Oil Prices: The Ridiculously Simple Reason Oil Prices Could Hit $20

Oil PricesMore Downside for Oil Prices

There was a fleeting rebound in oil prices, as tensions between Saudi Arabia and Iran briefly raised geopolitical risk in the oil-rich Persian Gulf. However, the markets seemed more than ready to absorb it. The oil price rebound, small as it was, has already fizzled, even though prices are now heading to such lows that a more sustained rebound could occur by the end of 2016.

A barrel of oil now sells for the lowest price in 12 years, having crossed a psychological threshold of $30.00. On January 18, it dropped below $28.00—less than the cost of the actual barrel itself. (Source: “Oil price falls below $28 a barrel, or less than the cost of an actual barrel,” The Independent, January 18, 2016.)

Oil traders will now be looking for a new bottom, after which a more lasting and substantial rebound could take place. That floor is likely to be $20.00. The culprit is the latest development in the negotiations with Iran. The International Atomic Energy Agency (IAEA) has confirmed that Tehran has honored the agreements on nuclear energy signed in July. (Source: “Iran has met obligations under nuclear deal, IAEA says,” France 24, January 17, 2016.)

The international sanctions that have strangled Iran’s exports since 1979—and more significantly since 2006—are now officially revoked. Iran is free to sell its crude to any buyer, but the market remains burdened by more than a million barrels per day of excess production. On top of that, the international sanctions have been lifted earlier than analysts expected, according to Barclays. (Source: “Barclays latest to axe oil forecasts,” Financial Times, January 12, 2016.)

In other words, the lifting of sanctions could not come at a worse time for the oil markets, which suggests prices should go even lower.

Iran Comes on Tap

The Iranian government says it can increase production of crude oil, now down to 2.7 million barrels per day from 3.6 million barrels per day in 2011, by some half a million barrels in a matter of months. (Source: “Iran Orders 500,000 Barrel Per Day Increase In Oil Production, As Brent Crude Drops To 13-Year Low,” International Business Times, January 18, 2016.) Even if that might be optimistic, because years of sanctions may well have damaged the oil fields, any increase would tip the oil market, now in full bearish mode.

Indeed, apart from actual production and even if the Iranian economy needs considerable oil for itself, Iran has a fleet of 22 huge tankers anchored in the Persian Gulf coast—each vessel able to transport two million barrels of crude. (Source: “Iran tankers set to target India, Europe as clock ticks down on sanctions,” LiveMint.com, January 14, 2016.) This means that buyers will be easy to find in Asia and Europe (Italy was among the major buyers of Iranian crude).

Iran will likely use good old-fashioned capitalist tricks to win back customers, ready to offer discounts on already super-cheap oil and certainly better terms in order to win back customers. Iran will likely offer more favorable terms than competitors, which are its allies Iraq and Russia, ironically, in terms of type and quality of product.

This could put even more pressure on oil prices, given that all three will increase production to cope. However, depending on quality, some oil varieties are already at $20.00 per barrel. Some heavy crudes, such as Mexican Maya, cost less than $20.00; those extracted from Canadian oil sands will sell for $10.00–$15.00 per barrel. (Source: “Worried about sub-$20 crude? Some sellers are already there,” Reuters, January 18, 2016.)

Oil Prices Reaching Intolerable Levels; Rebound Likely by the End of 2016

If there is a rainbow over the $20.00-per-barrel prospect, it is that prices per barrel are now reaching unsustainable levels for most producers. And not just shale oil extractors in the United States, but also the very same that OPEC—Saudi Arabia, in particular—has targeted as the weakest link in the oil production universe.

Then there is the notion of a Chinese economic slowdown. Despite the admittedly lower growth rate, China’s economy is still moving at a rapid pace and the government is committed to faster growth until at least 2020. (Source: “ETF Securities Outlook 2016: Don’t believe the hype…,” ETF Securities, December 1, 2015.) Moreover, the continuous growth of vehicle registrations in China and in other Asian countries will be necessarily accompanied by the demand for fuel.

This World Goes Well Beyond the Oil Industry

The world economy includes banks, private equity funds, and investors who, for years, have financed the fracking industry through shares and bonds. The costs of extraction are now too high to resist. At less than $30.00 per barrel, says Wells Fargo, which among U.S. banks is the most exposed to the energy sector, even the cheapest shale needs a price of at least $32.50 per barrel. (Source: “Big US banks reveal oil price damage,” Financial Times, January 15, 2016.)

BHP Billiton wrote off $7.2 billion from the value of its American shale assets in the first step suggesting that the oil “chickens are finally coming home to roost.” (Source: “BHP Billiton books $7.2 billion writedown US shale assets,” CNBC, January 14, 2016.) Goldman Sachs, which had been among the first to anticipate a $20.00 oil price, is now ready to predict a rebound by the end of 2016, because prices have fallen enough to lead to “fundamental adjustments to rebalance the market.”

The shale industry will not survive, however. Saudi Arabia’s tactic may have worked. Its low price targets have stunned North American producers, which face much higher marginal costs. The Energy Aspects consultancy expects American oil production to drop sharply in 2016, marking the first year since 2008 in which there will be a reduction in U.S. output.

While Saudi Arabia will be tempted to use low oil prices as a weapon against Iran, it is also facing a major $90.0-billion budget deficit. While it is true that the cost of producing a barrel of oil in the Persian Gulf is low, Saudi Arabia has started to pay for its price war.

A more empowered Iran within OPEC (the Organization of the Petroleum Exporting Countries), however, would find more political support to cut production against Saudi Arabia’s wishes. OPEC would actually prove to the world that it is working. As it is now, OPEC is the sole tool of Saudi Arabia and it has become irrelevant to anyone else.