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ECEGA's Insights

Oil prices on the rise. Is the rally going to last? 

The past week marked an important milestone for the price of crude oil - it broke above the psychological threshold of $50/barrel for the first time since the January depression. While a long-term recovery and/or reaching price levels of $100/barrel is not expected, further price developments would ultimately depend on a compilation of factors, notably OPEC’s production curve, the US shale developments and the oil stocks trading and expectations such creates in the market. 

Firstly, the key factor behind the 80% rally of crude oil prices is the disruption of supplies in Nigeria. The militant group Niger Delta Avengers has launched a series of attacks on oil production and transport facilities in the Niger Delta which led to a slash of 40% of production, going down to only 1.4mbd. The government is slow to react or neutralise the attacks (by rolling-out some of the recently cut payments to militant groups for example), so it is uncertain when the production would go back to normal, if at all, this year due to the serious damages already inflicted on infrastructure. Shell and Chevron evacuated their staff which sends important signals on the level of security risk evaluated by the companies, but also on how quickly production would rebound once the situation is eventually stabilised. The last unrest in the Niger Delta continued for over 3 years back in 2006 and sent shock waves in global commodity markets, which can easily be reproduced in the weeks to come. Other OPEC members have seen depressed productions as well, notably Iraq, Libya and Venezuela. The latter has established a 60-day state of emergency and recent undercover reports show a terrible state of the economy without power to feed even emergency hospitals and key government buildings. In Saudi Arabia, the recent reshuffle in the oil ministry has thrown markets into an anxiously watchful mode - Deputy Crown Prince Mohammed bin Salman (also known as MbS) has not clearly stated how he will change the production policy of his veteran oil predecessor Ali al-Naimi. For the moment, there is no indication of a higher output planned for this year. Despite the significant spare capacity, we do not expect the oil-rich kingdom to pump up production to more than 10mbd, even in the summer months, usually associated with peak electricity demand and higher production to address it. The upcoming OPEC’s meeting this Thursday (2d of June), which would be Khalid al-Fatih’s first as Saudi oil minister will be crucial as a first reflection on Saudi oil policy developments and provide possible hints for the 2017 output. No changes are expected in 2016 output.

Simultaneously, the raviging wildfires in Canada have depressed production in Alberta by about 1mbd which has directly affected the US, as the biggest market for the Canada’s oil. Further, the deficit in US oil stocks can be related to the low prices - in the US, production has fallen by 0,5mbd compared to the peak of 10mbd an year ago. Production in 2017 is expected to squeeze further to about 8.2mbd. Shale producers who have been struggling to maintain high-cost output could potentially pump up fracking if the price stays above $50/barrel but would need to hedge the costs of additional drilling with accumulation of debt and de-risking against future production, which might lead to a vicious spiral of price stagnation or downward direction. The disrupted global supply and recent price recovery led Goldman Sachs to project price increase for the rest of 2016 and well into 2017 (projecting $60/barrel) speaking of a long-awaited ‘physical rebalancing of the oil market’. Citigroup projects $65/barrel in 2017. BP has revised its price projections for 2016 as well to $55 instead of the previous $50/barrel.

Finally, despite the growing disinvestment movement hedge funds have been accumulating cheap oil stocks since January to an unprecedented level of 420mb of crude. While investors are growing increasingly confident that the global supply glut that has depressed prices is starting to ease, the expectation of a production rise in the US, the quieting wildfires in Canada and somehow re-established production in Libya might reverse the stock accumulation curve. While not probable at this stage, a profit-taking decision might prompt rapid selling and flood the market, leading to downward price spiral and a new cycle of depressed prices.  

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