Oil Price Movements in Perspective
August 18, 2016
Oil price movements over the few past weeks continue to mirror a now familiar modulating trend of alternating mini-rallies followed by more sobering corrections. The fundamentals of resilient supply, enormous stock overhangs, and questionable demand growth wage a constant battle with varying currents of positive market sentiment and both real and perceived changes in global affairs and events. Last week we witnessed oil prices reversing an earlier downward trend and exhibiting a mini-bull run based on selective and opportunistic reading of the fundamentals using a positive U.S. jobs report, weekly product stock draw data, renewed uplifting sentiment about economic growth, and prospects for another round of discussions for a Russia-OPEC production “freeze.” As a consequence, prices rose by over $3/barrel, topping $45 on August 9. In the process, money managers were quick to unwind short positions (which had reached decade-long volumetric highs) and make new bets on market upside.
The “rally” was short lived, however as news of crude stock builds, concerns over an economic slowdown, and reports of resilient U.S. output, return of Canadian oil volumes, and record OPEC output in July caused prices to pull back. Yet by the end of the week, the $45 threshold had again been reached—this time based on the release of the International Energy Agency (IEA) monthly report forecasting significant global stock draws this quarter and the imminent return of market balance. The uplifting sentiment continued into this week as Brent prices eclipsed $50 this morning, supported by larger than projected U.S. crude and product stock draws and refinery outages on the Gulf Coast.
For market watchers, number crunchers, and a wide array of analysts, weekly data can either be a harbinger of new (longer-lived) trends or a misleading head fake that suggests a temporary respite from a longer narrative. A longer perspective, say a six-month plot of oil prices, reveals a somewhat different picture as it takes into account seasonal variations, maintenance, and short cycle outages that may return to operation, as well as operational responses to persistently higher (or lower) prices. For example, a sustained period of prices above $50/barrel can spur new rig activity (however marginal) and lead to additional barrels being drawn into the market—either from wells or inventory. Against a backdrop of slower economic and oil demand growth, this version of the longer-view narrative suggests it will still take a while (absent some major supply disruption) for the bloated global inventories to be worked off.
A longer look back would capture the price plunge experienced earlier this year on the back of both resilient (albeit low-priced) supply and the panic arising from China’s currency devaluation and threats to the global economy. Here too, the sub-$30/barrel period was predictably followed by a rapid (four-month) price recovery based on the assumption that the price floor had indeed been hit and higher prices were needed to stimulate and support sustained new supply growth—even as analysts warned that debt-encumbered producers and project cancellations were already sowing the seeds for a future price spike.
In hindsight, the past five years’ experience has demonstrated that while a $120/barrel price was unsustainable, a $27 floor would be equally transitory.
So where does that leave us going forward? Well, oil stocks (both crude and refined products) remain in great abundance. Persistent low prices have curtailed large-scale new investments with impacts yet to be seen, both nationally and globally, but which are unlikely to be positive for consumers down the road. Production has been selectively resilient, due to technology advances, productivity increases, and declining costs (all interrelated), as well as the geologic richness of certain plays. U.S. producers continue to slog through difficult times, and those global players with higher break-even costs are likely to face even grimmer prospects. Geopolitical strife still threatens major supply areas in Latin America, the Middle East, and Africa, and sanctions/governance issues pose investment challenges elsewhere. The global economy remains challenged as well, though this too is not uniform. And alternative/cleaner fuels, spurred on by the renewed focus on climate change, and efficiency are chipping away at oil’s market, slowly but unceasingly. Yet oil remains the largest traded commodity in the world and is not going away anytime soon.
Since January (and actually well before) oil prices have been alternately driven by fundamentals and market sentiment. Traders thrive on volatility and deltas, not sameness. Absent a clearer and more sustainable trajectory, for the next several months one can expect prices to undulate in a limited price band with intermittent spikes and drops, depending on the whims of market players and the sometimes predictable, but oftimes not, interference of real-world events.
In 2015, the shape of the forward curve rewarded stock building. That excess inventory overhang has now given the market a complacency and comfort level that may prove to be shorter lived than originally envisioned. The story for 2017 may prove to be less about economic activity and consumption (though the demand side of the ledger remains key) and more focused on supply deliverability. Non-OPEC supply, including in the United States, is slated to decline both this year and next. Consequently, any measureable increases in consumption will have to come from either stock depletion or new volume from OPEC sources. Production from Libya, Nigeria, and Venezuela is likely to remain constrained, and Iran appears to be approaching its pre-sanction levels with further additions only likely through substantial new investment. Saudi Arabia maintains the ability to increase its already high production output, though any further increases will erode the world’s only viable spare capacity.
In earlier commentaries we have tended to downplay the impact and prospects for a Russian-OPEC output freeze, in part reflecting the animosity and conflicting agendas of the various participants, but also because the timing is not yet right. Freezing output at current levels does not relieve the current oversupply, especially since of the major producers only Saudi Arabia has the short-term ability to raise output further. In addition, countries with distressed output will inevitably want the flexibility to return those volumes to the market as soon as they are able to do so. Finally, higher prices, say above $55, will encourage additional supply while dampening new demand growth, thereby repeating/extending the current cycle. That said, producers have financially benefitted from production freeze discussions, and we would fully expect that dialogue to continue as fundamentals, sentiment, and events continue to alter market conditions.
If IEA forecasts for tightening in the third quarter of 2016 prove correct, stocks will decline and markets will tighten. But be aware that autumn also brings both seasonal refinery maintenance (less crude demand) and the U.S. Gulf Coast hurricane season (threats to supply and operations), so the next several weeks are likely to see further opportunities for price adjustment.
Looking a bit longer term, however, we are definitely headed for a day of reckoning for which we seem ill prepared today—and one only aggravated by calls for halting all new investment and keeping viable fuel resources in the ground. An energy transformation is surely underway, but one that requires policymakers to be prudent and forward looking even as they navigate current market machinations and strive to advance regional/global economic, foreign policy, and climate objectives.
Frank Verrastro is senior vice president and holds the James R. Schlesinger Chair for Energy and Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Guy Caruso is a senior adviser with the CSIS Energy and National Security Program. Kevin Book and Larry Goldstein are senior associates with the CSIS Energy and National Security Program.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
© 2016 by the Center for Strategic and International Studies. All rights reserved.