Crude's new normal
Has crude oil found a long-term top, or is a rally back to the bad old days (for consumers) of triple-digit crude oil prices in the cards? While no one we talked to is expecting $100-per-barrel-crude, there is an argument over whether the current range of $50 to $55 represents a new high, a rest stop in a longer-term rally, or the new normal price level (all things relative).
Like the futures markets structure themselves, the world of energy — crude oil in particular — has been shaken up so much in the last decade that no one knows what normal looks like.
Is normal the period between 2007 through 2014, when crude spent all but a few months above $70? Or is it the decades prior to the 2007 spike when it never breached $40? (See “Crude: A price history,” below).
The best answer most likely is that the market is still trying to figure it out. Despite all of the shocks of the past decade that roiled the markets — the Iraq wars, 2008’s spike and collapse, the threat of Middle East conflict, the threat of Middle East peace (lifting of Iran sanctions), the fracking revolution and the OPEC (Saudi Arabia) market share war — crude oil has stuck close to a long-term trendline tying the 1998 low to the 2001 correction low to the 2008/09 reversal low to the recent extended move lower.
The market has clung to that trendline since breaking it in January 2015 (see “Crude magnet,” below).
End of rebound or new bull?
“Last year, I predicted a 105% increase on the year; it did double,” says Price Futures Group Energy Analyst Phil Flynn. “Right now there is a pause in a major bull market. If anything, we are going to see $70 before we see $30.”
He bases this on the effect of the OPEC production cuts and the likelihood they will be continued for another six months. The cuts, approved in January and agreed to by some non-OPEC producers including Russia, total 1.8 million barrels-per day (bpd). Compliance has been high.
Still, crude price doubled in 2016 and producers’ ability to sustain lower prices was stronger than most analyst expectations. “It is going to be a tough environment for crude to sustain a rally,” says Jason Rotman, partner at Lido Isle Advisors. “It is basically balanced at around $50. I don’t see an impetus for a big move. It could go down because of supplies and the geopolitical situation
relative to oil has been news-free.”
Flynn adds, “They knocked the shale players down. They are still behind where they were. The Saudis feel they have regained enough of their market share that the shale guys are not as big of a threat because now the demand growth curve is going to continue to rise.”
The Saudi’s market share play was painful; will cuts work better? “The reason why Saudi Arabia changed its strategy in November is because its strategy failed,” says Dominick Chirichella, partner at Energy Management Institute. “[It] did not solve what they thought it was going to solve.”
He adds, “They spent several years at relatively low prices. Now there are much higher prices. Yeah, they gave up some market share, but having more volume at $30 oil is not as good as having a little less volume at $50 oil or a little higher.”
Demand has taken a back seat in the battle over crude but may be making a comeback. “Economic growth has not been great but is getting better,” says Carl Larry, president of Oil Outlooks and Opinions. “Every year is going to add [more demand].”
Larry expects crude to reach $65 by mid-summer. “We are seeing many rigs being added, but the production that comes from these rigs is a lot lower per rig than we have seen in the past few years. The rigs are coming up because credit is still cheap,” he says. “Looking forward as rates are increased, there are going to be a lot more people having a harder time finding money to get those things going. That will help support crude oil prices.”
Flynn argues that the added shale production since crude doubled from its early 2016 low has not made up for the OPEC cuts and won’t be able to, especially if demand increases. “They added about 400,000 barrels. You are now 1.1 million bpd short; you add a million barrel a day in demand and you are 2.1 million in the hole. The Energy Information Administration (EIA) says they may add another 300,000. You are still not meeting what OPEC took out.”
He adds that contango is starting to widen; a sign a supply deficit may be on the way (see “Where is price headed?” above).
In February, WTI set an 18-month high close near $55 before proceeding to drop 15% on record inventory levels. The sell-off was due to record inventory levels but did not last as crude recovered most of its losses by mid-April (see “Crude glut,” below).
“In (early-March) we had this inexplicable build in crude oil supplies,” Flynn says. “It was like 12 million barrels and the market didn’t recover because the funds were long and once it broke below that trendline it did huge technical damage.”
Flynn is still bullish, but acknowledges that the trendline in “Crude magnet” is a key; “It has to get back above that trendline, [roughly $52 per barrel].”
One of the reasons for Flynn’s — and others’ — bullish outlook is OPEC’s fidelity to the production cuts they agreed to in January. But despite the surprising fact that OPEC was staying disciplined, and more surprisingly non-OPEC producers like Russia, who agreed to scale back production, inventories continued to grow. “The funds kept looking for inventories to start breaking because we knew that OPEC was complying on production cuts,” Flynn says. “The first couple of weeks when we had big builds, and the funds were all long and they were buying, we continued to have these big builds.”
Daniel Shaffer, president and CEO of Shaffer Asset Management, points out that commercials have a high net-short positon and open interest has reached record levels. “Historically, high net-short positions by the commercials and high open interest is bearish for prices. Based on price and time measurements along with positioning, we remain bearish,” he says. “Fundamentally, there is too much oil in the world.”
However, the nature of the sharp rebound in April, going into a strong cyclical period for crude along with the likelihood OPEC will extend production cuts, has some analysts bullush. “We made a short-term bottom,” Chirichella says. “We’ve seen so much fundamental information picking up; we’ve had two weeks in a row (by April) where total U.S. crude oil and product inventories have declined, which is favorable. Compliance is still running high within OPEC and compliance is up outside of OPEC. Russia is less than 100,000 barrels-per-day off meeting its cut. All these things are positive; they all are saying the right thing regarding extending the deal, so the information flows are changing.”
However, all things aren’t bullish. “There are still a lot of headwinds we have to face,” Chirichella says. “Oil rigs continue to rise, U.S. oil production continues to rise, now to the extent we get a perk up in demand [will determine] where we go.”