Oil Price Bounce

How feasible is a sharp bounce in the year 2016?

Nobody is willing to believe that oil can bounce by 40% in the year 2016. But then, nobody expected gold to give a return of 18% in two months since mid-December 2015. A recent report by UBS points out that while oil will continue to be under pressure, there is a likelihood of crude oil rallying by as much as 40-50% during the current year alone. That means oil touching a price of nearly $50/bbl from the current Brent crude oil levels of $34/bbl.

Credit crunch in shale…

 The shale boom in the last 6 years has been largely funded through junk bonds. These high-yield bonds made a lot of sense as long as US rates remained low and oil prices remained high. Post 2014, both these scenarios have changed. Crude oil prices crashed from $115/bbl to $30/bbl on the back of excess supply and stockpiling. Then, after holding rates for nearly 7 years, the US Fed decided to hike rates by 25 basis points and has guided another 100 basis points increase in 2016. Fall in oil prices and rise in yields is bad news for shale companies who have borrowed through junk bonds. The pressure has just begun to show and experts are already estimating that the oil crunch could be as bad as the sub-prime.

Expect forced supply shocks…

The recent agreement between the OPEC and Russia may just be the beginning of a larger attempt to control the price of oil. The current fear is that US shale may fill the supply gap if prices move up. That may not happen if shale companies get into a credit crunch. That leaves the room open for supply shocks and that could rapidly propel the prices upwards. Supply shocks could come either from Russia or from the OPEC and that could really drive prices higher.

Then why only 40% rise…

The logical question then is why only a 40-50% rises in oil prices. If there is a disruption in supply or a credit crunch in shale, then can oil not go back to the $100/bbl level? That looks unlikely for two simple reasons. Firstly, global economic growth has to be really rapid to support a quick rise in oil prices. In 2003 and 2010 rising oil prices were supported by frenetic economic growth worldwide. With the world economy likely to be flat this year, a sharp rise in oil prices would be unlikely. Secondly, the incremental demand must come from China and that is a big question mark. With its economic troubles it is unlikely that China can drive a very sharp revival in oil demand.

Historically, oil rises rapidly when there is a combination of supply disruption and a spurt in demand. It is the demand side that is absent this time. Despite that, one can look forward to a 40-50% upside in oil prices this year. That will be a new economic challenge! ©

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