Oil slides on demand-supply imbalance

The accord with Iran could open the flood gates in the coming months

Iran is currently producing less than 3 million barrels a day, but has been mentioning a medium term target of production resumption to the vicinity of 5 million barrels. If drawing a parallel with the resumption of production monitored in Iraq lately, we think that such an aim may be manageable.
In turn, we expect some un-easiness from Saudi Arabia on geopolitical grounds (in the Sunni versus Shiite face up) that could foster even more production to be put in the market.

US production and stocking does not seem to reach a halt
Meanwhile, US production may have found a new lease for life with shale oil producers having cut costs quickly and drastically. US oil rig counts even ticked up – very modestly – in July.

The latest slide in prices has also mostly affected spot prices, and rebuilt some contango in the WTI curve, so that incentives are back on the table for further reserves to be accumulated and production not to be clamped down further.

Refining arbitrage cannot correct the supply glut
As hinted by crude oil reserves not dwindling promptly, US refining is having a hard time absorbing the extreme stock levels. Beyond US borders the price-differential opportunity between Brent and WTI has even triggered a vast arbitrage dynamics (with refined products being exported to more expensive Brent-supplied regions) which keeps the latter (Brent versus WTI) spread range-bound. At the moment, the increase in supply could actually put both regions on the same footing with both the US and OPEC countries capable of flooding the market.

Global demand is still to pick up
The new leg of oil slide ignited two weeks ago was fostered by acute concerns about global growth in the wake of the Chinese bond rout and Greek brinkmanship. These heightened worries underline the current unbalance where demand for energy remains hesitant in a context of very weak global economic improvements.

DEMAND-SUPPLY BALANCE HAS US NEUTRAL ON THE BARREL
We remain positive on the recovery potential of global demand in the months to come (spearheaded by a potential upturn in developed markets), but we think that further supply glut could swallow a would-be uptick in prices.
The main risk to keep in mind – would supply vastly overtake demand, and the oil slump rekindle – would be that deflation scares could knock at the door once again.
We also highlight two key threats with current oil prices. First, these levels are far below the breakeven prices that would allow most producing countries to balance their government budgets, and hence risk triggering instabilities in key EM markets. Second, US high-yield credit is vastly exposed to a hefty presence of oil producers (they would account for 15-20% of issued papers).
Forced restructuring or outright default on loans contracted for capital investment purposes during the shale gas run by these companies would hurt the asset class

Lyxor Cross Asset Research