Market Insider

Why oil could revisit its lows and then some

Where are oil prices headed?
Where are oil prices headed?
When the oil selling will stop: Commodities expert
When the oil selling will stop: Commodities expert
How low can oil go?
How low can oil go?

After another volatile session, oil looks increasingly set to test its lows of the year, and that could mean a temporary decline of near 20 percent.

Analysts say crude futures could continue to trade lower for now if the twin pressures on risk markets from Greece and China continue, and Iran succeeds in striking a nuclear deal that would ultimately mean more oil would hit an already oversupplied crude market.

On Tuesday, West Texas Intermediate futures for August traded higher early in the session and then plunged, touching the psychologically key $50 area before again reversing course. Already about 8 percent lower than at the start of the week, WTI futures lost just 20 cents Tuesday to finish at $52.33 per barrel.

"For now, I think we've bounced back…. Any more instability makes it swoon lower, but I think it's premature to say this is going to hell in a handbasket. Could it go there? Yep," said Bart Melek, head of commodities strategy at TD Securities.

Melek said the market is nervous about Greece but is also now worried that China has so far not been able to stem the selloff in its stock market even after taking policy steps to do so. He expects Greece to ultimately come to an understanding with the euro zone, but in the meanwhile negative headlines on talks between Greece and European leaders have made the market volatile.

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"We do think things improve but in the meantime, you have the oversupply situation and demand is in doubt. We do think there's risk of oversupply for a long time," Melek said. "Technically on WTI, we've fallen through some technical support levels and, depending on what happens, we could test the low."

The question, though, is when the lows would be tested. Some strategists say it would be more likely at the end of the third quarter or early fourth quarter, when gasoline demand drops off and U.S. refiners undergo maintenance, requiring less crude.

Gene McGillian of Tradition Energy said the big drop on Monday does not appear to have been heavy liquidation of positions and there still appear to be a lot of longs in the market. "A lot of them are still in, and if we don't see any pickup in demand or pullback in production, they could all get flushed out if we drop below $50," he said.

McGillian points to the retracement level from the May high to the March low at $49.20, and says that will be a key area. If oil should break that, some traders believe it will not see support until it gets to the March 18 low of $42.03 per barrel.

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"Certainly half of it's about financial flows and which players are pulling back. It could stabilize at this point," said Eric Lee, energy analyst at Citigroup. "You flushed out a little more length in the market, so perhaps there's less impetus for massive downside at this point."

Oil's recent decline was also in part a reaction to a build in U.S. supply and a report on U.S. rig counts, showing the first increase in rigs in 29 weeks. U.S. weekly oil inventory data will be released Wednesday at 10:30 a.m. ET.

Lee said it appears some of the selling in the front of the futures curve was being done by the oil ETFs, but there was also strong selling at the back end of the curve, likely macro players like hedge funds and others.

If oil retests its lows, analysts expect the move lower to be temporary. Melek expects the average third-quarter price for WTI to be about $60 per barrel, and the fourth quarter would be even higher at $63 per barrel.

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"We still think we're going to see robust declines in U.S. output," he said, noting the drop of more than 60 percent in rig count will still take its toll on production. "There's usually about a six-month lag."

Lee said U.S. shale production is more difficult to forecast than traditional drillers. "That's the tricky thing—the U.S. part of the issue.... Where is U.S. production going to end up? Where are U.S. producers going to end up? Where is the price going to end up? The big new factor that means we're now in a $50 oil market, not a $100 oil market, is the emergence of shale," he said.

U.S. shale production has surprised the market, as many producers have continued to use the technology in more efficient and cost-effective ways, maintaining production at lower-than-expected prices. Lee said at $65, there were producers making plans to resume production and already there are plans to add rigs back in and bring on some that are partially completed.

The oil market has been struggling this year with the ramped-up production from Saudi Arabia and other OPEC members as they pledged not to back off on their 30 million barrels-per-day production target, yet Platts, a provider of energy and metals information, said OPEC produced 31.3 million barrels a day in June.

The U.S., meanwhile, has also been producing about 9.6 million barrels a day, and the Energy Information Administration now expects U.S. average output this year of 9.47 million barrels a day.

That has resulted in the oil market's being oversupplied by 1.5 to 2 million barrels a day, and while demand has picked up, more oil is finding its way onto the market. For instance, Iraq's production has increased this year, and it is now producing 4.3 million barrels a day.

"I think we could test the lows, but I think you're really looking at later this year when refineries go into turnaround season and we see demand decline seasonally," said Andrew Lipow, president of Lipow Oil Associates.

I think that in conjunction with Iraq production at record levels and Russia and Saudi Arabia at near records, and if Iran reaches an agreement … come later in the year when we also could have a significant amount of Iranian oil hit the market, we could retest that low in the low $40s."

U.S. gasoline demand was at 9.7 million barrels a day in late June, a historically high level while U.S. refiners, running at 95 percent, are pushing out record levels of gasoline. In the past seven weeks, there were three weeks when production rose above 10 million barrels a day, something seen only once before, in December 2014.

"It's been the gasoline demand that's been the big surprise this year," Lipow said.

Lee also said the market could retest the lows in the fourth quarter, when the refining industry will be running at lower levels.

But the anticipation of that event could also keep prices lower. "There's enough of a belief it's going to happen. You could see some selling ahead of time," he said.