The recent sell-off in oil futures, following the rout in equities, was worrying to some and good news for others who saw oil prices overshooting upward, paving the way for an inevitable correction.
Oil prices in New York on one single day (Friday, Feb. 9) lost most of the gains they had made so far this year, the main reason being very bearish data for US oil production compounded by an immense increase in the number of drilling rigs searching for crude in shale oil basins in Texas.
As futures contracts of crude oil on the London and New York stock exchanges traded in red almost the entire day on Friday, I recalled Saudi Arabia’s energy minister, Khalid Al-Falih, telling CNBC in Davos last month that he was not convinced that the oil market had returned to balance, despite rising prices. “While I’m still anxious about the fragility of the mar- ket ... by and large we think we’re on our way, but we’re not there yet,” he said.
Is the oil market really still fragile or has it improved after more than a year since the OPEC and its allies came together to save the market?
The answer to this question depends on which half of the cup one is looking at. I’m looking at the full half, and I see a robust market guided by strong fundamentals despite all the worries that speculators and traders in paper contracts of oil might have.
There are four factors making the oil market robust at the moment, or until June when OPEC meets next. First, commercial oil inventories are down considerably in the member countries of the Organization for Economic Cooperation and Development (OECD). The OECD stocks, the main gauge for measuring global inventories, stood at around 340 million barrels of oil above the seasonal norm or the five-year average in January 2017. By the end of the year, OPEC reported that they had fallen to 98 million barrels, while the International Energy Agency saw it at around 70 million barrels. However, according to Goldman Sachs’ calculations, the glut in OECD inventories is now cleared. In January 2018, the OECD stocks seem to be in better shape, especially in the United States, which accounts for 75 percent of OECD inventories. They even reversed their normal trend of building up during January and witnessed a drawdown, although many analysts differ on the extent of the drawdown. One estimate made by Cornerstone Analytics, an energy research firm in the US established by veteran Michael Rothman, puts the US stocks drawdown last month at 24 million barrels. This is counter to their normal average buildup of 11 million barrels at this time of the year. It is also counter to last year’s buildup of 25 million barrels.
With these numbers, Cornerstone expects the glut in OECD stocks to be cleared by April. The second factor that makes the oil market robust is that demand is still very encouraging this year, or at least for the first half of the year. Oil demand is expected to grow by at least 1.5 million barrels a day this year. To add more optimism in the market, China imported record crude in January.
Third, supply response from US shale to higher oil prices this year is not expected yet to have a negative impact. Two reasons behind this belief: Firstly, with more self-restraint from OPEC and its allies on cuts, US crude oil is finding more markets worldwide and it will meet all the incremental demand. Secondly, many think that shale oil producers will not invest greatly to bring new supplies this year. Ian Taylor, the chief executive of the world’s largest oil trading company, is among those who think shale producers will apply capital discipline this year.
Another factor is that many members of OPEC are unable to add more production this year owing to political security, or lack of adequate investments to bring new capacities. Venezuela is at the forefront of this. The country’s production has dwindled this year and that will create shortage of heavy and sour crude oil grades for US refiners who prefer this type of crude.
That means new Canadian and Brazilian supply can find a home in the US Gulf of Mexico and that will add balance to the market. Nigeria and Libya are also struggling to keep their production stable around current levels. For all of the above reasons it’s fair to say that the market is head- ing toward balance in the first half of this year. In fact, analysts such as Goldman Sachs are arguing that the market might be tighter than expected this year if fundamentals remain as strong as they are.
What will happen in the second half of the year is still not clear. Risks are always there, from slow demand owing to an increase in oil prices, to uncontrollable increases in shale oil production. But these worries are more for the second half, and OPEC and its allies have another meeting in June when they can decide what to do next to stabilize the market in case they need to. And OPEC shouldn’t worry about oil prices as long as fundamentals are strong, as they will dictate the right price.
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