By Ole Hansen
It is said that the best cure for a low price is a low price. This is an apt description for what’s happened in global oil markets these past couple of years. The raised risk of supply disruptions following the Arab Spring in 2011 triggered a three-year period where high but also relatively stable prices became the norm. During this time, the Organization of the Petroleum Exporting Countries (OPEC) crude oil basket was averaging close to $108/barrel but while the world was preoccupied with the risk of even higher prices, a revolution occurred on the supply side.
High and stable prices helped support the developments of high cost production techniques. This led to the emergence of additional barrels from shale rock formations in the U.S., oil sands in Canada and deep sea sites of the coast of Brazil. By the summer of 2014, several supply disruptions from OPEC producers had begun to fade and this helped trigger a major change with the price risk suddenly being skewed more to the downside.
Following Saudi Arabia’s surprising but necessary decision not to support the price and later OPEC’s decision to remove the production ceiling, oil was left to balance itself. The 77% price collapse seen up until January was the medicine that was required to cure the rising imbalance between supply and demand.
While OPEC has been keeping the taps running at capacity in order to defend market shares and revenues, non-OPEC producers, especially in the U.S. have felt the pain. The slowing of production following months of decreasing oil rig numbers finally helped establish a bottom back in January. Since then, the price of crude oil has nearly doubled before hitting a stumbling block above $50/b.
The latest leg of the rally was supported by continued demand growth together with multiple and major supply disruptions emerging since May. But the return back above $50/b proved relatively short-lived on speculation that high-cost producers might be able to recover sooner than expected.
Several consecutive weekly rises in the number of U.S. rigs since last August helped support this view and triggered worries that the rebalancing process could run out of steam on the back of the high-cost production slowdown coming to an end.
The Brexit vote sparked a major round of risk aversion across global assets. With the U.K. being a small player from an oil-demand perspective, the selloff was mostly driven by the risk of a wider political macroeconomic impact. Growth prospects across some of the world’s major economies, including the U.S. and China are a much bigger worry and one that could potentially delay the rebalancing process further.
A lower oil price will however help support the rebalancing process by delaying high-cost producers’ investment plans, especially in the U.S.
Hedge funds jumped on the rally back in February and by April they had accumulated a record long position in Brent and WTI crude of more than 650 million barrels. As the price returned to $50/b, increased signs that high-cost producers showed signs of making a comeback helped trigger renewed selling. The number of oil rigs operated in the U.S. has been rising in five out of the last six weeks. This has been seen by the market that the breakeven level for some of the most efficient U.S. oil producers has fallen to $50 from around the $60 level where oil peaked last June.
In response to this, we at Saxo Bank have recently seen hedge funds reduce their gross-long by 27% on a combination of longs being reduced while new short positions have been added. This reduction helps to explain why oil has fallen back towards $45 during July.
During the peak summer months for U.S. gasoline demand we have seen gasoline inventory levels remain stubbornly high and as the peak driving season comes to a close it has raised some concerns about refinery demand going forward. Likewise in Asia very strong demand from Chinese refineries during the past six months are showing signs of slowing with gasoline inventories building up as refinery margins come under pressure.
In addition we are seeing supply from Canada, Nigeria and now potentially also Libya returning. These additional barrels will hit a relatively weak and still oversupplied market.
July and especially August have been two challenging months for oil prices during the past couple of years and with that in mind considering the recent developments in rigs, returning supply and the risk of weaker demand we could see oil be challenged in the short term. However, the oil market is now much more balanced than at this time last year so we do not see any major selloff from here.
During the current quarter there is an outside risk that Brent crude oil could fall as low as $43 but we maintain the view that such a level would help speed up the rebalancing by delaying any further progress among U.S. high cost producers. We view the $45/b to low $50s/b range as the most likely area for oil during the coming months before eventually rising towards $60 during 2017.
Ole Hansen is the Head of Commodity Strategy at Saxo Bank.