Are further falls in oil prices on the cards?

What happens to oil prices doesn't just affect commodity investors – it can also have big implications for corporations, governments and consumers worldwide. So it's no wonder everyone is watching with baited breath to see what will transpire in the months ahead.

There has been a huge drop in prices since last summer. In June 2014 the cost of Brent crude was $155 a barrel, and by January 2015 it had fallen to just $45. Now, following a brief upturn, it costs around $57 a barrel.

Of course, lower oil prices have their benefits. For example, they translate to reduced fuel costs for motorists, as well as lower energy bills for households, companies and importing nations. But there are also those who are desperate to see prices increase again – namely big oil-producing countries whose economies rely heavily on oil revenues.

So what does the future hold for oil prices? Has the rebalancing that has been going on since last summer come to an end, or are further declines on the cards?

What has caused the drop in oil prices?

There are a number of factors that have caused oil prices to halve in the last year, but predominately it is down to supply and demand economics.

Demand for oil has been falling thanks to weak economic activity, with many nations still recovering from the global downturn. There is also an ongoing shift away from fossil fuels towards cleaner alternatives in many parts of the world.

On the supply side, the fracking boom in the US has led to a huge surge in oil production, and there has also been a big increase in output in Russia and Brazil. At the same time, OPEC nations have continued to produce the same amount of oil, despite the drop in prices.

So while demand has fallen, supply has risen, and this has created an oversupply in the world oil market. In its latest Oil Market Report, the International Energy Agency (IEA) notes that global oil supply reached 96.6 million barrels per day last year.

The continued strength of the US dollar over the last 12 months or so has also played a part in pulling down oil prices, because when the greenback is strong the value of commodities – which are usually quoted in dollars – tend to fall. It can be no coincidence that the dollar's rise has coincided with the oil price decline.

Will they fall further?

The IEA thinks they will. In its Oil Market Report it says there are "huge headwinds" facing the global oil industry and insists price declines are likely to continue "well into 2016" because the oil market was "massively oversupplied" in the second quarter of this year, and remains so now.

"It is equally clear that the market's ability to absorb that oversupply is unlikely to last," the report states. "Onshore storage space is limited. So is the tanker fleet. New refineries do not get built every day. Something has to give."

Of course, this report was published before a landmark deal was reached with Iran to limit the country's nuclear activity. In return, economic sanctions will be lifted, and this could enable Iran to boost its oil exports even further.

According to Reuters, US investment firm Goldman Sachs thinks Iranian output could be increased by between 200,000 and 400,000 barrels per day next year, in addition to the release of 20 to 40 million barrels from floating storage.

If this holds true, it will present a real downside risk to oil prices in the months ahead. Amrita Sen, chief oil analyst at Energy Aspects, told the news agency: "Given how oversupplied the market is with Saudi output at record highs, the mere prospect of new oil will be bearish for sentiment."

Could we see a recovery?

There are, of course, some who remain optimistic about oil prices, and the Daily Telegraph's commodities editor Andrew Critchlow has listed several of the reasons why.

Firstly, shale oil production in the US is apparently slowing, with the number of drilling rigs falling. Secondly, lower oil prices are actually helping to lift demand once again, particularly in North America, where motorists are getting back into their cars.

There is also a rise in demand coming from China – which is the world's largest oil importer – and a decline in production from Libya thanks to warring factions and the expansion of Islamic State in the country, both of which could assist in pushing prices back upwards.

Global energy strategist Dr Kent Moors is one of the optimists. He thinks demand for oil is set to rise, and that this will support prices going forwards.

He told Money Morning: "Much of the demand surge is driven by pent-up needs from developing industrialisation and economic diversification. Some is the result of changing energy trading patterns and a fair amount is from the simple dynamic that markets use more energy as the price declines."

And although there are concerns over the impact of the Iran deal on oil prices, Richard Nephew, programme director for economic statecraft, sanctions and energy markets at the US Center on Energy Policy, thinks it won't necessarily trigger a downturn.

"New oil will not flow from Iran until 2016 and there will probably be less of it than optimists predict," he told Reuters. "I estimate 300,000 to 500,000 new barrels of oil on the market within six to 12 months after a deal begins to be implemented."

Even so, it seems that the majority of economists, analysts and market commentators are expecting to see further price declines in the near future, so it is definitely a market to watch.

 

Photo credit: iStock

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