at various locations need to shut in pipelines or run at low utilization so it doesn't come to Cushing."

Lee said if the market becomes very distressed, then the price could head to $40 per barrel and there is a chance it could see a price in the $20s before bouncing back to higher levels. West Texas Intermediate closed at a low of $44.53 per barrel Jan. 29, before moving higher during February.

Traders have been focused on the high level of oil storage capacity being used in the U.S., particularly at Cushing, Oklahoma, the storage hub for the benchmark West Texas Intermediate oil futures contract.

U.S. crude supplies are reported at their highest levels in 80 years, and analysts say as storage gets tight, prices for storage get higher, and that could result in more oil coming onto the market.

WTI was trading lower Tuesday, at $49.68, a decline of just over a half percent.

Cushing is the physical delivery point for the benchmark Nymex oil-futures contract, so futures prices are sensitive to supply levels there.

Andrew Lipow, president of Lipow Oil Associates, also expects to see $40 WTI before the shakeout is over.

"The catalyst is going to be over the next four to six weeks. We continue to build inventory here in the U.S. due to refinery maintenance, but as we exit the maintenance season, demand will pick up and we'll turn this crude into petroleum products," he said.

Lipow said he does not see a storage issue. "I think there's more space than people think. We could store well over 500 million barrels of crude oil," he said.

A slowdown in U.S. oil production should ultimately materialize but Lipow said it may not be as big a hit as expected.

"While the rig count would lead me to believe toward the third and fourth quarter, we'd see a slow down in production growth, we have companies saying they're moving their rigs toward the best locations and best prospects," he said. "It may turn out to surprise the industry and not be as low as expected."

Baker Hughes on Friday reported that the number of rigs exploring for oil and natural gas in the U.S. fell to 1,192, a decline of 75. That is down from 1,792 rigs a year ago.

Analysts say one wild card for oil is Iran, and if there is a nuclear deal it could boost prices as traders anticipate more oil on the market. Lee said, however, Iran's ability to produce more oil is limited and it would not be able to increase production quickly.

However, if there were a deal with the West to end its nuclear program, Iran could move oil that it may have in storage into market, spurring a temporary jump in prices.