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The outages start to hurt

The market has at last noticed the mounting supply-side problems, which are now pushing up oil prices

AFTER the failure of the Doha oil-producer meeting in April you might have thought crude prices would plummet. Saudi-Iranian rivalry has for now thwarted any attempt at capping Opec supply.

But Brent futures rallied, rising from around $42.77 a barrel on 18 April – the day after the Doha meeting – to just under $49/b on 17 May. WTI has also strengthened, reaching more than $47/b in mid-May, up from around $30/b in January. Futures look certain soon to enjoy a $50 handle.

An old market chestnut, seemingly forgotten in the glut, is the reason: unplanned production outages. Together, they have offset some of the effect of rising Opec supplies.

Wildfires in Alberta took an estimated 1.2m b/d of production offline at the beginning of May (although stored oil kept the pipelines full), while disruptions in northern Iraq, maintenance in the UAE, and outages in Venezuela and at Shell’s Forcados terminal in Nigeria also combined to support prices. In Libya, output has almost ground to a halt. All told, the unplanned production cuts globally in recent weeks amount to over 2.2m b/d. By mid-May, things looked like they would get worse still, as violence and conflict in Libya and Nigeria seemed destined to shrink output from two crucial suppliers to the Atlantic basin.

Throw in longer-term outages from the Neutral Zone (more than 0.5m b/d), South Sudan (120,000 b/d), Yemen (40,000 b/d), Syria (350,000 b/d), Libya (1m b/d that was lost even before the output plunge in recent weeks), and the supply losses point to an underlying problem that has been masked by rises elsewhere in recent years.

“The market has moved from strength to strength even though global supply remains high.”

“We’ve moved from one unplanned outage to another,” says Harry Tchilinguirian, an oil analyst at BNP Paribas.The market has moved from strength to strength even though global supply remains high.”

These cuts come on top of a swathe of planned ones in the refining sector, helping to limit some of the bullish impact of the supply-side problems. Global refinery maintenance peaked in April at around 6.55m b/d and was expected to remain high throughout May, at 5.2m b/d, according to Energy Aspects. But in June, as the northern hemisphere’s driving season kicks on in earnest, the amount of processing offline will fall sharply, to 3.5m b/d, and then average less than 3m b/d between July and September.

So the pull on crude oil will be greater then – while the supply-side outages show little sign of abating.

That’s the real source of oil’s growing price strength, and the collapse of the freeze deal is now already yesterday’s news. “Doha was not meant to matter for physical-market balances and was a distraction from the real supply-demand tightening underway,” investment bank Barclays said in a recent report.

Some hedge funds and other money managers have also supported the rally, taking long positions, waiting a few weeks, and then selling to take the profit – a cycle that seems to be repeating itself. Thus in the week ending 26 April speculators increased their net-long positions in Brent and WTI derivatives by 7m barrels to a record 0.663m barrels.

In the same week, money managers held futures and options contracts equivalent to 0.791m barrels of crude, betting on a further rise in prices. Just 128m barrels of futures and options contracts were gambled on the prospects of prices falling. At the beginning of May, after oil had cruised higher, some started taking the profits, cutting net long positions in Brent by 35m barrels.

But the longs are still in control, reflecting the shift in sentiment. According to analysts surveyed by Petroleum Economist, Brent and WTI will keep rising in the coming months as capital spending cuts start to bite.

Bank of America Merrill Lynch (BAML) expects global oil output to fall in May for the first time since the beginning of 2013. Behind the drop is the slump in upstream spending, which BAML expects to drop by another 16% this year, following cuts of 40% last year.

This doesn’t mean prices are out of the woods yet. One bearish but uncertain supply-side factor is the US, where many drilled-but-uncompleted shale wells could come on stream over the next few months. The Bakken alone holds around 907 such wells, according to BAML. A rebound in WTI may send firms back to these wells to gain quick cashflow.

Tchilinguirian reckons that if WTI reaches $50/b by June banks will also start extending credit to US shale producers again – a lifeline that would let them hedge new production while locking in lower output costs. Banks will also watch the forward curve – a deepening contango over the 12 months ahead would add value to tight oil assets, making hedges easier to secure.

In that scenario, US tight oil output would begin to rise again – pouring cool water on any rally or even driving the market back down. “The run up in US crude prices almost contains the seeds of its own demise,” Tchilinguirian says.

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