Iran n-deal may lead to excess oil supplies, plunging prices

The latest nuclear deal between Iran and world powers has been widely presumed as the last nail in the coffin for the global oil prices. But it isn’t as simple as it looks.

First of all, Iran needs to prove that it complies with the agreement terms and then the first movers should be some emerging nations such as India and China which would like to take the advantage of excess oil in the market and then the EU, which may lift its embargo on Iranian oil. All this would take a while.

The sanctions on Iran will be gradually lifted and oil exports could resume possibly by mid-2016. Iran currently exports around 1.1 million bpd of oil and if sanctions are lifted, this number could increase by another 1 million bpd by the end of 2016. A key risk, however, is the amount of crude oil in floating storage (around 40 million barrels) which could come back quickly once sanctions are lifted and weigh on prices.

One thing is for sure: if sanctions are lifted then the Iranians would chase their lost market share and would like to quickly return to 4 mbpd output within 12-18 months of sanctions being lifted.

This would enhance the complexity of OPEC on how to balance production and price, as Iran has already announced war against competition that it will not care for price and is willing to regain its share of market at the cost of price.

The OPEC continues to maintain its oil output at 31.3 mbpd (versus a target of 30 mbpd), a three-year high, and Saudi Arabia’s output notched a record 10.6 mbpd in June. Iraq also continues to maintain record output with production estimated to have touched 4.1 million bpd in June. The return of Iran will also force the OPEC to re-think their strategy about keeping output at current levels.

Already, the OPEC is supplying more than the call-on-OPEC and extra Iranian barrels could seriously push down oil prices if supply continues unabated from the likes of Saudi Arabia and Iraq.

On the other side, US shale oil industry is tightening its belt and improving efficiency to fight sustainable lower prices in crude. Baker Hughes data show that US rig count has been falling for the last six months without any major output loss as producers improve productivity of existing wells and idle less productive ones.

An average rig in the Bakken region produced 440 bpd in June 2014 which has now increased to 630 bpd. Similarly, in the Eagle ford region, drilling productivity is up from 563 bpd in June 2014 to 720 bpd by June 2015.

Demand, although improving, (a growth of +1.5 per cent QoQ and +3.8 per cent YoY), has failed to absorb rising supplies. Among the bright spots, US (50 States) saw an average 2.7 per cent demand growth in Q2 driven by a jump in gasoline demand.

Gasoline consumption is hovering near a seven-year high of 9.5 mbpd helped by prices at five year lows.

Consequently, US refineries are processing a near record 16.8 million bpd of crude. In Asia, Chinese net oil imports in Q2 averaged 6.7 mbpd, 6.3 per cent higher YoY as processing by Chinese refineries on average was 6 per cent higher. Indian oil imports in May were 17.5 per cent YoY higher at 4.29 mbpd and consumption is likely to stay elevated as lower oil prices boost demand.

One notable fact is that, India has nearly doubled its imports over the past decade and is now the third biggest importer of crude in the world.

Broadly, the oversupply in the market by the end of Q2 was 1.89 mbpd and it could exceed to 2.2 mbpd in Q3 at the current pace. In addition to this, a relatively peaceful West Asia and lack of any geo-political triggers and rising interest rates in US which makes storing crude expensive and finally a stronger dollar will provide strong headwinds.

On the inventories front, total crude oil stocks excluding SPR [strategic petroleum reserve] in the US are near 467 million barrels, still near the highest in 80 years. Along with US stocks, total European commercial inventories increased in Q2 by 3.7 per cent to 494.7 million barrels. While, crude oil stocks remain higher, better refinery profits have led to increased product stocks both in the US and Europe.

In Europe, gasoline stocks in June were 115.52 million barrels (+8.6 per cent y/y) and distillate stocks are at 393.15 million (+2.3 per cent y/y).

In effect, the crude oil glut is also leading to a product glut. In June, Product stocks at the Amsterdam-Rotterdam-Antwerp (ARA) trading hub were also at a record high, touching 45.38 million barrels (+35.8 per cent y/y).This overhang of product inventory both in US and Europe will eventually lead to a drag in oil prices and keep them under pressure in Q3.

Crude oil prices have resumed their downtrend after a long consolidation over the past two months as supply side fundamentals take centre stage again.

Despite a persistent supply glut in Q2’15, oil prices staged a spectacular rebound largely on an expected slowdown in US oil output and improvement in demand.

Looking ahead, the biggest factor that could lend a floor to oil prices is a sizeable slowdown in supply either from the US or OPEC, both look very unlikely. Purely looking at the fundamentals it is evident that the oil prices are still far from a bottom. From price perspective, unless the geo-political or other factors lead to considerable reduction of the current supply glut, Nymex WTI oil prices are unlikely to reverse their broader downtrend and eventually slide towards $35/barrel if our key downside risk scenarios play out.

Even in a slightly bullish scenario, upside is likely to be capped around $60-65.

The writer is Associate Director Head - Commodity & Currency, Motilal Oswal Commodities. Views are personal.