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Last week the National Bureau of Economic Research proclaimed the current US recession could be the worst since World War II, and there seems to be a growing consensus that world oil demand could actually contract next year. This outlook certainly raises the odds for crude oil prices to fall below $40 per barrel before there is enough of an adjustment in the supply/demand condition to stabilize the market. There has been no shortage of economic news showing global conditions worsening, despite international government efforts to revive growth.Therefore, with the prospect for further demand destruction likely to take place in the months ahead, we suspect it could take an even lower drop in crude oil prices before structural changes in the oil industry are able to remove enough oil from the marketplace to balance the fundamentals. In fact, with last week’s EIA inventory report showing total product demand down 6.2% and oil stocks more than 20 million barrels higher than last year, we suspect the market will remain undermined by persistent concerns over oil demand with supply issues continuing to have little impact. OPEC is threatening to cut production for a third time this year at their December 17th meeting, but with one measure of compliance at less than 70%, the cartel’s ability to influence prices has so far been ineffective. There is no doubt that crude oil at current prices are approaching cost of production levels for a variety of oil sources. However, since $32 seems to be the low profitability end for a range of oil production sources, we contend that the severity and long duration of the global recession may require another $10 to $15 drop crude oil prices for an extended period of time before supplies tighten enough to provide enough of a support mechanism for prices. Although crude oil has seen prices drop by about $100 since July, the November 25th Commitments of Traders report is still showing the combined non-commercial and non-reportable net long position at over 88,000 contracts, suggesting there is still ample selling capacity left in this market.
Gasoline is another market that may need to see even lower retail prices before the dynamics begin to favor the bull camp again. With US consumers being faced with mounting job losses into the New Year, it is certainly not the environment to expect a strong revival in demand just because retail gasoline prices appear relatively “cheap”. The latest EIA data showed US gasoline production just beginning to fall below the 5 year average. But it might take persistent negative refining margins, a lower operating rate and possibly even some temporary refinery closures before gasoline supply concerns begin to outweigh demand worries.
Therefore, with economic conditions set to worsen, there is the potential for January gasoline to slip under $1.00 per barrel and possibly test prices as low as $0.78 per gallon, a price level not seen since late 2003. At some point low oil prices and the retrenchment in supplies will set the oil market up for a potentially explosive rally once economic conditions stabilize and demand is revived, but that scenario may still take some time to unfold.
