The current oil price rally is primarily driven by traders who, having been convinced that oil was heading to the low $20s per barrel (/b) in late January, are now more focused on the possibility that the excess supply of oil will shrink faster than previously thought. But is that a safe assumption, or is the recent rally simply the result of trader’s games and unreasonable optimism which will soon reverse?
For now, the momentum is strongly positive and investors will be reluctant to ignore one of the truisms in global markets, ie. “the trend is your friend”. But one needs to be also aware that there has been very little physical change in the oil market to justify the recent move and the Russia-Opec discussions look illusionary if not cynical. The reality is that, without some real changes to supply or credible agreements that can ensure an actual supply cut, the price of Brent and the ruble exchange rate are more likely to fall as Brent approaches the next technical resistance level in the low $40s/b.
But given the willingness of traders to build speculative positions and the fact that more US shale production was about to come off-line when oil last dipped below $30/b, it is now reasonable to assume that a return to the low point of late January is unlikely, albeit not impossible. Equally, without some physical changes, a push much further into the $40s, or below $70 for the ruble, is not justified and would be temporary.
The price of Brent crude started 2016 with a price just below $37.5/b. It quickly fell to a low of $28.5/b in late January and since then has sustained a steady recovery to close above $40 on March 7. So what are the reasons for that 180-degree turn in sentiment and how real are they?
Proposed Opec-Russia deal raises optimism: Officials from Russia and several Opec states have said that they support a production freeze that would not see extra oil coming into the market from either side. In theory that should be price supportive, as a freeze would allow the excess supply to shrink as demand grows. The other way to look at that proposal (ie. reality) is that it also ensures that there will be no supply cut from Russia and those Opec countries participating in this discussion. The initiative would certainly suit the Russian side because the industry is now pumping at maximum, especially as the government is considering a windfall tax in the sector as it looks for extra budget revenues. That expected tax would reduce oil company’s free cash flow and hit capex spending. It would mean no possibility of any additional oil volumes over the medium term.
The second problem with this proposal is that Saudi Arabia has said it will only participate if “all other producers join in”. The US producers clearly could not participate due to competition and price manipulation laws, while Iran has simply refused to contemplate the idea. Iran’s stance is that it was forced to cut 1mn barrels per day (b/d) from production due to sanctions and now needs the money. It is impossible to assume that Riyadh will participate in any action which would primarily help the US shale industry, Iran and Moscow.
There has been a big cut in active rigs: The number of active rigs operating in the US has been reduced to 514 as at early March this year. That is 800 fewer than at the same date in 2015 and, on the face of it, a big reason for price optimism. But the context is that many of those idled rigs were operating in speculative areas and used to develop new producing wells, ie. not in the main producing fields. It is also important to bear in mind that there has been a big advance in technology in the US shale sector so that far fewer rigs are actually required to sustain production today than used be the case.
US shale output is declining: The most recent data from the International Energy Agency (IEA) shows that US oil production averaged 12.61mn b/d in January. That is down from 12.78mn b/d in December and an average of 12.93mn b/d through the last quarter. The IEA expects US output to decline steadily to an average of 12.3mn b/d in the third quarter this year. But that assumption is made on the basis of low oil prices persisting all year. If the oil price stays at, or above, $40/b, then much of that expected production suspension will not happen.
Demand has improved: The IEA expects global demand to expand by 1.2mn b/d on year and to rise by another 1.0mn b/d in 2017. China demand is still growing despite the slower pace of headline economic growth because the bulk of what China uses is gasoline. Gasoline is more sensitive to a cheaper pump price and, as has been seen in other economies, is less sensitive to overall economic activity. Besides, a 6.0-6.5% growth in an economy the size of China is still very material for the oil market. The lower oil price is also likely to stimulate greater demand for gasoline and the IEA is more likely to have to raise its demand outlook through the summer.
Trader optimism is a factor: Oil traders have reacted to the news of the rig count, the Russia-Opec talks and the decline in US output with considerable enthusiasm. Traders recall the situation in the first quarter of 2009 when oil reached a low point of near $40/b against widespread predictions of weakness to come. Instead, the price rallied to over $100/b within 18 months. They don’t want to get caught out again and have increased net long bets to 342,460 contracts (up 22,171 in the last week of February) according to ICE data.
But, there are also some very relevant factors which have not yet changed:
Excess supply remains: Even with the improved demand outlook and the expected reduction in US shale production (IEA forecasts), the global market will still have excess supply through 2016 and for much of 2017. We can see that in the table below that shows the amount of Opec crude required to keep the market in equilibrium. In 2016 the equilibrium requirement for Opec crude is expected to be 31.3mn b/d. That takes into account the cut in US output, a modest decline in Russia and a 1.2mn b/d increase in demand.
The problem is that Opec countries produced 32.65mn b/d in January according to IEA data, ie. an excess of 1.3mn b/d over that required to balance the global market. Saudi Arabia is very clear in the fact that it has no intention of unilaterally reducing supply to help either the US shale producers or to help its enemy Iran. The proposed agreement with Russia is to freeze that excess supply and not to reduce it. That is the critical point.
There is little spare storage: Oil in storage is near record levels in Cushing (Oklahoma), in Rotterdam and across other major oil trading hubs. The reality is that there is not much more room left in the world’s major storage hubs to take more oil.
The oil price recovery slows supply cuts: The strong recovery in the oil price means that some high cost producers, in the US shale industry in particular, which have had to suspend operations will be able to return quickly as the oil price rises and their operations again become net cash-flow positive. That means the IEA’s expectation of a big reduction in average US output this year may fall well short of target. It also means that the excess oil glut will be higher and downward pressure on the oil price will return.
Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer