Oil could plunge about 60% from current levels

Oil futures have staged a magnificent comeback in recent months. However, if history is any guide, the struggling market isn’t out of the woods.

Looking at the performance of West Texas Intermediate crude oil CLN6, -1.24%  since 1870, Paul Jackson, head of research at exchange-traded-fund provider Source, predicted that prices will tank to $20 a barrel, or about 60% from its current levels, and languish for a while, before recovering.

“Those high prices sow the seeds of their own destruction. Supply goes up, demand comes down. So prices come back down and there’s a gravitational pull back to that $20-$60 range…”

“What you find is that in four out of every five months since 1870 the price has been between $20 and $60, when you measure in today’s prices,” he said at the sidelines of the Inside ETFs Europe conference in Amsterdam. “Every three or four decades, oil goes above that range. And occasionally you get a bubble, like we had in the last 10 years.”

“Those high prices sow the seeds of their own destruction. Supply goes up, demand comes down. So prices come back down and there’s a gravitational pull back to that $20-$60 range, but […] when the price comes down, it doesn’t stop at $60, it doesn’t stop at $40, it always goes down to $20,” he added. Jackson has been bearish on the oil market since he joined Source in 2014.

The following chart illustrates those moves:

Paul Jackson, Source

Oil prices were close to touching the $20 handle in January and February, when Iran came back to the international oil markets after sanctions on the country were lifted.

Fears of a sharp slowdown in the Chinese and global economy, along with a lack of response from major oil producers—including the Organization of the Petroleum Exporting Countries— also helped fuel the selloff. Crude oil fell to around $26 a barrel in February, while Brent LCOQ6, -1.71%  while slumped to $27 in January.

Since then, prices have staged a stellar rebound, with both contracts up more than 80%. Analysts have become more upbeat on the oil outlook and argue that production and demand are nearing equilibrium. The International Energy Agency, for example, said in its monthly report out on Tuesday that stronger-than-expected oil demand and unexpected supply disruptions should help erode the supply glut in the second half of the year.

Goldman Sachs—which back in September warned oil could slide to $20 — also has turned more upbeat on the market, saying in May that the surplus in crude had come to a “sudden halt”. Meanwhile at Citi, analysts have further noted that the worst is over for the beaten-down oil market.

Market far from rebalanced

In contrast with those more upbeat outlooks, Jackson says fundamentals aren’t supporting a sustained recovery in the market.

He explained that the marginal cost of production is still so low that oil producers haven’t started to materially cut supply. Compared with the total cost of production, which includes one-off expenses such as exploration and well drilling, the marginal cost only reflects the cost of getting the next barrel out of the ground from a well that is already up and running.

According to the Oil & Gas UK, the U.K.’s offshore oil-and-gas industry association, the marginal costs were expected to fall to $17 a barrel for the country’s producers this year, down from around $21 in 2015.

“So even with oil at $30 a barrel, it’s not below the marginal cost of production in the U.K., and the U.K. isn’t the cheapest place in the world to produce oil,” Jackson said.

“The price has to stay below the marginal cost for some time before [oil producers] will cut production,” he added.

That means even if—or when—oil slumps to $20 a barrel, it’ll need to stay around that level to force producers to dial back supply, rebalance the market and eventually push prices higher, according to Jackson.

While he stands out as ultrabearish on the outlook, he isn’t alone in forecasting a snap back in oil prices. Susanne Alexandor, client portfolio manager at Cougar Global Investments, also said at the same event that investors should bury hopes of oil remaining around the $50 handle.

One reason is the technologically advance in U.S. shale production, which could lower the break-even price for American producers and add more pressure on the global oil markets, she said.

“The world is still oversupplied with oil and that supply and demand imbalance is unlikely to change,” she said.

marketwatch