We care about oil prices right now because a big decline in oil will cause a big decline in XLE, which has already fallen a lot. As we’ve analyzed in a previous study, big declines in XLE tend to precede small corrections in the S&P 500.
So why are oil prices falling right now? Will they continue to fall (and will XLE continue to fall)? Here are the bearish factors that oil faces.
*Take our thoughts with a grain of salt. We are not experts on oil, we don’t have complete data, we don’t have an oil model and we don’t trade oil. These are just some thoughts and factors – nothing more.
Supply is increasing
In the short-medium term, supply is much more important in determining oil prices than demand. This is because supply changes much more than demand in the short-medium term.
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In addition, history shows that oil prices lag changes in supply (medium term time frame). For example, oil’s supply kept increasing from 2012-2014. Oil only started to fall in mid-2014.
The biggest problem oil prices face right now is that supply is increasing. Regardless of how much production the Saudis cut, the U.S. just keeps pumping more and more crude. This is because:
- Producers only have to produce at a price that covers variable cost and not the total cost (variable + fixed).
- U.S. shale technology continues to improve, allowing U.S. oil producers to pump at cheaper prices. That’s why previous estimates for the cost of U.S. crude production were wrong.
OPEC announced a 1.2 million barrel a day cut in production in November 2016. But since the start of this year alone, U.S. crude production has increased by 450k a day! Meanwhile, Libya has brought its 700k a day production back online after years of civil war.
Likewise, Russia and Canada have all increased their production drastically since July 2016, when the year-over-year change in oil prices first turned positive. Their economies rely on oil exports, so they need to pump as much as possible if prices are high enough.
OPEC meets again on May 25, and some bullish investors hope that OPEC will extend its production cuts. We don’t think OPEC will extend its production cuts. OPEC has already seen that every time they cut supply, the U.S., Russia, Canada, and other nations increase their supply. Thus, prices are not lifted, and OPEC nations’ market share for crude shrinks. So OPEC does not stand to gain anything by continuing its supply cuts. OPEC just doesn’t have the same monopoly over oil that it did in the 1970s. This is the classic textbook example of how a cartel breaks down.
U.S. rig counts continue to rise, and various estimates believe that the U.S. will add another half million barrels a day in supply by 2018.
Although we’ve said that demand isn’t as important to crude oil, it still plays a minor role in determining short-medium term prices. With the recent weakness in Chinese economic data, perhaps oil’s emerging market demand will slow down.
The risk of a self-fulfilling prophecy
With prices falling, hedge funds and long term oil investors who were caught on the wrong side of the market have been dumping their holdings. However, some are still hanging on and praying for a rebound. If oil falls to $40, they may want or be forced to liquidate their oil stocks while oil is falling. That would result in a mini-crash and a self-fulfilling prophecy. Once investors give up all hope, oil prices will continue to fall merely because oil prices have been falling.
How low can prices go?
Honestly, we have no idea. We don’t think that oil will fall below $30 or even retest $30 a barrel. Perhaps the bottom is already in at $45. Perhaps oil will fall and bottom at $40. Perhaps oil will bottom at $35. We would set the odds at:
- $45 oil: 30%.
- $40 oil: 50%.
- $35 oil: $20%.
U.S. shale cost at $36.5!
We’ve been analyzing a very interesting point recently. The floor for medium-long term oil prices is usually the price at which a major producer is willing to produce. For example, oil consistently found support at $70 between 2010-2013 because that was the break-even price for U.S. shale.
U.S. shale is a huge player in oil nowadays. The break-even price for U.S. shale is $36.5 in 2017, so U.S. producers are pumping more and more crude. That’s why there’s been weakness in oil prices recently.
So if oil prices continue to fall, than $36.5 is a very probable target. That is the break-even price for U.S. shale, which is driving this downtrend in oil. If oil falls below $40, expect global inflation to tank again. When that happens, global investors will be scared because falling oil prices bring back memories of 2015 and early-2016.