The oil market is becoming extremely tight as consumption outstrips production, and traders expect it to tighten even further over the next six months.
The balance between production, consumption and inventories is intimately connected with the shape of the oil futures curve.
If consumption is expected to exceed production, and inventories are already low and falling, spot prices tend to trade at a premium to forward prices.
The premium for spot prices over forward prices, known as backwardation, acts as a signal to conserve remaining stocks as much as possible.
The premium for spot prices is intended to boost supply in the short term while encouraging consumers to defer purchases.
Backwardation is the most important and reliable signal of a tight and tightening oil market. Front-month Brent futures have recently been trading in a backwardation of more than $3.40 per barrel over the seventh-month contract. The current backwardation in Brent is among the most extreme in the last quarter of a century and in the 91st percentile of all trading days since 1992. If the backwardation was confined mostly to one or two months, it could be dismissed as an aberration or a sign of market manipulation.
But big backwardations are evident for all months through 2018 and 2019.
The increasing backwardation is consistent with statistics from the physical market showing oil inventories are becoming increasingly tight.
Stocks of crude oil and refined products in the OECD industrialised countries have fallen to just 43 million barrels above the five-year average, from a surplus of 340 million barrels at the start of 2017. If OECD stocks are adjusted for the rise in consumption, current inventories are now below the five-year average. Stocks are expected to decline even further in the second half of the year, which traditionally sees higher consumption.
Global oil consumption is expected to rise by more than 1.5 million barrels per day in 2018, mostly as a result of strong economic growth. Production from Venezuela is already falling. Traders are concerned about further output declines if the United States imposes sanctions on Venezuela and/or Iran. OPEC members have indicated they will not increase output before the end of the year, which will tighten the market further.
The oil market is currently on an unsustainable trajectory, with global demand growth systematically outrunning supply. If something cannot continue forever, it will stop, according to Stein’s Law, one of the most fundamental constraints in economics, popularised by Herbert Stein, the chief economic adviser to President Richard Nixon.
Logically, there are five ways in which the oil market can be moved off its currently unsustainable course and brought back towards balance:
1. Slower consumption growth (in response to higher prices, an economic slowdown, or a combination of both)
2. Opec and its allies lift their output
3. Supply disruptions (existing and threatened) ease
4. US shale output increases even faster than expected
5. Non-Opec non-shale output increases faster than predicted.
The most likely path to rebalancing of the oil market is likely to involve a combination of some or all of these factors. Global consumption is sensitive to price changes, albeit the response tends to be slow at first before accelerating later, and is notoriously slow to appear in the statistics.
The relationship between prices and consumption is highly non-linear. The higher prices rise and the longer they are expected to stay high the bigger the eventual response from oil consumers. Experience suggests by the time “demand destruction” is evident in the data, the oil market will be well on its way to the next slump (this was true in 2007/08 and again in 2013/14). Some of the actual and anticipated supply disruptions may ease, especially if the rise in oil prices causes the United States to hesitate before imposing tough sanctions on Venezuela and Iran or to leave loopholes.
US shale output is likely to accelerate further in the second half of 2018 and into 2019: the number of rigs drilling for oil is rising again in response to the increase in prices. Escalating prices should also filter through into increasing exploration, production and development in the non-OPEC, non-shale sector.
Finally, Opec and its allies may decide to start lifting their production, via a formal decision or a decrease in compliance, before the end of 2018.
The oil market is already tight and on track to get tighter. The backwardation is high and could rise even further. But experience suggests such large imbalances between production, consumption and inventories are not stable for long.
Something will have to give soon. Supply. Demand. Or both.