Why oil will drop to $35 by end of summer

The state of the oil market these days can be summed up in a four-letter word—no, not one of those salty terms, but a powerful, unoffending term: glut.

After peaking in early June, near $52, WTI oil prices have fallen upwards of twenty percent, getting under $41 per barrel, for a time, on Friday.

There were several supply issues that ranged from the Canadian wild fires to renewed unrest in the Niger Delta that combined to reduce global oil output, or so it seemed.

OPEC production has risen steadily, with Iran, Iraq and Saudi Arabia leading the way.

In fact, Iran claims to need only two more months to return to full pre-sanction production levels, having already reached 80 percent mark. Their aggressive marketing efforts are bearing fruit, as sales to their historical customers in Asia have risen nearly 50 percent in June, from year ago levels.

Saudi Arabia is back to pumping at near-record levels just above 10.5 million barrels per day.

The surge in Iranian sales to Asia is certain to irk the kingdom, and a renewed battle for market share, between the two, is not out of the question.

Making matters worse, it appears Libyan exports are set to resume, as a result of an uneasy agreement among warring government factions and the resolution of a last-minute glitch over pay for the guards at their key export terminals.

"It is going to be a rough end-of-summer and fall for oil prices. The glut has finally registered with market participants, disabusing them of the notion that the market was nearing balance."

Despite the hand-wringing in the market over barrels of oil that could not be given away, at points during the past year, Nigeria is still exporting a decent portion of its oil output.

The oil price losses accelerated, recently, due to a dark outlook by the International Energy Agency, in its June report, which was a change, saying that "there is an enormous inventory overhang to clear." Adding, "this is likely to dampen prospects of a significant increase in oil prices."

They got that right!

The glut is a global phenomenon, with record gasoline inventories at the main European trading hub in the Amsterdam region, and an over-supplied diesel fuel market in Asia, coupled with brimming supplies in storage of all things petroleum in the United States.

There was a rush to judgement by many in the market that supply-demand dynamic was coming to balance. Some observers actually declared it balanced already.

Meanwhile, the price curve, especially for diesel fuel, is steepening (longer-dated futures contract prices are appreciably higher than that for near-term contracts), encouraging more and more stockpiling of the fuel, including a surge in the use of floating storage.

Refinery profit margins have gotten crushed, as the earnings of ExxonMobil, Chevron, and Phillips 66 showed on Friday.

That sets up a vicious cycle for the oil market.

Refiners will react to the poor economics by cutting back on operations, in order to try and drain the refined product swamp. Of course, that will result in lowered crude oil demand, causing a renewed back-up in global crude oil inventories.

The poor economics appear unlikely to hold back production and exports of refined fuels from the new kids on the block, the so-called "tea pot" refiners in China, who recently received government approval to export greatly increased amounts of fuel that are already at record levels.

Speculators in the market have awoken to all of this, and they have dumped most of the long-position built up by them and have actually gone net short on energy, CFTC data shows.

It is going to be a rough end-of-summer and fall for oil prices. The glut has finally registered with market participants, disabusing them of the notion that the market was nearing balance.

Prices by late September are likely to trade down to $35, at least, although the low from earlier in the year at $26 is probably safe.

The current downturn may also be the final one for the cycle.

Companies that were able to barely hold on, financially, will likely give up the ghost and U.S. production will resume its fall. The U.S., it should be noted, is the only place where production has been cut for economic reasons.

Another result of the swoon, a bit of a wild card, with Iran back at full production strength, there may be a coming back together of OPEC, where the pain from the low prices, created by their own doing, gets them to agree to a coordinated production cut, in an effort to raise prices.

Next year may be a better year for the oil industry, but the second-half of this year will not be.

Commentary by John Kilduff, a partner at Again Capital, an investment-management firm that specializes in commodities. Follow him on Twitter @KilduffReport.

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