Oil prices charge higher, but rally has an expiration date

  • Oil prices stage impressive rally, driven by a classic supply shortage

  • This occurred despite worries of lower demand from Europe and China

  • Risk is that US ramps up production, putting an expiration date on this rally

Crude deficit

Oil prices went through the roof in recent months as the market encountered a serious supply deficit, courtesy of Saudi Arabia and Russia. The two nations slashed their oil production, cutting around 1.3 million barrels per day until the end of the year, in an attempt to drain global inventories and boost prices. 

Their efforts were successful. Inventories in the United States have fallen to their lowest levels in four decades, lifting Brent and WTI crude prices by 25%% and 28% respectively this quarter. The sharp drop in inventories partly reflects the political decision to deplete the nation’s emergency oil reserve, but even so, there are plenty of other signs the oil market is undersupplied. 

One of these signs is the backwardation in crude oil futures. In plain English, that means prices for short-term oil contracts are higher than longer-term contracts, as traders are willing to pay a premium for supply delivered immediately. This is a testament to the ongoing scarcity. 

Demand outlook is grim

What is striking is that this relentless rally has taken place even amid concerns about lower demand from China and Europe, the two largest oil consumers in the world after the United States. These two regions are grappling with a severe slowdown in economic growth, which paints a softer outlook for oil demand. 

In fact, this was the reason why Saudi Arabia and Russia decided to cut their production in the first place - they were concerned about demand weakness pushing prices lower, and tried to offset that with less supply. It turns out they reduced production so much that prices not only stabilized, but cruised higher instead. 

An increasingly tight oil market has seen speculators return. Funds and other big players have raised their oil exposure to the highest levels in more than a year, chasing the rally. This indicator is backward-looking and therefore holds little predictive power, but it still shows that there’s institutional interest behind the latest moves. 

Eurozone and Japan seem vulnerable 

Rising oil prices have repercussions that stretch far beyond energy markets. Higher fuel costs dampen economic growth as they squeeze consumer budgets, and simultaneously stoke inflationary pressures. 

Economies that import their energy from abroad are particularly vulnerable to these effects. In this sense, the Eurozone and Japan are the most exposed. Both nations import almost all their energy, so their currencies tend to suffer in a regime of high fuel costs, as their trade surpluses are eroded and economic growth takes a hit. 

In other words, a continuation of the rally in oil prices would have negative consequences for the euro and Japanese yen. 

Rally can stretch further, but risks loom

As things stand, there isn’t much on the immediate horizon that can push prices significantly lower. The oil market will likely remain in a supply deficit for the remainder of the year, which argues for some further gains in prices, especially when considering the depletion in inventories. 

That said, the longer-term picture is not so bright. American producers have already started to raise their supply in response to higher prices. The US is the largest producer in the world, and its oil output is currently near record levels and rising. It will take some time, but if this trend continues and US production hits new records, it will help to plug the hole in supply and cool prices off. 

Coupled with the risk of demand weakness over the coming year - as business surveys increasingly warn that the global economy is slowing down - it seems that the rally in oil prices has an expiration date. 

Arguing in the same direction is the easing of tensions between the US and Iran. Although the nuclear negotiations between the two nations have stalled in recent months, there has been some political progress, with a mutual exchange of prisoners and the unfreezing of some Iranian funds taking place this week.  

Even if US sanctions on Iranian oil exports are not officially lifted, it seems that the US is no longer enforcing those sanctions as strictly as it used to, something evident by the recent surge in Iran’s oil production and exports. Hence, there might be other sources of supply hitting the market beyond US production. 

In short, oil prices have risen so sharply because a shortage of supply overpowered concerns about softer demand. The theme of undersupply will probably continue to dominate in the coming weeks, but over longer time horizons, it seems that a return of supply and softer demand conditions could put the brakes on this rally. 

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