So When Will Markets Rebalance?

Over the past several weeks, a fundamental shift has appeared to happen in markets and in oil market commentators.  While there are certainly still skeptics concerned about market rebalance who continue to cite surging shale production as a principal culprit that will keep oil prices suppressed and the world in a constant state of oversupply, most of the commentators  now seem to be debating the question of when, rather than if, markets will rebalance.

The IEA’s monthly market report, released last week, suggested that the global oil market is “very close” to coming into balance.  The IEA forecasts non-OPEC supply will grow by 485,000 barrels per day, with U.S. production forecast to increase 680,000 barrels per day.  This alone means that other nations will see a decrease in production according to the IEA.  However, they also revised their demand growth forecast slightly downward by about 100,000 bpd.

As we noted in a prior Edition of The Five Star Standard, crude markets began an unanticipated plunge on February 21, and continued then tightened.  But then plunged between March 8 and 23.  However, they now seem to have regained their losses.  As of April 4, hedge funds retained on overall long position equivalent to 696 million barrels, with on overall ratio o long to short f more than 4:1.  Thus, markets still appear to have confidence that a rebalancing will occur, the question remains when.

As you may know or remember, markets trade in contango or backwardation.  Contango markets basically  mean that traders believe the market will be oversupplied in the future.  Backwardation markets are characterized by a belief that there will be a supply deficit in the future. In the chart above, we can see where the contract for a period of time was in a given month.  Positive means backwardation, and negative means contango.  If you look in November 2016, and the red line, you see that right after the OPEC deal, more traders moved the needle from almost $0.40 contango to less than $0.20 contango.  That means that the traders collectively were now betting more and more that oil would be positive by June or July.  

But when you look at March 2017, you see that number dramatically dropping.   You also see that the September/October and December/January 2018 contracts, while having fallen into contango from backwardation, are still pretty close to the line.  But again, that’s a change.  Optimism ran high November 2016-January 2017 that oil markets would reach balance by Third Quarter.

I suspect that we see oil markets tightening more than is readily apparent.  Famous oil bull Pierre Andurand sees oil going back up to $70 a barrel.  Interviewed by CNBC on March 31, 2017, Mr. Andurand stated, “I think oil prices are likely to recover to around $70 … I think the market will switch to backwardation – sustainable backwardation – by late summer and that will bring the next wave in oil prices”.

Similar comments were made by Saudi Arabian Oil Co. CEO Amin Nasser a few days ago.  Mr. Nasser said that global oil markets are moving closer to balance even as increases in U.S. oil production have pushed prices down in the short-term. 

This is not a good indication of where the market is likely to be headed going forward, as the large new production capacity and investment we will need in the future are lagging,” Nasser said during an event at Columbia University. “While the short-term market is pointing to a surplus of oil, the supply required in the coming years is falling behind.

Many indicators are pointing to a more balanced market, Nasser said. The combined inventories of countries in the Organization for Economic Cooperation and Development are flattening and poised to drop, among other signs that the market is tightening, he said.

Additionally, OPEC seems poised to continue output cuts.  According to an April 20, 2017, Reuters article Saudi Arabia and Kuwait have given clear signals they plan to extend production cuts into the second half of the year.   According to Saudi Oil Minister Khalid al-Falih, there is building consensus amongst producers that the output cuts should be prolonged, but indicated that not all producers were on-board yet.  Kuwait's oil minister Essam al-Marzouq also said he expected the agreement to be extended.  Interestingly, OPEC may consider Iran’s desire to raise production as a non-issue as one source indicated they realize Iran faces structural barriers that may thwart any attempts to raise production according to an OPEC source cited by Reuters.  (http://www.reuters.com/article/us-oil-opec-idUSKBN17M0MY).

While inventories remain high, and traders are skittish of shale ruining the party, worldwide production has not recovered nearly to the extent the U.S. has.  This means that as Mr. Kilsgaard suggested (as discussed in this Week’s article on U.S. Oil data),  world decline rates may be taking oil offline at rates faster than suggested.  With U.S. inventory data skewing the true results of OPEC’s cuts, and other indicators seeming to demonstrate worldwide inventories diminishing, oil markets may be closer to reaching balance than we think.

The prevailing wisdom of the hedge funds seems correct: that the true correction will occur later rather than sooner.  However, we are just a month or so away from the start of the summer driving season in the United States.  During that time, I suspect we will begin to see inventory depletion here at higher rates.  Until then, while oil is always unpredictable and it is always possible that we won’t reach balance or a supply shortfall, I think we are on track to do just that.  

By: Ty Chapman
Five Star Metals, Inc.

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Twitter: @FSM_TY
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