Oil prices could fall further despite hitting a new 12-yr low
This week, Brent oil prices have plunged another 5%, breaking a major support level around $35 a barrel and hitting new 12-year lows in the process, adding further unease to an already volatile start to the New Year for the financial markets.
The downward pressure in oil prices is of course nothing new given the 35% fall in prices last year. The fresh bout of oil selling this week has been the result of weaker demand for refined products - mainly from China, signalled by a continued contraction in manufacturing. In addition, Chinese service PMI numbers grew at its weakest pace for 17 months, fueling concerns of a faster slowdown in oil demand from China, which is the world's largest net importer of the so called 'black gold'.
The fact that prices continue to hit lower lows and recent falls are gaining in momentum poses the ongoing question as to where and when they will likely hit a bottom?
The three key catalysts for a return in oil prices to around the $50-$60 per barrel level is strengthening demand from China, a lessening in the geopolitical tensions at OPEC and a depreciation of the US dollar. All three catalysts look very unlikely at present.
China recently trimmed it GDP target from 7% annual rate to 'around 7%', a subtle but significant difference in tone and most take Chinese GDP data with a large pinch of salt anyway. There is every chance Chinese GDP could be closer to 6.5% this year.
The oversupply of oil production has been exacerbated by geopolitical tensions in the Middle East between Saudi Arabia and Iran - both members of OPEC. Oil production by the OPEC cartel has historically been led by Saudi Arabia, by far the most powerful member of the group. In December 2015, OPEC decided to keep oil production output at a high average level of 31.7 million barrels a day in the hope to drive out US shale producers to help them gain market share. At the same time and after years of Western sanctions imposed on Iran, the country is readying itself for its return as an oil exporting country, adding further supply to an already saturated market.
Rising tensions between Saudi Arabia and Iran following the formers execution of a prominent Shia cleric that has led to a cut in diplomatic ties between the two nations; further exacerbating the tensions within OPEC. With relations between the two nations at a historic low point; the supply glut appears set to continue. Both factors could well keep oil prices under severe pressure.
Finally, the US dollar continues to appreciate in value and this is becoming a further headwind for oil prices, which are priced in US dollars. A stronger dollar therefore makes it more expensive to buy oil for overseas purchasers who don't hold US dollars, reducing demand. This issue is also compounded by the fact that China, the largest consumer of oil, continues to devalue its yuan currency, therefore weakening its buying power for oil. The renminbi is now trading at 6.5646 per dollar, the lowest since March 2011.
But for us to start highlighting where a potential bottom may emerge in prices, we need to take a look at the cost of production.
The cost of oil production from most Middle Eastern countries is in the realm of $10-$12 a barrel. At $35/bbl OPEC nations are still largely profitable, however US producers may struggle to keep up production at depressed level given the cost of production for US suppliers ranges between $30-$70 a barrel. So the OPEC strategy of trying to cut US producers market share could gain more traction with the latest oil price fall but does leave further scope for more downside given the flexibility left in OPEC profit margins. In fact, we could see prices go as low as $25/bbl or even $20/bbl before OPEC considers cutting supply. It is here where we may see a bottom in oil prices.
This article is for information and discussion purposes only and does not form a recommendation
to invest or otherwise. The value of an investment may fall. The investments referred to in this
article may not be suitable for all investors, and if in doubt, an investor should seek advice from
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