The Fuse

No Freeze: Oil Markets at a Crossroads

by Matt Piotrowski | April 18, 2016

It was no surprise that oil prices sold off sharply in the aftermath of OPEC and non-OPEC producers unable to reach an agreement to cap production, although the market has recovered most of those losses. The question is what happens next. With prices swiftly rebounding, it appears the market has already moved past the collapse of the freeze talks.

“Whether there was an agreement or not, it would’ve had no impact on fundamentals. It was all about market psychology,” said Mike Wittner, global head of oil research at Societe Generale in New York and former principal analyst at the International Energy Agency (IEA). “Looking forward, the market will shift back to U.S. production declines and the pace of the ramp-up in Iran.”

“Looking forward, the market will shift back to U.S. production declines and the pace of the ramp-up in Iran.”

A number of supportive elements should keep a floor under prices, while the market will be capped by the ongoing oversupply. For the time being, the market is set to remain volatile and range-bound with many competing factors pushing prices in both directions.

“The market is likely to backtrack to square one,” said analysts at Barclays, arguing that the focus will return to fundamentals.

NYMEX West Texas Intermediate (WTI) traded as low as $26 in mid-February and ICE Brent dipped below $30, but both rallied by as much as 50 percent on the back of talk of producers capping output, short-covering among speculators, the run-up to the U.S. driving season, and expectations for tighter balances during the second half of the year.

Supportive signals

While the sentiment turned bearish in the immediate aftermath of the failure of the freeze agreement, there are some bullish elements to watch out for.

While the sentiment turned bearish in the immediate aftermath of the failure of the freeze agreement, there are some bullish elements to watch out for. Prices are unlikely to retest lows reached earlier this year. For one, in the Brent market, the contango—when prompt prices are below future contracts—has narrowed and the June and July contracts are in parity, possibly indicating tighter fundamentals. Non-OPEC supply is starting to weaken, particularly in China, the U.S., and Mexico. Goldman Sachs, which sees prices averaging $58 per barrel next year, says non-OPEC supply will fall by 1.1 million barrels per day (mbd) in 2016. Inventories should begin to draw down in the coming months. Oil demand, meanwhile, remains robust, with expectations around 1.2 mbd for 2016—even though that would be 0.6 mbd weaker than year-ago levels. For now, too, the Kuwaiti oil strike has sliced output in that country by 1.6 mbd. The overall market effect depends obviously on how long the strike lasts.

Bulls, don’t get too excited

Despite some supportive signals, market bulls shouldn’t be overly enthusiastic about a sustained rally occurring. Traders will have to wait for the oil market to rebalance on its own since producers have shown they can’t agree to take any kind of action to shore up prices. Sunday’s outcome in Doha puts to rest any action at the next OPEC meeting in June.

“If agreeing to a freeze of output among producers whose output is close to capacity is proving this difficult, then this exercise shows to the market that achieving a cut, should there be a need for one in the future, will be almost a non-starter,” said Barclays.

While non-OPEC supply is declining, the losses will be partially offset by rising output in OPEC. For instance, Goldman puts OPEC supply growth at 0.6 mbd this year and 0.5 mbd in 2017. Furthermore, in the U.S., supply is falling at a slow pace and may bounce back if prices strengthen. With regards to inventories, although stocks are set to fall, they are still near record levels in the OECD, providing a robust cushion against supply shocks, output declines, and demand growth. At the same time, demand growth is not getting the stimulus from low prices like last year since motorists and the global economy has adjusted. Perhaps even important, the International Monetary Fund (IMF) gave stark warnings in its world economic outlook last week.

Funds to liquidate soon?

One big bearish indicator is positioning among hedge funds and other speculators.

One big bearish indicator, too, is positioning among hedge funds and other speculators. As of now in WTI and Brent, they are net long by 608 million barrels of oil, the highest level since July 2014. If many of these players liquidate en masse, oil prices would come off sharply. “It’s really just a paper play at the moment,” said a trader. “There are always lots of plays until they panic and have to get out.”

specsfreeze

In middle of February, once prices hit their bottom and news of the production freeze surfaced, speculators closed out of their short positions, causing prices to rally. At the same time, more traders went long, betting on higher prices. Traders had high hopes the freeze would be agreed upon to ultimately speed up any rebalancing. But some traders got cold feet ahead of the Doha meeting, buying a large amount of put options to protect against a move to the downside. The tension between Saudi Arabia and Iran, along with failed OPEC meetings in the past, such as the ones in December 2015 and November 2014, led some traders to short the market ahead of this past weekend from their lack of trust in the cartel to effectively manage the market.

Recently, Goldman Sachs analysts said that the oil market would be “trendless and volatile” and trade in a range of $25-$45 for the second quarter, before rising. Given that there are so many contradictory signals and the market is always full of surprises, they are still correct, for now at least.