Navigating the Oil Market in 2016

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The oil price collapse was one of the biggest stories of 2015. It caused ripples and shocks throughout the global financial system, as energy exporting nations, shareholders and oil and gas companies all felt the brunt of the deepening bear market. If the first trading week of the year is any indication, 2016 may be a very long year for the global financial markets in general and oil in particular.

China Growth Woes

The year 2016 started off with a bang, with Chinese equities posting their biggest selloff since the August financial crisis. China’s Shanghai Composite Index plunged a staggering 6.9% in the first trading session of 2016; the CSI 300 Index of the largest 300 companies listed in Shanghai and Shenzhen also dived 7%. The rout quickly spread west to Europe, where the pan-European STOXX 600 Index fell 2.5%. Meanwhile, Wall Street’s Dow Jones Industrial Average plunged 276 points on the first Monday after New Year’s Day, marking its worst start to the year since 2008. When the dust settled, the Dow had fallen a staggering 1,079 points in its first week of 2016, marking the worst ever start to the year for the blue-chip index.

The news that sparked the massive global equities rout was the Caixin China manufacturing PMI, a monthly report surveying the current state of the Chinese manufacturing sector. The report showed that China’s manufacturing output contracted for a tenth consecutive month in December, raising fresh warning signs about the world’s second-largest economy.

For oil traders, a deeper economic slowdown in China likely means lower prices for crude and natural gas. China, which is the world’s largest energy consumer, has been mired in a protracted economic slowdown for more than two years, as Beijing implements painful economic reforms intended to make the economy more consumption-oriented rather than export-driven. Weaker oil demand from China has been a principal factor behind the 18-month oil price collapse. Chinese growth is expected to weaken for the next three years, making any rally in oil prices limited at best.

Geopolitical Tensions

Despite the apparent global supply glut keeping oil prices down, intermittent spikes may be possible and likely in 2016. The year 2016 began with Saudi Arabia – the OPEC kingpin and world’s second-largest oil producer – cutting off diplomatic and economic ties with Iran after Tehran harshly criticized the Saudi regime for executing a prominent Shi’a cleric. Saudi Arabia’s Gulf allies Bahrain, United Arab Emirates and Kuwait quickly followed suit by severing their ties with Tehran.

Escalating geopolitical tensions in the Persian Gulf are a harbinger of higher prices because they raise concerns about a production disruption in the region. Investors may expect relations to deteriorate further in the short-term. However, barring any military conflict in the region, political tensions are unlikely to counteract the global supply-demand imbalance. This is may be true given that hedge funds, money managers and other institutional investors are betting on weak oil prices.

Oil Companies

Oil and gas companies have been hit hard by the ongoing waves of oil price volatility. Producers in North America and Europe have slashed investment plans and cut staff as a result of the devastating price collapse. This has raised fears about “waves of failure” in the UK oil and gas sector, which is generating significantly lower tax revenues. According to a November statement by the UK Office for Budget Responsibility, tax revenues from the oil and gas sector slumped to just £130 million in 2015 from £2.2 billion in 2014. The slump is even more devastating compared with just four years ago, where the oil sector provided tax revenues of £11 billion.

The oil price collapse resulted in a devastating year for oil companies. The S&P 500’s energy component declined nearly 24% in 2015, leading all other sectors lower. Companies may continue to scramble in 2016, as oil prices hover near six-year lows. This is likely to result in even more job cuts and reduced spending amid declining earnings and revenue.

Higher Iranian Exports

The Organization of the Petroleum Exporting Countries (OPEC) not only maintained its production target above 30 million barrels in its November meeting in Vienna, Austria, it also raised its daily output ceiling to 31.5 million barrels per day, according to reports. This could be partly due to expectations for higher Iranian exports in early 2016 once US-backed sanctions on Tehran are lifted. Iran is expected to increase its production levels by at least 500,000 barrels in early-2016. According to sources, Iran may be planning to increase production by up to 1 million barrels per day once sanctions are lifted.

Supply/Demand Imbalance to Persist

Investors looking to trade oil in 2016 should bear in mind the underlying market dynamics. With supply well in excess of demand, oil prices are expected to remain very low throughout the year. In November US investment bank Goldman Sachs reiterated its previous forecast that light sweet crude could fall to $20 a barrel under the most extreme conditions. Even Saudi Arabia, which posted its worst budget deficit in history in 2015, has priced in oil at around $29 a barrel in its 2016 budget.

Peak OPEC production, an ongoing US shale boom and declining demand in China may continue to define the oil markets in 2016. Investors should prepare for a prolonged period of possible low prices. According to some analysts, $50 may be the new $100 for oil prices, signifying a huge shift in the market equilibrium.

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