What’s been the stellar major commodity over the last six months?
Oil has to be up there with the best of them. Since 10 July last year, the price measured in US dollars has risen by 50%. Brent crude is currently hovering just below the $70 per barrel mark, having already climbed 4% in 2018.
So is this just part of a major recovery from the lows of January 2016. Or has the rally now run its course? Let’s have a look…
Hope in the depths of despair
In early-2016, I noted in Strategic Intelligence that “sentiment in the oil sector is just about as bad as it could be. That’s a classic buy signal for contrarian investors. It takes nerves of steel, but this…feels like a buying opportunity in a truly hated area. As demand steadily increases and supply is curbed, I believe that within two years Brent crude could return to the $65-$70 per barrel area. That would give upside of around two-thirds from today’s level.”
Now that Brent crude has reached my target, it’s very tempting to take profits in either oil ETFs or stocks whose values are closely aligned to the spot price. But before reaching that decision, I’m going to look at the forces driving the oil market.
The first is the most straightforward. Brent measured in US dollars has been boosted by the drop in America’s currency over recent 12 months.
Further weakness in the greenback would give crude another boost. But while the dollar’s longer-run prospects may be dimming as the US state debt mountain grows, forecasting shorter-term moves in the currency is fraught with difficulty. If the Fed keeps lifting interest rates in order to be able to cut them when faced by a future recession, the buck could benefit. That would be a negative for the $ oil price.
Then, most importantly, there’s the global supply/demand balance – and how it’s likely to develop over the coming months.
At first glance it can seem very difficult to get to grips with this. There appear to be lots of moving parts.
But as regular DR readers will know, I reckon we can simplify things here.
Demand for oil has steadily increased year-on-year for decades, admittedly with the occasional recession-inspired dip.
Despite growing competition from renewable energy and increasing numbers of electric vehicles, global oil consumption is set for continued growth over the next two years, according to the latest forecasts from the US Energy Information Administration (EIA). In other words, it’s situation normal.
Supply the real issue
Oil supply, then, is the likely determinant of the price.
Recent history has seen an output battle between OPEC (the Organisation of Petroleum Countries) cartel and US shale producers. As the latter initially gained market share, crude costs crashed in 2014/15. Then OPEC curbed its own output as those shale producers adapted to the new reality.
“The approach of OPEC and its allies for the coming year is clear”, says Bloomberg, with “Brent…above $70 per barrel apparently confirming the success of OPEC’s plan. Production cuts have been extended until the end of 2018 and excess inventories are being drawn down.”
That sounds quite bullish. But Bloomberg isn’t convinced. “Get ready as OPEC and Russia try to plot a way out of their production cuts but likely get stymied by market twists and turns that upset their calculations”, it says.
“The fundamental supply-demand balance doesn’t support OPEC’s optimism. Even if it did, transitioning from supply cuts isn’t going to be smooth, with growth in demand likely to weaken throughout 2018.”
Indeed, Russian Energy Minister Alexander Novak doesn’t see ‘balance’ in the market being achieved until the third or fourth quarters of next year, meaning that supply curbs could be extended again to beyond end-2018.
Meanwhile OPEC members will still need to be disciplined in raising their output nice and slowly.
As always with the oil market, production forecasts differ, depending upon the source. OPEC sees supply growth of 1m barrels per day (b/d) this year, 720,000 of which would be from the US. The International Energy Agency estimates there’ll be 1.6m b/d extra, with just over half coming from American shale producers. And the EIA is anticipating an increase of 2.37m b/d of total world production in 2018.
But $70 Brent is leading to even higher US output than previously expected. Surging shale production is poised to push American crude production to more than 10m b/d. That’s “toppling a record set in 1970 and crossing a threshold few could have imagined even a decade ago”, says Reuters.
And while – as already noted – global demand should keep expanding, a possible dip in Chinese growth is a further possible concern. Against this, major crude supplier Venezuela is falling apart, which could remove a large chunk of supply, though the exact timing of that country’s collapse remains an ongoing unknown.
Confused? Let’s try to sum this all up.
While uncertainties abound, no one wants to see either an uncontrolled surge in oil prices or a renewed collapse. Global crude output growth needs to be constrained rather than either increased sharply or reversed.
The EIA expects that the modest inventory build-ups it’s forecasting for 2018 and 2019 will contribute to Brent crude oil prices dropping to an average of $60 per barrel in the first quarter of 2018, staying around that level for the rest of the year.
At the risk of sitting on the fence, I’m turning neutral on oil and expect a pullback from current levels in the near term. But I’m not becoming over-bearish. Drastic cuts to upstream spending when prices were very weak could mean a dearth of new supply sources and an oil supply shortage after the end of the decade.
But that’s a few years off yet. Put another way, for the moment oil is no longer as exciting as it was. If you want some serious price action, it’s time to look elsewhere.