Stronger than expected demand and supply rebalancing prevent oil from further decline. The recent rally seems to be driven by non-fundamental aspects.
The rally in risky assets in recent weeks has been quite surprising for a number of reasons. One of them is the oil price. Some suggested that a freeze in production, a more accommodative policy from the Federal Reserve which helped to put the brakes on the US dollar, as well as some geopolitical developments in the Middle East, have weighed on oil prices.
Oil prices lost more than 30% in 2015 and in January 2016 it added a further 28% loss in less than one month, reaching the price of $26 per barrel, the lowest level in 12 years. After trading around $30 per barrel for at least a month, it started a rally in February 2016 which bought the price of West Intermediate Texas (WTI) up to $40 per barrel. A level not seen since April 2015.
Many analysts were surprised by this earlier than expected rebound. From a fundamental perspective, oil price is highly related to supply and demand, which in fact has not changed a great deal in the last month. Recently, the overall impact of non-fundamental factors has been high; the majority of trend-following fund players are now long oil, due to the upward momentum. This can help to explain the recent rebound, but the fundamental picture has not had any significant changes to justify an approximately 60% return since the lowest point in January 2016.
The question everyone is asking is if these price levels are sustainable?
Recent developments in supply
The process of rebalancing in crude oil is underway. We have seen some deterioration in the supply picture (and thus, a positive support for a rise in prices) from two sources: unplanned disruptions and the emergent impact of reduced spending in non OPEC producing countries.
Two consecutive years of capital expenditure cuts in non-OPEC and non-US regions caused current rates of production to suffer. Capital expenditure measures the funds used by a company to acquire or upgrade physical assets such as industrial buildings and equipment and thus they can give an idea of new investments and projects undertaken by drilling companies. In Kazakhstan, Brazil and Russia’s major oil companies reiterated their announcement of investment reduction, resulting in a downward revision to production guidance. Also in the United States, production of shale oil is decreasing.
In addition, unplanned disruptions in Iraq and Nigeria have so far negated the impact of higher Iranian production. In Iraq there was a disruption of the northern pipeline, which was hit by sabotage sometime in February and then was restarted on 11 March. It caused the production to decrease by 20% from January to February. In Nigeria production was down 10% due to a suspected act of sabotage.
On the other hand, Saudi Arabia announced that they will not cut oil production if countries such as Iran do not cut production too. But Iran will not even discuss a cut in production until it has recovered to pre-sanctions output or hit a plateau. It is unclear how long this will take.
A much bigger issue
Growth in demand was much stronger than expected in 2016, this was led by China and the US. This, combined with a declining non-OPEC supply, helped to give some relief on oil prices. What many analysts fear is that this rally has been prematurely pricing a balanced market, whilst markets are still characterised by oversupply. Any sustained rally above current prices, which would allow many unprofitable drilling projects to became profitable again, will cause US shale producers to increase spending, drilling and, after a time-lag, production. The rise in oil prices could soon became counter-productive, delaying the necessary demand-supply adjustment.
Risk is still skewed to the downside
If we look at what can have an impact on commodity prices, we see an upside risk in the case of an increased instability in oil-exporting countries. On the contrary, downside risks can come from a larger number of scenarios: weaker than expected macro and oil demand growth, high market volatility, risk of a new global recession (due to excessive market reactions to disappointing news and overburdened central banks), risk of a hard landing in China and a risk of Brexit.
Crude prices are already $3-4 lower than the recent peak on 22 March and until surpluses information remain on the news flow, geopolitical and economic uncertainty will weigh more to the downside.
