Why This Year’s Oil Rally Might Be for Real
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At first blush, the rally in oil to start 2016 bears some resemblance to the rally at the start of last year, which ultimately ended in tears.
This time, though, analysts at Citigroup Inc. led by Seth Kleinman say the rally has legs.
“The extra year of low prices has finally derailed the supply resilience that defined markets last year,” writes Kleinman.
A big factor differentiating this year from last year is what the markets are expecting a few months from now. Kleinman and his team point out that 24-month West Texas Intermediate (WTI) futures are currently around $49 a barrel, versus the $65 a barrel seen in the second quarter of 2015. If the futures market doesn’t expect the price to rise, producers can’t lock in a profit like they might have at $65. If you can’t lock in a profit, you can’t produce as much and thus the supply should theoretically fall. This has led some analysts and economists to say the futures price is far more important than the current or spot price.
“To keep all capital sidelined and curtail investment in shale until the market has rebalanced, we believe prices need to stay lower for longer,” Jeff Currie, head of commodities research at Goldman Sachs Group Inc., wrote in early 2015. “As short cycle shale production is a 12-month investment proposition, producers typically hedge out 9 to 12 months…As a result, the market anchor is shifting to this ‘one-year-ahead’ swap which creates the level of investment to balance future physical markets. It is therefore this forward price that needs to remain below full-cycle costs to curtail investment, not the spot price.”
While U.S. supply was a big driver last year, it’s time to look at supply outside of America. The analysts note that U.S. production peaked last April, and supply outside the country is now significantly impacted by low prices. This is important because it’s much harder for other countries to get drills back online than in the U.S. Due to the nature of shale, once oil prices start to rise, U.S. producers can quickly ramp up production while other countries can’t.
“[T]he list of countries with declining supplies has grown rapidly: Brazil, Mexico, Colombia, China, Azerbaijan and others. Total non-OPEC oil production (excluding the U.S.) fell year over year in February and March (-105,000 barrels/day and -142,000 barrels/day, respectively) after rising for the prior 33 months,” Kleinman and his team wrote. “This dynamic is particularly important, because unlike shale, these supply declines are much harder to reverse in the short- or even medium-term.”
To be sure, the team at Citigroup doesn’t expect a massive rebound in oil prices either, due to risks such as Saudi Arabia’s continued unwillingness to budge on production: “Saudis are not looking to reduce oil production under the current market conditions and if anything are likelier to be putting more barrels on the market. This is probably the biggest bear risk to oil markets right now.”
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