Global Crude Oil Prices And A Delicate Re-balancing Act

Global crude oil prices have risen by more than 75% from near twelve-year lows reached in January. The recent spike was driven largely by unscheduled supply outages in major oil-producing centers including Canada, Ghana and Nigeria. Given the sustained, significant oil imbalance (the excess of supply over demand), the outages were seen by not a few traders as a major step towards a long-awaited, supply re-balancing.

Estimates of the total oil supply reduction due to the outages including other withdrawals year-to-date, stood at about 2.5 million barrels per day, bpd, just a few days ago. Not discounting the recent price spike, such rapid supply withdrawal ordinarily would have generated a global price shock. The rather tepid market response was perhaps informative.

Fundamentals

Quite a few analysts believe an oil supply re-balancing is imminent, if not in progress already. Such sentiment however is not altogether consistent with extant market fundamentals.

While the global oil imbalance has declined somewhat ― having fallen to 1.34 MMbpd in 1Q 2016 from 1.75 MMbpd in 4Q 2015 ― that decline was not driven by a growth in demand. According to recent data from International Energy Agency, IEA, global oil demand fell consecutively from 3Q 2015 through 1Q 2016, for a total decline of 660,000 bpd.

This is significant. Some analysts had based their re-balancing projections on a spike in demand, particularly since recent attempts at a supply re-balancing failed dismally; but as some of the recent unscheduled production outages are coming back on stream, global oil supply is set for additions. Suncor Energy Inc. (SU), Syncrude Canada Ltd and Imperial Oil Ltd (IMO), Canada’s oil sands operators in Fort McMurray, for example are restarting operations and are expected to attain pre-disruption output levels shortly. Libya’s jostling leadership factions have reached a negotiated ― even if tenuous ― modus vivendi and are currently loading export cargoes having reached almost 75% of pre-disruption output. Even Venezuela has successfully renewed an oil-for-loan agreement with China. The case of Nigeria however, is somewhat uncertain especially with the threat of militant uprising in the oil-producing Niger Delta region and concerns about the tenor of president Muhammadu Buhari’s response; operations by Exxon Mobil (XOM), Shell (SHLX), Chevron (CVX) as well as Agip have been affected and the country has seen production fall to near twenty-year lows.

In addition, Saudi Arabia, the only producer currently with a significant spare production capacity, has a new and hawkish energy minister who has threatened to further flare the country’s output taps in a bid to force more of the higher-cost producers offline. Iran’s oil output for April was 3.6 MMbpd, a level last seen in 2011, according to IEA. More significant is the country’s export level which rose to 2 MMbpd from 1.4 MMbpd in March; and the government has set a target output of 4 MMbpd by the end of the year.

The growing volume of global crude oil inventories including those in floating storage is a reflection of the lingering imbalance. In the U.S., stock levels have risen steadily over the past two years and now stand well above the 5-year range.

For member countries of the Organization for Economic Co-operation and Development, OECD, days of forward demand rose from just under 58 in 1Q 2014 to more than 67 in 1Q 2016.

It is therefore not surprising that the recent supply outage, massive as it was, did not trigger a commensurate price increase.

Dollar Exchange Rates

Crude oil prices are denominated in U.S. dollars. That means that when the currency strengthens, it renders the commodity more expensive, exerting downward forces on prices. Driven by prospects of a rate hike by the country’s Federal Reserve, the dollar has, over the past few days appreciated significantly against a basket of currencies. Higher interest rates are usually indicative of rising economic strength, and in the case of the U.S., the tendency would also be for an increase in the value of the dollar, as it becomes more attractive for investors seeking higher yields.

Re-balancing

Prospects of a strengthening U.S. dollar could weigh in on the oil futures market. Net-long positions on crude oil (WTI and Brent) futures and options held by hedge funds and other money managers, spiked between January and end of April to a record 663 million barrels from 243 million barrels, Reuters reports. While there has been some cutback, mostly on the net-long side, accumulations of long or short positions are often followed by steep reversals when traders, bidding to lock-in profits exit or liquidate en masse; and there is some degree of correlation between the accumulation/liquidation of such positions and crude oil prices.

With the current crude oil supply and inventory levels, a rapid re-balancing is unlikely in the near term, save for a dramatic change in global demand and, or, supply profiles. Even in the event of a re-balancing, any sustained increase in oil prices above US$50 per barrel ― the industry’s estimated threshold price ― could easily be tempered by the re-entry of shale oil producers. In the U.S. for example, shale producers last week delayed rig cancellations on prospects of improving oil prices. While a good number has been put offline following the “sheikh-versus-shale” duel, many of the producers have remained resilient, gaining in production efficiencies including shorter production cycles. This would enable them to quickly return on stream and add to the global supply pool. Rystad Energy reports that there are currently about 3,900 drilled but uncompleted (DUC) horizontal wells in the U.S., with about 90% of them located within major liquid plays.