In 2016 the world’s economy feels more largely tied to the price of oil than any recent year. If oil recovers, it will drag up other commodities — and hopefully drag up the market. If that caveat holds true, then any additional drop off in supplies will potentially help prices.

Jefferies has issued its oil market report for February. The good news, for oil prices rather than for the frackers and producers who want higher volumes, is that oil production is expected to fall another 750,000 barrels per day this year. The bad news is that Jefferies also expects the oil market to remain oversupplied by 1.2 million barrels per day through the second quarter, and the drawing down of bloated inventory levels will begin in the fourth quarter.

One key issue here is that Jefferies sees a production freeze as likely with some members of OPEC. That is not a production cut, so the freeze may have minimal impacts.

Jefferies believes that, outside of Saudi Arabia, Iran and Libya are the only countries with significant spare capacity. Iran has grown its crude exports after the sanctions. They have seen that exports have risen by 500,000 barrels per day since sanctions were lifted in mid-January, but some of this volume was sold out of storage.

Total OPEC output is projected to reach 32.6 million barrels per day in the second quarter with the incremental Iranian volumes, about 1.2 million above the Call on OPEC. Jefferies expects that the market will come close to balance in the third quarter with inventories drawing seasonally in the fourth quarter at a rate of a small 100,000 barrels per day or so.

One issue that may help is that non-OPEC declines are kicking in, with non-OPEC supply down by 800,000 barrels per day in 2016. The report said:

Jon Wolff currently estimates that US exit-rate production will be down by 650,000 barrels per day this year with a bias for further reductions due to the sharp recent fall in the oil-directed rig count and company commentary that DUC conversions would be muted at current prices. Capital spending globally by non-NOC companies is down dramatically; our survey of 113 company capital budgets indicates that spending in 2016 will be 22% lower than 2015 and 46% lower than in 2014.

Where things get tricky ahead is in a massive inventory overhang. You may have heard in recent weeks about there not being any sizable storage left for crude oil, and Jefferies believes that this notion is just not going away soon. Its oil outlook said:

The daunting level of inventory is a difficult obstacle for any price recovery. OECD commercial inventories built by 252 mbbls in 2015 and are 372 mbbls above their seasonal 5-year average. US onshore storage utilization is >84%, and tankers afloat in the Gulf of Mexico now hold over 30 million barrels. Interestingly, the level of contango in the forward strip is insufficient to economically incentivize this storage, indicating that logistical issues could be the reason for the offshore storage build.

Jefferies also sees a risk for $20 and $40 oil, with a significant negative margin for even $30 per barrel. The report said:

When posed the question on which we would see first, prices at $20 per barrel or $40 per barrel we would be biased to $40 – but the price in the near term could be range-bound and won’t necessarily reach either value over the next few months. At $30 per barrel prices there is significant current production that generates a negative cash margin (Wood Mackenzie estimates ~5 million barrels per day) and if prices were to fall near $20 we could see voluntary curtailments that eliminate the current 1.4 million barrel per day oversupply.

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