Oil market woes look like deja vu all over again

After a furious spring rally, the oil market has been flirting with bear market territory recently. Some might say it looks eerily similar to last year, when crude shot up in the spring before free-falling. For oil, will it be déjà vu all over again?

The Latest Roller Coaster

Consider just what a wild ride we’ve been on this year. After bottoming out at about $26 per barrel in February, benchmark West Texas Intermediate crude climbed on signs that U.S. oil production was waning and on hopes that the supply glut that has plagued the global oil market since 2014 was finally going to clear up. By early June, WTI had nearly doubled, to about $50 per barrel, and the stocks of major oil companies came along for the ride.

Brexit put the brakes on the rally in late June. British voters’ surprising decision to depart from the European Union sent WTI reeling back into the $40s as markets weighed the sudden risk that Brexit could weaken economic growth on both sides of the English Channel, which would be bad news for oil demand in Europe. Since then, the price has been volatile, but the trend has clearly been down. By early August, WTI had slipped below $40 per barrel.

For those who remember the pattern last year, the similarity now is hard to miss. After a deep winter dive, the spring of 2015 saw WTI rocket to $61 per barrel. But soon, prices were heading south again, and WTI closed out the year at about $36 per barrel. Is the market on the same trajectory again this summer?

Supply Woes

The oil market is a complicated beast. But what’s ailing it now is simple: Too much supply and not enough demand. The oversupply issue is nothing new, but many analysts and traders have been surprised at just how resilient the glut has been. This summer has seen U.S. gasoline consumption surge to its highest level on record, with motorists burning up nearly 10 million barrels of gas each day. And yet stockpiles of gas in storage are considerably higher than they were at this time last year. The amount of crude in storage is near an all-time high. The International Energy Agency reported last month that petroleum stockpiles held collectively by the world’s developed economies stood at a record 3.074 billion barrels. That’s a lot of oil!

U.S. oil output is falling, but only slowly. Energy firms continue to find ways to get more oil out of each well they drill, which means that they need to operate fewer rigs to keep their production up. In Texas’s prolific Permian Basin, for instance, federal estimates project that operators are coaxing about 500 barrels of oil per day out of each new well when it is first drilled, up from 400 barrels per day a year ago.

Scott Sheffield, the outgoing CEO of Pioneer Natural Resources Co., recently claimed that production costs have been cut so much that Pioneer’s Permian operations rival those of giant fields in the Middle East, widely assumed to be the cheapest oil to produce in the world. “Definitely we can compete with anything that Saudi Arabia has,” he was quoted as saying. And now the energy industry is starting to put more rigs back to work, which means even more highly productive wells coming on line soon.

Overseas production is also trending higher. June saw OPEC’s output reach an eight-year high of 33.2 million barrels per day, according to the IEA. Iran is dramatically ramping up exports, now that sanctions on its oil industry have been lifted. Attacks by militants in Nigeria have died down enough to let production rise, and there are signs that war-ravaged Libya could soon restart some of its shut-in output.

A Crash, or a Soft Landing?

So where does that leave prices going forward? The drop from more than $50 per barrel in June to less than $40 in early August was sharp enough to constitute a bear market for crude if you use the conventional definition of a bear market to be a 20% drop. Last summer’s sell-off ultimately turned into a ferocious bear market. Is history repeating itself now?

Our best guess: Another drop in oil prices could be lurking. But the risk of a sustained plunge looks low, unless the wheels suddenly come off the global economy. There’s no denying the hefty inventories of oil and fuel in storage right now. And with the summer travel season drawing to a close, gasoline demand figures to pull back in a few weeks. Plus early fall is when many refineries slow down for scheduled maintenance work, which means less demand for crude oil. Given all of that, we wouldn’t be shocked to see WTI slip a bit more, maybe even to $35 per barrel or so.

Another prolonged slide in oil prices can’t be ruled out, of course. But for the time being, it looks unlikely. The U.S. economy is hardly hitting on all cylinders, and for that matter, neither is most of the world economy. But to really drag down oil again, an outright recession somewhere would probably be required. Meanwhile, global oil demand is still trending higher, albeit slowly. And unlike last summer, when U.S. oil output ticked higher, production is slowly declining. Even with energy firms getting smarter and more efficient about when and where to drill, they’ll probably still pump a bit less oil in coming months.

Gas Prices: Good for Motorists, and Getting Better

Whatever the price of oil does in the near term, we look for prices at the pump to keep trending lower. The national average price of regular unleaded has slipped to a bit more than $2 per gallon, which is the lowest summertime level in years. And given the ample supplies of gas in storage and the impending end of summer, we expect gas prices to keep slipping. By the end of summer, if not sooner, $2 gas looks like a good bet.

Consumers are feeling good about having to shell out less for gas. The National Association of Convenience Stores reported last month that its survey of consumer sentiment showed customers to be the most upbeat on the economy since March. Cheaper fill-ups no doubt help fuel folks’ optimism, and they also free up a bit more cash for purchases of everything other than gas — a helpful tailwind for an economy that could use one right now.