Oil price animation shows bulls taking charge

Crude prices have broken through some key resistance levels over the last two weeks.  Brent front month futures pushed above 60 $/bbl for the first time since Jan 2015. This helped drag the US WTI benchmark above 55 $/bbl shortly after.

This bullish breakout in oil prices comes against the backdrop of an intense energy industry debate about the long run future of oil.  Many senior industry participants are projecting ‘peak oil’ to occur at some stage next decade.

The logic behind peak oil projections is an anticipated decline in the use of oil as a transportation fuel.  This is the result of the increasing penetration of fuel-efficient engines and electric vehicles.  The arguments to support this logic are sensible and it is interesting that the peak demand thesis has now surpassed the peak supply narrative.

But there is an important question of timing.  Over the remainder of this decade, there are stronger forces driving the oil market than a fear of peak demand.

Strong demand & cuts rebalancing market

Global oil demand growth is strong and has been so for three years.  Global demand rose by 2.0 million barrels per day (mb/d) in 2015 and 1.6 mb/d in 2016.  Demand growth for 2017 is forecast to be 1.6 mb/d.  Demand is being supported by lower prices and relatively strong global economic growth since 2015.

On the supply side, OPEC’s production cuts are helping to steadily erode global oil inventories.  The current production cut agreement expires in Mar 2018 with a meeting on Nov 30^th likely to see OPEC extend cuts beyond this.  OPEC have indicated a willingness to extend, possibly by 6 to 9 months, and this has been a key factor supporting the recent price rally.

The excess of OECD oil inventories over their 5 year average levels has fallen by more than 50% in 2017, with inventories currently at around 160 million barrels. If current trends continue, inventories are likely to return to the 5 year average at some stage in 2018.

What are crude futures prices telling us?

Oil market sentiment has been weighed down by bearish supply side drivers for the last two years.  This has reflected the threat of lifting of OPEC production caps (or non-compliance), given significant production headroom particularly from Saudi Arabia and Russia.  Large incremental volumes of US unconventional oil production also loom over the market.

But despite these supply side threats, crude price behaviour in 2017 is being driven by a tightening global market. Chart 1 shows an animation of the monthly evolution of the Brent futures curve over the last 10 years.

Chart 1 illustrates three important factors that point to a tightening market:

1. Spot price strength: Both key global crude price benchmarks have broken above resistance levels that have defined the top of trading ranges since the Q1 2016 price slump (Brent above $60 and WTI above $55).
2. Shift to backwardation: The Brent curve has swung from contango to backwardation in Q3 2017. Contango typically indicates a near term oversupply, with spot prices at a discount to the curve. Backwardation on the other hand indicates buyers are willing to pay a premium to secure physical supply today, rather than waiting to buy it more cheaply in the future.
3. Rising calendar spreads: The oil market focuses on the price spread between the spot contract and a point further out along the curve (e.g. 6 mth or 12 mth) as a curve shape barometer for a tightening market. Calendar spreads have been increasing for three years as the market has swung from contango to backwardation and are currently at their highest levels since 2014.

US shale is still key swing provider

Strong demand has helped to rebalance the oil market from 2015-17.  Further demand growth strength through 2018-19 looks key to determining whether the market continues to tighten, or falls back into a 40-60 $/bbl Brent range.

But even in a tight scenario, oil prices are unlikely to run away to the upside.  WTI remains anchored by the scale of response of incremental US shale production.  If the WTI curve pushes significantly above 50-55 $/bbl then US producers can sell into the rally to hedge forward production expansion.

There may be a 6 month lag to bring new US production to market.  But market tightness over this horizon is likely to be reflected via steepening backwardation rather than a structural move higher in the futures curve (e.g. back towards $70).

The ability of OPEC to respond to higher prices will depend on the conditions under which it extends the production cap.  A longer extension (e.g. to Dec 2018) could precipitate further near term tightening.  But at the end of the cap horizon it is unlikely that OPEC will sit back and watch US producers dominate incremental supply growth without a fight.