The drop of the OECD inventories observed in the last six months is the single most important factor behind the recent uptrend in oil prices, as stronger than expected global demand clashed with a constrained supply, the latter partly due to the restrictive policies put in place by the main producing countries (Opec+Russia) in early 2017.
The shape of the market curve that, after being positively oriented for more than 2 years, starting from September shifted to a backwardation structure (a situation that, in industry jargon, happens when prices for future delivery are higher than spot prices) is a further evidence of a poorly supplied market.
Even though the recent run-up in oil price appears justified in view of a tightening supply-demand scenario, it should not be underestimated that the rise in price coincided with a dramatic surge in financial activity. Indeed, the last 6 months were marked by an unprecedented increase of the money managers (operators that normally enter the commodity markets for speculative purposes) long positioning, both in the WTI and Brent (Figure 2) markets.
It is always a difficult task that of distinguishing how much of the price fluctuations is due to a genuine change in physical fundamentals and, on the opposite, how much is a result of bets placed by speculators anticipating the future movements of the market. Further encumbering this task is the simultaneous emergence of several risks, and the uncertainty about the extent these latter have been priced in. Among the most important, though with no pretentions of exhaustiveness, we recall the political tensions within Iran, those between Tehran and Washington and, finally yet importantly, the fluctuating trend of oil production in the other four among the “Fragile Five” Petrostates: Libya, Iraq, Venezuela and Nigeria.
The combination of these risks with other exceptional factors (including the cold wave in the United States, and the temporary interruption of the Forties pipeline in the North Sea) could justify the addition of a premium to the price of oil. However, that placed between December and January appears overestimated, especially whether if in perspective, given the foreseeable reaction of the North American producers to such a high profitable market environment.
Indeed, a 65+ dollar/barrel price for 12-month deliveries is an appetizing morsel for the shale oil industry who will hardly hesitate in increasing the output volumes. This trend is already visible in the latest oil drilling reports, and likely set to receive further impetus in the current year. Indeed, according to the latest Energy Information Administration (EIA) forecasts the Us oil production will rise by nearly 1 million barrels/day, easily breaking the previous 9.6 million barrels/day record set in more than 40 years ago. Such progresses alone will hardly be large enough to fill the global gap between supply and demand in 2018. In any event, and other things unchanged, the magnitude of the oil market deficit (and the risk of global shortage) is intended to be substantially lower in 2018 than in 2017.
It should be moreover be considered that a stronger-than-expected bounce back of the Us shale oil supply is not the only bear risk the oil market could face in 2018.
Now that the global market re-balancing goal is almost achieved, and in order to avoid a further loss of market share to the advantage of the North American producers, the Opec countries should start working for an exit strategy from the current cuts regime. The six months separating us from the June Opec meeting will then be decisive, both to test the elasticity of the shale oil industry and to gather signals of tensions among the agreement participating countries (particularly between Russia and Saudi Arabia).
Should the underlying global supply-demand fundamentals turns weaker than expected, many market participants will likely rush to liquidate their contracts. Given the enormous amount of long positions held by speculators there is a clear possibility that such a sell-off would definitely trigger a steep drop from the current price levels. This definitely stands out as the most impactful short-term risk to the oil outlook.