How Low Can Oil Go?

The oil market’s reaction to America’s renewed military operations in the Middle East has been counter to normal expectations. Rather than rise in price, Brent dropped from $115 in June to below $100 in September. How can this correction be explained?

By Sameer Massis

Geopolitics continue to drive the risk premium in Brent prices. Currently, tensions in Iraq, Libya, and Ukraine threaten to spill over into surrounding countries. Oil prices can climb quickly if production is hampered in any of these global flashpoints. Back in February 2011, for instance, disruption of Libya’s roughly 2 million barrels per day production pushed the price of oil up 6 percent in just one day. Today, the oil price risk is even higher since between Iraq and Russia, there’s a further 11 million barrels per day swilling around global markets.

As the United States has decided to intervene directly in the region to push back Islamic State militants, the market perceives a reduction in geopolitical risks. However, the situation is a long way from being resolved, and there is a delicate line to balance as the U.S. re-enters this foray. For instance, currently the US policy is in line with Iran, as it fights radicals in Iraq, however, this may not be for long. If no deal is reached on Iran’s uranium enrichment program, then the United States would be forced to deepen its sanctions on Iranian oil exports.

Despite all this, the Energy Information Administration (EIA) cut its 2014 oil price forecast in its latest report published in August this year. The EIA forecasted a WTI average price of $100.45 and a Brent average of $108.11 per barrel. This was due to a lower-than-expected level of oil demand of 92.96 million per day, as well as a growing oil supply. The EIA further notes that most of the global supply growth is flowing from non-OPEC countries, particularly the United States. The American burgeoning oil production is expected to average 8.46 million barrels a day this year, and to top 9.28 million in 2015, the highest average since 1972.

Growth in the global economy remains sluggish at 3.2 percent, but remain in a regional dichotomy. Whereas the developed economies, especially the U.S., the UK, and Germany, showed clear signs of recovery, other parts of Europe, China, and India continue to underperform in their growth expectations. This dichotomy is reflected in their respective central bank policies. Whereas the Fed and Bank of England are likely to raise rates in the first half of 2015, the European Central Bank and Bank of Japan are likely to deploy fresh stimulus.

Stop the Drop

Effectively, the combination of a tepid global growth, combined with rising non-OPEC oil supplies have pushed the price of oil sharply down. Nevertheless, OPEC has the ability to slow, or even reverse, this decline as its members collectively comprise 40 percent of the oil producers market, 50 percent of the oil exporters market, and two-thirds of the world’s oil deposits.

Should the price of oil continue to fall, it could threaten the GCC countries’ fiscal breakeven oil price point. Breakeven oil prices are the minimum at which oil-producing countries are able to balance their government accounts. Back in 2012, fiscal breakeven oil prices fell as GCC producers increased output to replace loss of produced oil from other MENA countries. In 2013, some GCC countries continued to increase the oil output, but pressure on OPEC to restrain its output had the effect of raising the fiscal breakeven price for other countries. Current estimates place Kuwait with the lowest implicit fiscal breakeven oil price of $61, whereas it’s significantly higher in other GCC states. The estimate for both the UAE and Saudi Arabia is around the $90 mark.

Looking forward, the balance of domestic government finances and oil exports is especially delicate for Saudi Arabia. For instance, the country is expected to reduce its oil output by at least 200,000 barrels per day, which would increase its fiscal breakeven oil price to over $97. This seems to be reflected in the Saudi budget for 2014, which assumed only a 4 percent year-over-year growth in spending to $228 billion, as compared to the 20 percent rise in 2013. Most of this expenditure has been earmarked for infrastructure projects that aim to tackle the kingdom’s 12 percent unemployment rate, and diversify its economy away from its overwhelming reliance on oil revenues. Diversifying Saudi Arabia’s economy won’t happen overnight, and it might slip into a deficit in the meantime. Nevertheless, what’s almost certain is that the country will take a leading role in reducing OPEC’s oil output from 30 million barrels per day in order to support global oil prices.

Curating the COT Report

Away from the folly of forecasts, another way to foretell the market’s direction in oil price is in the so-called Commitments of Traders (COT) report. The Commodity Futures Trading Commission (CFTC) issues the COT report each Friday to reflect the futures market as of Tuesday of that week. It summarizes the different positions of traders for all the futures markets in America. The COT legacy report breaks the market participants down into two categories: the reportable and the non-reportable. A market participant is deemed reportable if its positions held are large enough to meet the reporting level established by the CFTC in that market.

Whereas the non-reportable category is more likely to contain small speculators, the reportable category is further broken down between commercial traders and non-commercial traders. The former are hedgers who need to use futures to hedge their physical trade position. Even though commercial traders are knowledgeable of the business of the underlying asset, their aim is to hedge, rather than profit from the futures market. They don’t seek future market profit, but rather focus on business profits. In contrast, the non-commercial traders are the large speculators who provide liquidity in the futures market in order to gain profit. These seek direct futures market profits, and have sufficient clout to change market direction.

Each futures market is important in its own way, but a prominent one to watch is the US Dollar Index futures market. This market is important because the US dollar is the basis currency for all commodities and most world trade. The relationship is inverse, so that if for instance the US dollar increases, then the oil price will decrease, and vice versa.

The information from the US dollar futures COT report can be distilled to analyze the Brent oil price.Over the last five years, as the non-commercial traders took a net short position, it corresponded to a bottom in the price of the US Dollar Index. The non-reportable small speculators would then fuel the rise of the US dollar as long as the net position is long by at least 4,000.

More recently, the non-commercial traders’ positions had a net short position in April-May of this year, when the US Dollar Index stood at 80. Today, the non-reportable small speculators net position is around 8,000, which indicates that the US dollar still has some room to rise as it already surpassed 84. Accordingly, as the US dollar rises, the oil prices and other commodities are likely to ease further, unless perturbed by other political or economic factors.