4 Reasons Oil Could Drop Further

 

Right around the time analysts gave up trying to predict the bottom for oil prices, the all-important commodity mounted a strong comeback.

In fact, oil's recent reversal is leading to predictions that the commodity has finally bottomed and is poised for a "V-shaped recovery," which means it could rise so fast that its price chart forms the letter V.

What's more, many asset managers have started to say it's safe to go back into oil stocks and, in some cases, are forecasting such stocks will be 2015's best investments.

Those are bold claims, and they could be right. But I doubt it.

Simply put, the fundamentals behind the bear market in oil haven't changed much: there are still too many factors that could weigh on oil prices in coming months. Indeed, there are at least four reasons why it's probably far too soon to call a bottom in oil and why prices could still set new lows before heading consistently higher.

1. Production Far Outpaces Demand

Plunging oil is prompting many U.S. energy firms to cut output. Oilfield services firm Baker Hughes, Inc. (NYSE: BHI) notes that during the last week of January, the number of oil rigs in service fell by 128 to 1,937. There are now 25% fewer domestic oil rigs in service than were active just four months ago. Rig counts are considered good indicators of future oil production, and the sharp drop is a hint supplies could soon diminish.

However, rig counts haven't fallen nearly enough to reverse overproduction issues, say Citigroup analysts, who estimate a current global oversupply of 1-to-1.5 million barrels per day. In fact, U.S. production is still on an upswing and hit an all-time high of 9.3 million barrels per day the week of January 23, according to CNNMoney. It's projected to peak next year at nearly 10 million barrels daily.

Saudi Arabia, Kuwait and other key members of OPEC keep ramping up production as well: OPEC output increased by an average of 160,000 barrels per day in January. OPEC is loath to cut production in order to retain market share.

2. Stockpiles Are Surging

The cutback in U.S. drilling activity has yet to make a dent in supplies. The Energy Information Administration (EIA) said in late January that U.S. oil inventories rose 10.1 million barrels, the largest one-week gain in 14 years. At just more than 413 million barrels, U.S. stockpiles are now at around 80-year highs, according to the Wall Street Journal.

It's unclear if the strike by crude oil refinery workers represented by the United Steelworkers union is worsening stockpile overgrowth, but it could be. A good portion of the nation's gasoline (an estimated 10%) comes from the refineries affected by the strike. So extended interruption of their operations may mean substantially more crude than usual will remain in inventory.

3. The Imports Keep Coming

U.S. crude oil imports have actually been slipping, most recently by about 204,000 barrels per day in the week ended January 23. However, imports are still quite robust overall, now averaging roughly 7.4 million barrels a day -- not far off 2013's daily average of 7.7 million barrels.

And they're not even down across the board. Volume from Canada, by far the largest crude importer to the United States, has lately been above three million barrels per day, versus 2.6 million barrels daily in 2013.

4. Demand Could Be Falling

Although oil's problems are widely blamed on oversupply, there are also ample signs that global demand may be waning. Many point to the slowing economy of China, which overtook the United States as the world's largest energy consumer years ago.

While initially most pronounced in the vast manufacturing and real estate sectors, China's growth issues have also spread to its services sector, which had been a bright spot, but recently saw its rate of expansion fall to a one-year low. Also, China carries a massive debt load that's nearing 300% of GDP.

There have been some worrisome developments in the United States, too, including large drops in durable goods orders during the past six months. Further anecdotal reports point to slowing corporate earnings growth, declines in measures of manufacturing activity and weaker-than-expected consumer spending.

Globally, Europe and Japan are facing the specter of deflation and recession. Russia is already in recession, and the outlook for that country remains bleak in the face of the ruble crisis and continued Western sanctions over the Ukraine situation. Global economic forecasts call for moderate growth at best this year, with the projected expansion rate of 3.2%, falling well short of the 4.8% growth the IMF originally targeted for 2015 a few years ago.

Risks To Consider: Along with the other factors I've described, the strong U.S. dollar is placing heavy downward pressure on oil prices, since the commodity is priced in dollars. What's more, Societe Generale analyst Albert Edwards warns that overall deflationary pressures are much worse in the United States than most investors realize. The strong dollar is contributing to this.

Action To Take -- Sit tight and wait for the oil rout to finish playing out before buying oil-related stocks or exchange-traded funds. Even though oil has rebounded, Citigroup analysts see plenty of potential for the price to reverse course and fall far further, perhaps to as low as $30 a barrel. If you're a risk taker, you might consider shorting an oil ETF such as the United States Oil ETF (NYSE: USO) or an energy sector ETF such as the Energy Select Sector SPDR (NYSE: XLE).

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