Why The Oil Rally Isn’t Over Yet

By Nick Cunningham

Drilling

Crude oil sentiment is shifting in a bullish direction, with OPEC+ cuts and a growing list of serious outages taking supply off of the market.

Saudi Arabia recently signaled that it would slash its production to just 9.8 million barrels per day (mb/d), or about 0.5 mb/d more than required under the OPEC+ deal. That would take Saudi production down to close to a four-year low, a sign that Riyadh is aggressively trying to push up oil prices.

That is significant, especially since Russia is not really carrying its weight. Russia cut output by 42,000 bpd in January, according to Bloomberg, only about one-sixth of its promised 230,000 bpd reduction as part of the deal.

But Saudi Arabia is more than making up for its lagging partner. Meanwhile, the outages in Venezuela could mushroom in the days and weeks ahead. The crisis is fast-moving and the precise amount of oil that is knocked offline will be tricky to gauge, but it’s a safe bet that the losses will mount.

Iran could also add to the supply woes. U.S. Vice President Mike Pence was met with a frosty reception at the Munich Security Conference in recent days, as the Europeans are loath to cooperate on Washington’s “maximum pressure” campaign. Pence had expected several of his lines to be met with applause, but instead they were met with awkward silences.

Nevertheless, U.S. foreign policy has grown much more aggressive in the year since Mike Pompeo became Secretary of State and John Bolton became National Security Adviser. The U.S. still hopes to zero out Iran’s oil exports, although that could prove tricky as the oil market is tightening up.

More recently, an unexpected outage at a Saudi offshore oil field has added to the supply outages.

Meanwhile, President Trump appears to be warming up to a trade deal with China. Over the weekend he tweeted “Big progress being made on soooo many different fronts!” in the negotiations with China, which suggests that both sides are eager to dial down the tensions. The March 1 deadline is fast approaching, but the odds of a major hike in tariffs seems to be waning.

All of this is boosting bullish sentiment in crude oil. Major hedge funds and other money managers increased their bullish bets on oil futures at the fastest rate in nearly six months on February 12. “Many of the worries we’ve had about demand have dissipated,” Bart Melek, head commodities strategist at TD Securities in Toronto, told Bloomberg. “That’s convinced people to strap on some risk again.” Brent oil prices are at three-month highs.

Of course, further gains are not inevitable. “We view the current price rise as exaggerated and see growing correction potential. The fact that oil production in the US is currently rising significantly more sharply than previously expected is being completely ignored at present,” Commerzbank wrote in a note. The EIA recently revised up its forecast for U.S. oil production growth for 2019 by 300,000 bpd, estimating production at 12.4 mb/d for the year.

The largest downside risks to oil prices can likely be chalked up to a combination of the potential for a global economic slowdown, weaker demand, and rising U.S. supply.

But there is also the risk that Saudi Arabia becomes fed up with non-compliance by Russia, especially if unilaterally cuts are only met with surging U.S. shale supply. Saudi Arabia won’t want to shoulder the burden of balancing the oil market forever. Riyadh is running sizable budget deficits and is turning to the bond markets to fill the gap. If production cuts are not met with higher prices, the pain will grow. “Hence Saudi Arabia will not keep turning the spigots off if it is not succeeding in supporting prices, either because of poor compliance from other OPEC+ members or if US production was to rise enough to pour cold water on their efforts from last Dec’18 decision,” JPMorgan Chase wrote in a note.

For now, Riyadh will want to let this strategy run its course. So far, prices are up sharply this year, offering some evidence that the cuts are working. The supply curbs have already begun to drain off the surplus. Meanwhile, aggressive U.S. foreign policy will also contribute to a tighter oil market.

By Nick Cunningham of Oilprice.com

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