Can the oil price rally continue?

Following an oil price rally of nearly 50% since its February lows, we look at the main catalysts behind the move and whether the rally will last.

24 March 2016

Geoff Blanning

Geoff Blanning

Head of Emerging Market Debt and Commodities

A slowdown in oil production growth combined with sustained record levels of demand and a reversal of deeply-depressed investment demand is already boosting the oil price and could underpin a sustained rally in 2016.

Have we reached peak oil supply growth?

While oil supply grew overall in 2014 and 2015, the rate of production growth slowed sharply in the second half of 2015.

The main reasons that suggest we could be at the peak of production are as follows:

  1. The most significant decline in production growth will be seen in the US, given the recent renewed collapse in drilling activity and initial decline rates of shale wells.
  2. Saudi Arabia and Iraq boosted supply materially, but growth has already stopped.
  3. February's Saudi announcement, with Russia, of a “freeze”, gives us a strong indication that even the Saudi pain threshold has now been reached.
  4. OPEC production has likely also peaked as a necessity to drive the price higher.
  5. Considering the cost of production, it is plain that no producer will survive if the price remains at $30 or below: BP thinks it could breakeven at $60 while the best US shale producers could perhaps live with $50
  6. Oil inventories remain high and still represent a risk factor until the physical market surplus definitively erodes.
  7. Globally, supply will likely be stable or decline moderately on account of the sustained, reduced level of capital expenditure (capex) and maintenance spending.

Is demand for oil being maintained?

Future demand projections are dependent predominantly on expectations for economic growth in major economies and thus have the potential to vary widely.

Realistically and conservatively, however, we expect additional demand of over 1 million barrels-per-day (mbd) in 2016 to reach 95-96mbd, another record, and likely a further 1.5mbd in 2017.

We see a few reasons to believe that the “oil age” is not over yet and demand should remain healthy:

  • We assume very modest growth in the US, EU and China but more robust growth in India.
  • Structural demand growth in emerging markets (EM) remains an important feature of the global demand picture.
  • In developed economies, we can expect structural demand weakening to be offset by a return to normal weather and also by an uplift to demand as a result of the cheap price.
  • A weakening in the US dollar could also act as a counterbalance to any fall in structural demand.

Has the market got it wrong?

With conservative assumptions, the oil market supply/demand balance appears already to be on a tightening trajectory.
Sooner or later it will result in a deficit which then will expand and show persistence for some considerable time, however much the price rises.

Consensus market expectations appear wrong, therefore, on two counts:

  • That the price will not recover until late this year or 2017.
  • That the rising price will catalyse new US shale supply which will cap the rally.

This latter point is crucially important to understand.

It is widely suggested that US shale is the new "swing supplier". The riposte to this suggestion is "not at this price, and not likely for many years to come", as the financial wounds from the current episode are much too deep to heal quickly.

Thus, there is an interesting question now regarding excess capacity in the market and what could happen to the price in the event of a meaningful supply disruption.

Is now the right time to buy oil?

The oil price has been driven to the current low level partly because of the "free for all" price war within OPEC (and involving Russia).

Many countries have been producing flat out to retain market share. So who will fulfil higher demand in the next 12-24 months if not US shale?

Only Saudi Arabia has spare capacity (2mbd, it is believed) but the Saudis will certainly be reluctant to risk driving the price lower again and in any case, by mid-2017 the supply deficit could be well over 2mbd.

Investment demand for oil is clearly pro-cyclical (the value of oil tends to move in the same direction as the economy) and is currently deeply depressed.

Should the price rise, this picture will start to reverse, possibly (depending on the trigger) in a very substantial way. The risk in this market is now heavily skewed to the upside.

This article has been adapted from an internal research report dated 02/03/2016.

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