Market analysis: Output freeze was a red herring

Railroad tanker cars sit outside the Paulsboro Refining Company in New Jersey. Declining US crude production provides more evidence that the market is rebalancing. Luke Sharrett / Bloomberg

The oil market absorbed the disappointment from the Doha producers meeting much better than many had feared. The dip in oil prices that followed immediately after an output freeze failed to materialise was short lived, with oil prices subsequently rallying sharply, suggesting that the issue of freezing production at already elevated levels was something of a red herring when Opec production is already close to its limit, and in the context of the much bigger issue of the global demand and supply imbalance.

The limited reaction and subsequent strong bounce in prices suggests that this imbalance is gradually improving, with the markets becoming more confident that oil prices at about US$40 per barrel are a closer reflection of fair value, relative to the $30 area that was tested in January. The omens heading towards the second half of the year are more favourable as well.

Oil prices have moved strongly up from their January lows, with Brent futures having added $18 per barrel (more than 70 per cent) since hitting $27.88 per barrel at the start of the year. The narrative around this rally was that it was mainly because of the market being “talked up” on anticipation of a production freeze this month, following the initial four-country freeze announced in February. However, in hindsight it also had to do with other things – most importantly a tightening in the US oil balance, where crude production is down by 250,000 barrels per day since the start of the year and more than 650,000 bpd since the peak last year. US production is now below 9 million bpd, which would have been unthinkable only a few years ago.

A softer dollar has also been partly responsible, with the US trade weighted dollar index down by 5.2 per cent from January’s highs. Also new “outside” supply risks have become apparent. Although the Kuwait oil workers’ strike did not extend beyond a few days, it has created a new risk in investors’ minds about potential for supply disruption, with other countries potentially at risk from similar disruptions.

There are still some reasons to remain wary, however. Despite the progress being made in reducing US oil supply, oversupply is in general clearly still a significant issue. Opec has added nearly 1 million bpd since March last year, mainly thanks to Iraq, Iran and Kuwait, but Saudi Arabia and the UAE have also added 180,000 bpd between them. Russia has added 220,000 bpd in the past year, while Oman is now ticking closer to 1 million bpd total output.

The outstanding inventories imbalance is also an overhang to progressive price improvements. Despite drops in US product inventories over the past few days, US crude oil inventories are at 536 million barrels, more than 140 million barrels higher than their five-year average. The US consumes about 19-20 million bpd of oil, meaning inventories account for about one month of extra demand, well above the level of about 20 days that held from 2012 to early last year.

It is not just an American story. Product inventories in Europe and Singapore are at elevated levels. Demand is performing well but it is not enough to burn through production plus the excessive inventories.

Finally, there is a danger that too quick an oil price jump might risk bringing shale producers back into the market, increasing overall volatility in the process. Shale producers surprised on the upside when prices were falling and they may do the same if prices rally too fast and too much. The exact timing is unclear, but a run-up to $50 per barrel could allow shale and other high-cost producers to pile back into the market.

These dynamics are going to persist at least until the end of the year, particularly on the issue of inventories. Markets have responded positively to the latest developments, with the front of the Brent curve having flipped into backwardation. This looks a little too bullish and premature for the moment, as it is hard to see how much more prices can rise considering glutted inventories around the world.

Tim Fox is the chief economist and head of research at Emirates NBD and Edward Bell is a commodity analyst at the bank.

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