The Daily Reckoning UK

Is The Oil Rally Over?

David Stevenson

by

Posted 9th March 2017

Oil is back in the news again. While financial markets elsewhere have been volatile, the cost of Brent crude has traded in a narrow band over the last three months between $54 and $57 per barrel.

But this morning, Brent prices – a key benchmark – have slipped below that $54 level. So is this a blip or the start of a new downswing in the value of crude?

One problem about trying to understand the oil market is the sheer number of stats that are bandied around, with the United States to the fore.

The US Energy Information Administration (EIA) has just recorded the ninth rise running in America’s domestic crude supplies last week as total commercial inventories grew by 8.2m barrels to a record weekly level of 528.4m barrels.

Meanwhile, the American Petroleum Institute says that US domestic crude supplies expanded by 11.6m barrels over the latest seven days, vastly higher than forecasts of a 1.6m barrel rise by analysts surveyed by S&P Global Platts. And as MarketWatch notes, Chinese crude imports fell in February.

Against this, petrol supplies dropped by a much bigger-than-expected 6.6m barrels, according to the EIA – not to be confused with the IEA (International Energy Agency), from whom there’s more later – while we often have data from OPEC (the Organisation of Oil Exporting Countries). It’s all rather bewildering.

So what’s really going on?

As with all markets, the oil price depends on supply and demand – specifically, how the balance between them is expected to develop over the coming months.

The easy bit to understand is demand. For decades this has steadily increased year-on-year – admittedly with the occasional recession-inspired wobble – and it looks set to continue to grow, despite a few caveats as well as growing competition from renewable energy sources.

So let’s concentrate on supply. One major recent event in the headlines has been the annual CERAweek energy conference in Houston, Texas. This was attended by oil ministers of crude-producing countries as well as industry leaders.

And much of the focus in Houston was on Bloomberg-reported comments by Iraq’s oil minister Jabbar Al-Luaibi that OPEC would likely need to extend output cuts into the second half of 2017. Further, he said Iraq is ready to join such an effort.

OPEC originally agreed to cut output during the first half of this year. To begin with, Iraq wanted to be exempt from any reductions, saying that it needed oil revenues to fight an Islamic State insurgency. But then the country agreed to reduce production by 210,000 barrels of oil per day (bp/d).

The main reason for OPEC’s first-half production trim was concern about US shale drillers. Having chopped their costs, making the average shale well more profitable today than it was pre-downturn, these are now ramping up output again. The IEA warns this may grow by 1.4m bp/d by 2022 with prices at about $60 per barrel while more than 3m bp/d of extra capacity may come on stream if prices hit $80 a barrel.

To sum up so far, then: in the short-term, OPEC probably needs to rein back output further to offset a nascent recovery in US shale production. Even then, the immediate outlook for oil at its current level isn’t too bullish with China cutting its growth rate target to 6.5% from 6.7%, implying lower than expected demand. So I wouldn’t be surprised to see the cost of crude being clipped further over the next few months.

As always, though, there are two sides to every argument. America’s shale suppliers don’t want over-production to crush oil prices again. “Some of the [US] shale industry’s most influential voices say they’re keeping a tight hold on production budgets”, says Bloomberg, “[and] vowing not to repeat the mistakes of the first phase of the shale revolution from 2010 to 2015 when companies spent well above the cash they generated.”

And in the longer run, another oil price spike is likely at some stage, according to a new report from – yes, as promised – the IEA.

Three years of drastic cuts to upstream spending because of the meltdown in oil prices could result in an oil supply shortage within a few years, says the agency.

When oil prices collapsed in 2014, producers axed spending. Global oil & gas investment dropped by a quarter in 2015 and by an extra 26% last year, according to IEA estimates. Many major projects were shelved. Because such ventures take years to develop, there’s set to be a dearth of new supply sources at the end of the decade.

In addition, the IEA believes that even the above-mentioned US shale recovery won’t prevent a supply shortage by 2020 as the new project pipeline is too small. Unless oil explorers soon start a cascade of new upstream ventures, OPEC’s spare capacity will fall to low levels and crude prices will rise sharply.

“One of the more eye-opening predictions from the IEA is that oil demand will continue to rise without interruption”, says Nick Cunningham at Oilprice.com. “Global oil demand grew by a whopping 2m bp/d in 2015 because of low prices then by 1.6m bp/d in 2016. Moving forward, demand rises steadily year after year by an average of 1.2m bp/d through 2022. India takes over as the largest source of demand growth, a mantle long-held by China.”

“The IEA, unlike a growing chorus of analysts, thinks that electric vehicles might only have a marginal impact on demand, slowing consumption growth but ultimately not reversing it. On top, oil demand will grow in various sectors not related to passenger vehicles, including freight, marine transit and aviation, [meaning that] the much-discussed peak for oil demand remains some years into the future”.

You could argue that the IEA has a vested interest in being long-term bullish about crude costs. But if the agency proves to be only partly correct, in a few years’ time we could all be paying much more for our oil supplies.

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