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Why oil prices are headed lower in 2016

Some market commentators think we are close to a low for oil prices after the benchmark Brent Crude oil plunged more than 60% from above US$100 a barrel in September 2014 to US$36.94 a barrel overnight.

Brent oil price history chart

Source: Bloomberg

 

In dollar terms, they are probably right. Oil can’t fall another $63 a barrel so we are closer to the bottom than the top, but it could still fall further from here and appears likely to for a number of reasons…

  1. The Organisation for Petroleum Exporting Countries (OPEC), which includes some of the world’s largest oil exporters such as Saudi Arabia, Iran, Iraq, Nigeria and the United Arab Emirates (UAE), abandoned setting a limit on its production targets, leaving oil to find its own equilibrium price.
    OPEC countries produce around a third of global oil needs, pumping 31 million barrels a day.
  2. The United States has agreed to lift a 40-year ban on oil exports, perhaps stimulating more demand for its own oil production. US oil production has already gone close to doubling since 2008, thanks to new technologies allowing oil to be extracted from shale deep underground.
    The dramatic boost in US oil production, particularly from shale, has in part contributed to falling oil prices, with the world awash with cheap oil supplies.
  3. While lower oil prices will eventually kick out higher cost producers – an estimated two-thirds of US oil drilling rigs are no longer active – newer technologies mean oil production costs are falling.
  4. Growth in demand for oil is expected to fall in 2016, according to the Wall Street Journal, adding further strain to an already oversupplied market. The International Energy Agency forecasts global oil demand growth to fall from 1.8 million barrels a day this year to 1.2 million next year while OPEC is forecasting similar falls.

That’s not good news for Australia’s oil and gas producers, particularly Santos Ltd (ASX: STO) which is already struggling to breakeven at current prices, as well as Origin Energy Ltd  (ASX: ORG), BHP Billiton Limited (ASX: BHP) and Woodside Petroleum Limited (ASX: WPL).

The four oil giants could well be forced to slash production costs even further, raise more capital to shore up their balance sheets and rely even more heavily on gas, particularly liquefied natural gas (LNG), production.

Foolish takeaway

Markets can remain irrational for longer periods than expected. Higher cost oil production may not exit the market as fast as expected, if at all. Add in the factors above and an oil price in the low US$30s a barrel or lower is not that hard to conceive.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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