Oil is back in a bear market – how much longer will it last?

Oil prices are back down to their lowest levels seen this year.

The price of Brent crude – the international benchmark – is hovering below $45 a barrel. In fact, oil is now in a bear market – the price is more than 20% lower than its most recent high.

This is just a few months after oil cartel Opec teamed up with Russia to cut production.

Its goal was to prop up prices. So much for monopoly power…

Opec is powerless to prevent oil prices from falling

Late last month, oil cartel Opec and Russia extended a deal to cut production by nearly two million barrels a day. The once-dominant oil producers of the world had suffered enough.

They had hoped to drive oil prices low enough to put US shale producers out of business. But in the end, the pain was too great for their own economies, grown over-reliant on high oil prices to fund social spending.

The goal was to put a ‘floor’ under prices. And for a short while, it seemed to work. But now oil is back in a bear market, and it looks in danger of testing this idea of a price floor to its limits.

Part of the problem is that Opec members Nigeria and Libya are both exempt from the supply deal because they’ve suffered serious disruption in their production. However, they’ve both been unexpectedly successful at driving production higher in recent weeks, and that’s taken the edge off the deal.

But the biggest problem is that the US just won’t quit. The Baker Hughes US drilling rig count just keeps going up. It’s now risen for 22 weeks in a row, a streak not seen since 1987.

As Eoin Treacy points out on FullerTreacymoney.com, many US producers have hedged their production at close to the $60 a barrel mark. So they can carry on pumping oil, as “with hedges locked in there is very little risk in producing even in a falling price environment. That is of course, until the hedges run out, which could take another year or more.”

Meanwhile, they raised an awful lot of money from risk-seeking investors last year, notes Lex in the FT. Fracking companies sold $15bn of equity between them, putting them on a more sound financial footing. They’re hardly low risk, but they have a good bit more breathing space before they go bust.

No wonder, the US energy department reckons American oil production will hit an incredible ten million barrels a day in 2018, which would break a record set back in 1970.

In short, it doesn’t look good for Opec. If they want to have more of an impact, they may have to impose bigger cuts. Whether they can afford to do so is another matter.

How much further will oil prices fall?

There are a few interesting things going on here. Firstly, the last time oil hit a bear market, everything else took a tumble too. Markets around the world had a fit of the vapours.

But as Capital Economics points out, markets have (so far, although there are murmurings of trouble in the energy junk bond market again) taken this in their stride. Why?

Firstly, the slide isn’t as bad. Oil might be down 20%, but it hasn’t halved in the last year. Secondly, no one is panicking (rightly or wrongly) about China this time – they can see this is an oversupply story, not a demand collapse story. Thirdly, investors quite like lower oil prices because it takes pressure off inflation and that increases hope that interest rates will stay lower for longer.

Another interesting point is the market mood surrounding oil. There are lots of good reasons to be bearish, no doubt about it. But it currently seems impossible for any news to drive the oil price higher.

Here’s what I mean. In the bull days, Qatar falling out with Saudi Arabia would have been seen as a good excuse to drive oil prices higher, even although it’s really not that relevant.

More to the point, the market shrugged off data from the US Energy Information Administration yesterday that showed stockpiles of oil falling by more than expected. Meanwhile, a tropical storm (this one’s called Cindy) shut down about 17% of production in the Gulf of Mexico. The oil market couldn’t care less.

I’m also seeing a lot of casual predictions that oil will hit $30 a barrel again, or even lower.

When all news is either bad news or irrelevant and people feel comfortable making calls that would once have seemed outlandish, that shows something interesting about sentiment. It suggests that traders and investors are probably getting too bearish.

When they get too bearish, it doesn’t mean that you’ll immediately see a rebound. But it does mean that the market will steadily become more prone to a sudden over-reaction in the opposite direction if anything happens to force investors to re-evaluate their views.

David Rosenberg of Gluskin Sheff is probably right when he says that before we get a lasting rebound, we’ll have to see “the credit taps being turned off for the weaker hands”. The market is already differentiating quite clearly on the equity side between “good” and “bad” shale companies, so we may not have to wait long.

I’ll be keeping an eye on the energy junk bond spread (I may even add it to our “charts to watch” in the subscriber-only MoneyWeek Unlimited email). In the meantime, oil looks as though it’s stuck in another downward trend – but it’s a question of how much more pain all the producers involved can take.