Crude oil market: too much good news in the price

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Crude oil prices have rallied by close to 20% this year, marking the biggest gain within the commodities asset class and the steepest rise among the liquid assets that macroeconomically oriented investors monitor closely (Exhibit 1).

Macro fundamentals have supported oil prices and so have geopolitical developments. However, after such a strong rally, we believe there is too much good news in the price.

Exhibit 1: Crude oil has been the star commodities performer this year (2018 year-to-date total returns)

Year to date total returns crude oil

Source: Bloomberg, as of 22/05/2018

Demand outlook: crude oil is benefiting from a maturing economic cycle

Commodity prices in general and crude oil prices in particular typically do well in the mature part of an economic cycle. This is usually the case when growth is above trend and inflation starts picking up. In other words, growth is strong enough to put upward pressure on scarce resources such as commodities.

Unlike equity prices, which discount earnings and dividend prospects, commodities are an asset class where spot prices reflect the clearing of demand and supply ‘today’. This means that as the business cycle matures, demand for commodities increases and so do their prices.

After the sharp correction in oil prices in 2014-15, investors were sceptical about whether prices could experience a persistent rally. This was largely because of the efficiency gains in the extraction of oil from US shale fields that led to the build-up of large crude inventories in the US.

As demand recovered in the past few years, those inventories have begun to fall again (Exhibit 2). The growth recovery in other developed economies and more recently in emerging markets also supported crude demand.

Exhibit 2: US crude inventories falling as demand recovers

US crude oil inventory levels

Source: Bloomberg, as of 22/05/2018

Supply: strong in the US and restrained in OPEC countries

On the supply side, there are three principal forces at play.

  • First, US shale oil production remains strong and continues to be the main driver of US production (Exhibit 3). According to Department of Energy data, crude output rose by 8.5% this year to end-April, after increasing by 12% in 2017. This trend could continue as higher prices incentivise shale supply. A crucial question is whether the low-cost phase of extraction is coming to an end as shale production hits bottlenecks such as pipeline constraints, scarcity of production inputs and more challenging oil fields.
  • Secondly, since OPEC extended its production cuts until the end of 2018, its production has surprised further to the downside, especially in Venezuela and Angola. Iran has become an additional source of concern after the US withdrew from the JCPOA[1]. This may put Iran’s production at risk. For now, Saudi Arabia has filled the gap, compensating for most of the losses from these OPEC producers.
  • Thirdly, the threat of escalating geopolitical tension in the Middle East is supporting crude prices. This premium is difficult to measure, but perhaps the most visible signal is the rapid rise in crude prices since early May. Since then, other fundamental factors have not really changed.

Exhibit 3: US crude oil production continues to rise

US crude oil production continues to rise

Source: Bloomberg, as of 22/05/2018

Global crude market currently in deficit, but macroeconomic risk could tip the balance

Given our baseline estimates of robust demand growth and moderate supply growth, we expect the global crude oil market to remain in deficit for the remainder of 2018 and potentially into 2019.

We see two major macroeconomic risks to this central case.

  • Firstly, demand could disappoint, notably in the non-OECD bloc. This accounts for slightly more than half of global demand. China, for instance, accounts for about 22% of non-OECD demand and its growth rate has been flat since early 2017.
  • The second principal risk, in our view, is higher-than-expected inflation, notably in the US. This could reflect strong growth, which supports crude demand, but could also cause the Fed to tighten monetary policy and bolster the US dollar.

We struggle to see Brent crude prices materially above USD 80/bbl (close to current spot prices) in such an environment. As such, we believe the risk/reward for crude prices is currently skewed to the downside.

Crude prices have already discounted our central case of a tighter market and an increase in the geopolitical risk premium. There is thus a decent chance that prices have risen too far relative to the fundamentals.

In fact, some market indicators are already showing that prices are vulnerable to a correction.

  • Firstly, crude prices have risen by about 20% this year, which is much stronger than most risky assets and certainly than most other commodities.
  • Secondly, positioning (according to futures contracts for West Texas Intermediate (WTI) crude oil) is long and historically stretched (Exhibit 4).
  • Thirdly, our technical analysis suggests that, considering weekly and monthly cycles, crude prices could peak in the next few weeks. In addition, our analysis of quarterly cycles suggests that crude prices are likely to face resistance as they are approaching the 20-quarter moving average.

Exhibit 4: Analysis suggests investors are overweight WTI futures and stretched on a historical basis (2010-18/05/2018; weekly WTI positioning, 3-yr rolling z-score)

WTI positioning 2010-2018

Source: Bloomberg, as of 22/05/2018

Asset allocation: crude oil prices look vulnerable

Conditions in the crude market have tightened fundamentally. This could persist into 2019, but prices have gone a long way in discounting good news on demand and supply. The balance of risks is shifting towards a re-alignment with other growth-sensitive assets. After such a strong rally, long/stretched positioning and technicals showing signs of peaking in the coming weeks, we believe the risk/reward profile for crude oil prices looks skewed to the downside.

[1] The Joint Comprehensive Plan of Action between China, France, the UK, US, Germany and Iran – the ‘Iran Nuclear Deal’

Guillermo Felices

Senior Market Strategist, Multi Asset Solutions

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