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Can oil's rally last?

Physical tightness and geopolitics suggest so. But price threats are lurking

Everything looks bullish right now. Physical markets are tight. Demand is stronger than expected—Gulf Opec producers had thought Q4 would be much weaker. OECD stocks continue to fall. Oil is being drained from floating and onshore storage. The excess inventory is now mainly in the US, from which exports are soaring. The futures curve, in backwardation over the next six months, reflects the underlying shift in the fundamentals. The market seems to expect Opec to extend its cuts beyond the end of Q1 until end-2018.

Geopolitics is the bull-shaped figurine on top of the cake. Some supply interruptions have already occurred: exports from northern Iraq have been cut several times in recent weeks and the volume is now unreliable. Protesters shut another field in Libya last week.

The bigger risk—in the Gulf—hasn't cut supply, but nor have many commentators grasped the scale of the potential upheaval. The Saudi purge/shake-down, the missile shot down over Riyadh airport, the new sabre-rattling aimed at Iran, the kingdom's extraordinary political meddling in Lebanon, the apparent Saudi-Israeli cooperation to target Hezbollah, the deterioration between Qatar and its GCC neighbours, and the approval of all this from Donald Trump 's White House sharply raise the chances of another major war in the region. Wall Street scenario-builders are already drawing up the flowcharts, and talking of Iranian-Saudi threats to oil-export infrastructure.

Unless these scares fizzle, the rally of the past fortnight, which has drawn in huge speculative long positions, may be sustained. Yet while the signals all point to price appreciation, their flashing lights may also be hiding a bull trap. Three main reasons could yet hold back oil—and a premature price rise would be behind them.

First, Opec's decision to extend its cuts until the end of 2018 isn't a done deal. Ed Morse, Citi's head of commodities research, was the first major market voice to say publicly what has been said quietly by some Opec insiders lately: the group may disappoint the market on 30 November. Citi's base case is that a full-year extension isn't agreed, he told Bloomberg.

Even if an agreement is struck in Vienna, execution next year will be much more difficult than in 2017. Russia, Iraq and Iran all want to produce more—and at $60 plus a barrel they're more willing to break free. Opec and Saudi Arabia will insist they still want to bring OECD stocks down to the five-year average. But the purpose of the cuts is to lift the oil price—the stocks target was just a means to the end. Russia's producers, which have around 400,000 barrels a day of new oil supply they could bring online in 2018, have always been more sceptical of the cuts than the Kremlin, which authorised them. Lukoil's Vagit Alekperov has said explicitly that an oil price of $60/b means no further cuts are necessary. And President Putin's need for the cuts is less urgent at this price too; fulfilling a deal with Opec will be lower on his priority list after he wins the presidential election in March.

Iran and Iraq didn't think they were signing up for perma-cuts last year, so the idea of forestalling growth again, even though the oil price has risen, will be hard to swallow. Iraq wants to increase production by almost 0.5m b/d next year. Iran wants more too. Corralling these reluctant cutters into another phase will be difficult, but more difficult still will be keeping them compliant. This all complicates Opec's decision at the end of November. A three-month extension, to mid-2018, may be a safer bet. The market would probably sell that.

Second, for all the surprises in demand in 2017, the balances in 2018 don't look so rosy. The International Energy Agency still expects Q1 to be weak. Demand for Opec's own crude next year will average 31.9m b/d in Q1 and 32.5m b/d for the whole year, according to the agency—but its output, including Libya and Nigeria, was already 32.65m b/d in September. And that's at historically high compliance rates. There's no space for extra Opec oil next year.

Shale slowdown

As for non-Opec producers, $60 plus oil will surely take the screws off. Yes, Wall Street has grown warier of tight oil's cash and debt problems. Output growth has also slowed-down to 1% over the past three quarters, according to Morgan Stanley. This reflects the plateau in the oil-directed rig count, which after hitting a 2017 peak of 768 in August has been drifting lower.

Yet it's hard to see this slower pace of activity carrying on in a sustained price rally. Even in high-cost Canada, oil sands producers say $65/b would be time to start sanctioning new projects. At that price in the much-cheaper tight oil patch, the oil-rig plateau may start to look more like a perch, if not a springboard. Morgan Stanley reckons shale producers would need to add 8-10 rigs per month to meet the need for their crude next year. But in the run-up from the start of 2017 to the August peak, rigs were added at almost 30 per month. And that was when price sentiment was far less bullish than today.

A sudden uptick in drilling activity in the US would be difficult for this rally to manage because so much of the recent speculative buying leaves long positions without a great deal of depth. The unwinding would be swift and volatile.

The last problem is demand. Cheap oil and fuel prices sparked a buying spree even in areas the market had largely written off, like Europe. But demand growth in countries such as Germany and France seems already to be easing. In countries such as the UK, underlying data look very weak (car sales fell by an annualised 12% in October). China's buying for storage is price-reactive. The IEA thinks the net build fell back to 100,000 b/d in September because of the higher oil price. But $64/b Brent, on 10 November, is 15% more than the average price in September. Demand grew in the OECD Americas by an average of 375,000 b/d between 2014-17; but will be flat in 2018, forecasts the IEA. All told, global growth will be 200,000 b/d lower next year than this year.

That's if the forecasts hold. They were made before a host of analysts started raising their price predictions for the coming months. These forecasters failed to predict the cheap-oil-induced surge in demand this year; they may miss the impact of costlier oil on consumption in 2018.

In short, slack in the market has started to disappear quickly in recent weeks, tightening balances. Opec's deal and stronger-than-expected demand growth are the chief reasons. But neither can be relied on next year—and the kind of price surge that geopolitics now make possible could easily offer the ingredients for another downward correction.

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