Energy Monitor – Oil price rally continues…again

by: Hans van Cleef

  • Oil prices have continued to trade higher
  • The view of market speculators seem to diverge from the views of most oil analysts
  • EIA: ‘oil production US will continue to rise’. But this extra supply is also needed to meet growth in demand

 

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Oil price have rallied to USD 70/bbl after another drop in crude US inventories

The first reason why oil prices rallied is the fact that US crude inventories have dropped for eight weeks in a row. This is the longest and strongest decline in inventories since 1999. The US crude oil inventories approach the five-year average (see graph). As a result of this, WTI prices have risen to USD63/bbl and Brent oil prices have traded even above USD 69/bbl. These levels are only slightly lower than the average prices for the past five years. Since the US inventory data are the only indicators that are available on a weekly basis, the outcome is often conclusive for the oil price direction on that specific day. Nevertheless, these numbers only reflect a small portion of the global market, and are often very volatile. Therefore, for the bigger picture, we prefer to look at monthly and quarterly data by the International Energy Agency (IEA), the Energy Information Administration (EIA) and the OPEC.

Market speculation hints on further price gains

Market speculation is seen as the second important driver for the recent oil price rally. The outstanding number of contracts speculating on further price gains (long positions) has never been this high. The outstanding number of contracts speculating on price declines (short positions) dropped to the lowest level in more than three years (see graph below). It is remarkable to see that most market analysts believe that prices have rallied too far since consensus forecasts is significantly lower than the current spot prices. On the other hand, most investors are still positioned to benefit from further price gains.

It is not that strange that the number of long contracts reached these excessive levels. Besides the fact that US crude oil inventories have already declined for eight weeks, there is also a better balance between global demand and global supply after the extension of the OPEC/non-OPEC coalition production cut agreement in November. As a result of this agreement, 1.8 million barrels per day (mb/d) are kept off the market for the remainder of this year. That is, if all participants stick to this agreement, even if prices continue to rise.

Return of geopolitics

A third argument is the return of geopolitical risks as a driver for oil prices. In recent years, geopolitical tensions did not, or hardly, affect oil prices. This seems to change now. There is an increased risk that an escalation of geopolitical tensions leads to lower oil production and/or oil exports. The main focus is aimed at the unrest in Iran and the tensions in Saudi Arabia. In Iran, tensions build as the local people hardly benefit from the economic improvements as a result of the nuclear deal with the west. Instead of better living conditions, the Iranian population is confronted with lower subsidies and more taxes on e.g. food and fuel.

In Saudi Arabia, tensions build as a result of political developments within the ruling family. This does not only lead to tensions in the ruling family of Crown Prince Mohammed bin Salman after the arrest of some of the family members, but also tensions on the international playfield continue to rise. The Crown Prince has become more harsh towards countries like Qatar, Yemen and Lebanon. Especially his approach towards Iran has become more aggressive.

The developments in geopolitical issues in both Iran and Saudi Arabia will be closely monitored as an escalation in these countries can have a major impact on the global oil supply, and thus the oil prices. Nevertheless, such an escalation – in which also oil production would be hit – seems unlikely because of strong mutual economic interests.

New EIA outlook is seen as optimistic, but appearances are deceiving

Recently, the EIA released its Short-Term Energy Outlook. The oil market has taken this report as bullish for the US oil production. Due to higher oil prices, US crude production is expected to rise in the coming years. The average US crude production was 9.3 million barrels per day (mb/d) in 2017. For this year, a rise to an average of 10.3 mb/d is expected. According to the EIA, the increase in production will continue in 2019 to an average level of 10.8 mb/d.

The expected growth of demand will be approximately 1.7 mb/d for both 2018 and 2019 and will be partly compensated by the rise in US crude production. The remaining part (0.7 mb/d in 2018 and 1.2 mb/d in 2019) must be met by the OPEC/non-OPEC coalition. This offers an opportunity to build an exit strategy for the production cut agreement in the coming years.

Some investors fear that the US crude production will show continuous exponential growth, and thus cap the upside in oil prices. Partly this assumption is correct. Due to the increase in US crude production, the risk of global shortage will be lower which in turn limits the upside in oil prices. However, global investments in the oil sector outside the US and outside OPEC are still low and the risks for future oil shortages have increased. As a result, we think that the EIA outlook is not as negative for oil prices as the headlines may suggest.

President Trump intends to open up more offshore oil production

President Trump recently indicated that he supports and will allow more oil production in the waters around the US, except for Florida. Although these plans seem to be negative for oil prices, it is still uncertain whether the US offshore oil production will be increased at all. The process of licenses, building infrastructure and solving financing issues take often many years. Therefore, in the near term, the effects will be limited as US offshore oil production will not increase based on this decision. When oil prices continue to rally, the average US oil producer would prefer to invest in shale oil projects rather than the more expensive and lengthy offshore projects.

Oil price forecast unchanged; near-term downside risks increased

Oil prices have rallied to USD 70/bbl for Brent and USD 64/bbl for WTI. In our view, recent developments justify these higher oil prices. Nevertheless, the rally may have gone too far too fast, and with current long positions being excessive, a temporary downward correction seems possible. Especially since also some OPEC related Oil Ministers have started to hint that oil prices have gained too fast. Although, the precise timing and length of such a correction is hard to predict. For the longer term, we maintain our forecast as set in November. We see further upside potential for Brent and WTI, especially in the second half of the year.