Crude Oil is an essential component of economic life- nearly everything that gets moved, does so using either oil directly or a derivative thereof; (until such time that Drones become more widespread). It is therefore a good indicator of economic growth, which investors will do well to watch. It has been quite a wild ride over the last 5 years.
After a big fall from over $111 dollars a barrel in 2013 to just $28 dollars 3 years later, Oil prices have seen a steady rise back up to over $65 this week, with the Dollar’s weakness providing a tailwind, as more signs emerge of a reduction of the huge inventories built up over the last few years. The OPEC deal to curb production, which was extended in late 2017 has led to some analysts suggesting that $70 a barrel may be reachable in the near future according to analysts, as stockpiles are drawn down amidst strong economic growth and production discipline amongst producers.
But the wildcard remains the US Shale oil industry, which has responded to price rises by increasing its output to offset the effects of OPEC’s restraint. According to the industry US Oil production will continue to rise, for the foreseeable future, with total output set to rise above that of Saudi Arabia, to reach a par with that of Russia. So far, the Saudis (who control OPEC), have not responded in kind; they have indicated that production curbs may be eased next year (2019).
However, US producers have ramped up their output, with the “Rig Count” (the number of Oil rigs in operation), rising to levels last seen in June 2017 in response to WTI (West Texas Intermediate) price gains (see graph below). Speculators too have become extremely bullish in recent weeks, establishing the highest level ever. The last time they had similarly extreme positions was in January 2017; thereafter prices fell from around $54 to $42 in the space of 5 month .
The question is what happens next.
Historically, (i.e. in the last 10 years or so), it appears that $80 a barrel is too high; the oil industry splurges on new drilling, too much capacity is added, and costs rise, leading to competitiveness problems. As the price gets towards $80, consumers cut back and demand drops.
$40 on the other hand seems to be too low; cash flows dry up and investors withdraw capital from firms, leading to production cuts, unemployment and lower output. Consumers respond to the price signal by increasing their consumption and the cycle re-news.
So, in theory, “market balance” would be achieved around $60 a barrel. But it is a bit more complicated than that, US cost-curves (the level at which producers “break even”) have dropped sharply in recent years from over $60 a barrel in 2014, to around $40 now (according to the World Bank). This of course means that the price will have to fall further than previously to induce production cuts from US Shale drillers.
How will we know when prices are set to decline once again? Look at the Oil futures market and the price curve. Under normal conditions (if there ever any such), the market will have higher prices for contracts that expire further into the future (so June 2018 futures will be more expensive than the current spot market price and December 2018 futures will be more expensive still). This reflects the fact that storage costs/insurance etc. must be paid for (implicitly by the buyer). But supply and demand can trump this, so there are times when prices for future months are lower than spot prices called “backwardation” due to reductions in inventory levels, prompting investors/users to pay more for oil now, rather than later. This is now the case, with, for example June 2019 oil trading nearly $7 cheaper than spot prices, reflecting a desire to buy oil now, rather than later.
If the futures curve were to invert back to Contango, this would suggest supply is rising to meet demand (pushing the spot price down) and may indicate a trend reversal. Under what circumstances might this occur? The resolve of OPEC members, not known for their forbearance when it comes to increasing their market share, will be tested once inventories have eroded and prices go higher. The temptation to “cheat” could be overwhelming, leading to the collapse of the current deal on production especially if they see US Shale Oil firms taking both market share AND higher profits from current price trends.
There are no real “experts“ in oil markets (or any other for that matter). Even former Oil industry titans have been humbled in recent years, so making predictions is even more fraught than usual. So, it can be safely assumed that more money will be made advising on market movements than acting on them. Plus ca change…
 This is NOT an exact timing tool- but as Speculators are “trend followers”, they tend to be the most bullish at highs (and vice versa). Once prices move far enough the “wrong” way for them, they start to liquidate positions, exacerbating the movement (and the intensity of it).
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid-1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He also shares responsibility for the portfolio management of EBI’s Varius funds. He qualified as a Chartered Financial Analyst in 2005, and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at firstname.lastname@example.org.
Providing Investment management & supporting resources to a select group of UK and European financial advisers who have embraced evidence based investing.