Cheap oil forever? Not so fast

Oil prices have been a source of great concern for capital markets, yet should we be worried?

After all, the imbalances between supply and demand are neither extreme nor persistent plus market forces should start to move the market closer to equilibrium by mid-2016. That ought to provide fundamental support for crude prices, paving the way for a reversion toward a more sustainable price equilibrium above $60 a barrel in 2017.

On top of that, the current oversupply level of 1.5-2.0 million barrels a day (mb/d) is not that large, especially in the light of virtually zero spare capacity. And China's thirst for oil is unlikely to slow down materially in 2016. The country's economic slowdown is often cited as the reason for the price correction, yet car sales there have surged in recent months and gasoline demand rose by 11 percent in China during 2015.

The slide in oil prices may not be over yet though. The lifting of sanctions on Iran threatens to swamp an already oil-laden market with more supply at a time when seasonal refining maintenance will dampen demand in the first quarter.

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In 2016 we believe that 1mb/d of global demand growth is realistic, but given the oversupply of 1.5-2.0 mb/d, rising demand won't be enough to restore the global demand/supply equilibrium.

Supply, however, will inevitably decline given that – with the exception of some Middle East producers – production is uneconomic at current prices. But the big question is when?

At around $30 a barrel, a supply cut by the oil-producing cartel OPEC cannot be ruled out, especially if weaker demand warrants it. But, for now, OPEC's decision-making remains opaque. Oil prices rallied in the middle of last week on the back of Iran's support for a Russia/Saudi-led move to freeze production at January 2016 levels. However, such a deal would not materially change the situation. OPEC is already producing at full capacity and it seems unlikely that Iran will refrain from ramping up its production after years of sanctions.

With attention focused on OPEC, recent developments in U.S. oil supply are in danger of being ignored: A large number of U.S. producers are announcing additional massive cuts in capital expenditure and production expectations. U.S. supply has already peaked and this latest data points to an accelerated decline in U.S. supply.

Given the already 70 percent decline in the number of active drilling rigs, a 1 mb/d drop in U.S. output is realistic this year. This is probably more than enough to offset the increase of Iranian production. A million b/d increase from Iran by the second half of 2016 is the word on the street, but the rhetoric from analysts has turned more cautious lately. Most analysts expect a 0.4-0.8 mb/d increase of Iranian production in 2016.

For now, Saudi Arabia is pumping as much as it can, while Iraqi production is unlikely to grow over the next two years. Last autumn, Baghdad told producers that they should scale back investment because Iraq will not be in a position to pay due to low revenues per barrel and the high cost of the war against ISIS. Libya could be a substantial risk if its crude oil production and exports come back on line, but with a fragile security situation, a production recovery isn't probable soon.

Overall, excess supply should start to shrink in second quarter 2016. By mid-2016, the market could start to focus on 2017 when the decline in conventional oil production in many regions will start to kick in - potentially leading to a supply deficit situation. Of course, the exact timing and initial magnitude of a price rebound is difficult to predict in the short-term. Rising market concerns about global growth may intensify near-term pressures on many commodity prices, including oil.

But, over time, prices need to return to levels where oil producers can invest to meet demand. Globally, prices in the $70 a barrel neighborhood are necessary to maintain and adequate flow of oil to keep up with rising global demand.

More so than other markets, oil is subject to long and significant price swings, driven by investment cycles and cartel pricing behavior. This time is no different. Don't bank on cheap oil lasting for long.

Larry Hatheway is Chief Economist and Roberto Cominotto is Investment Director at GAM. You can follow GAM at @gaminsights.

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