Calling a bottom in the volatile oil market has been a dangerous game this year. Crude oil prices dropped by more than 50% -- from around $100 to less than $50 -- between Labor Day last year and mid-January. There was a tentative recovery in February and an even stronger bounce-back during the spring, but each time bulls have been disappointed as oil prices have retreated toward the lows reached in January.
Plenty of industry insiders, like oil billionaire T. Boone Pickens, expect prices to recover soon due to factors like rising gasoline demand and falling production in the U.S. But there are also plenty of skeptics. Just last week, highly regarded investment bank Goldman Sachs cut its 2016 WTI oil price forecast from $57/barrel to $45/barrel -- and said that it could briefly go as low as $20 in a worst-case scenario!
How can we reconcile these dramatically different projections? Let's take a look at some of the data to understand why it's so hard to call a bottom for oil prices.
U.S. supply finally starts to correct
Domestic oil producers have surprised most observers this year with their resiliency in the face of rock-bottom oil prices. For most of the first half of the year, U.S. oil production crept up, despite repeated predictions that it was about to peak.
However, in the past month or so, U.S. production has finally retreated in a meaningful way. According to the U.S. Energy Information Administration's Weekly Petroleum Status Report, domestic production declined to 9.14 million barrels per day in the first week of September, down from 9.47 million barrels per day in the last week of July.
It's important to recognize that EIA oil production estimates can bounce around from week to week. Still, the data from the past six weeks appear to show a genuine production decline. Confirming this trajectory, oil services provider Baker Hughes has reported that the U.S. oil rig count has declined for the past two weeks, after rising for six straight weeks.
On the other hand, U.S. oil production was still up more than 6% year over year last week. And it's unclear whether oil production will continue to drop at a steady pace in the next few months or if it will soon stabilize again.
The inventory glut remains
On the flip side, the oil inventory glut is worse than ever. U.S. commercial crude oil inventories rose by 2.6 million barrels to 458.0 million in the first week of September. At the key delivery hub of Cushing, Okla., inventory declined by 0.9 million barrels to 56.4 million barrels.
Both of those figures are down from the highs reached this spring. For example, in late April, total commercial inventories peaked at 490.9 million barrels, including 61.7 million barrels at Cushing.
However, that isn't much of a drawdown, considering that the summer driving season just ended and U.S. refineries have been running flat out for the past few months. Refiners are expected to take a large amount of capacity offline for maintenance and the switch to winter-blend gasoline for parts of the fall. Additionally, we are entering a seasonally weaker period for oil demand that will last roughly until next spring.
During the comparable period in 2014-2015 (from early September to late April), U.S. crude oil inventories swelled by more than 130 million barrels, while inventories at the Cushing delivery hub tripled from 20 million barrels to roughly 62 million barrels.
This time around, inventories are starting from a much higher baseline. Based on the most recent data, total commercial crude oil inventories are up 99.4 million barrels year over year, while stockpiles at Cushing are up 36.0 million barrels year over year. And the International Energy Agency affirmed last week that the gap between supply and demand over the next few quarters will remain substantial, even as cheap oil stimulates consumption and reduces supply.
What does it all mean?
From a long-term perspective, there is growing evidence that low oil prices are crimping production outside the OPEC cartel. That sets the stage for an eventual price recovery, which is good news for oil bulls.
But today, the oil market remains out of balance. With demand likely to drop seasonally in the coming months, it will take until late 2016 or even 2017 to get production and demand properly aligned.
In the meantime, oil inventories will start to swell again, and there isn't nearly as much spare storage capacity available as there was a year ago. As it gets harder (and more expensive) to store oil over the next six months, oil prices may need to fall further to convince traders to take the risk of buying and storing crude.
The combination of a relatively bullish long-term supply demand picture and massive short-term oversupply is likely to drive a lot of volatility in the coming months.
The biggest factor to watch is the trajectory of U.S. oil production -- a steeper-than-expected decline could restore balance to the market fast enough to avoid another price crash, while stable production would exacerbate the current imbalance. While OPEC still seems unlikely to rein in production, a policy change there would have an even bigger impact.
Personally, I think that the seasonal rise in inventories over the next six months will create an overhang leading to even lower lows before the oil market recovers. But the evidence is mixed, and a quicker recovery is certainly a realistic possibility.