- Crude oil remains sensitive to supply, which has caused rising prices in recent times
- Supply has been limited by OPEC and adverse weather in 2017, helping stocks to keep falling
- That picture could change in 2018, as US crude supply comes back online
Last week, we examined how crude oil prices have been strongly influenced by narratives surrounding falling supply. Looking at recent history, the bull market in crude collapsed in 2014 as US shale flooded the market with new supply, resulting in much higher supply relative to demand. Prices then bottomed in Q1 2016, once US supply growth went into reverse. With WTI hovering around $30 at the time and a simultaneous slowdown in US junk bond markets, few US shale oil producers could raise financing or produce positive cash flow from their operations. US crude supply thus fell as a result.
While crude oil remains down year-to-date in 2017, the commodity has been recently strengthening thanks to falling stocks. As crude stockpiles fall around the world, markets have become more sensitive to cuts in supply. Unsurprisingly, the latest military operation in Iraq’s Kurdish region has helped prices rally in the past week. Our medium-term outlook is now bullish, and our view is that crude oil prices can keep rallying in 2017. Given strong global demand and relatively weaker supply growth, inventories should continue falling for the rest of the year. While this dynamic is likely to flip in 2018, for now the crude oil rally looks intact.
Falling stocks to support crude oil in Q3/Q4 2017
Given strong demand and weak supply this year, stocks are forecast to keep falling for the next few quarters. This is shown below:
With stocks set to keep falling, supply narrative alive and well
Picture in 2018 and beyond less certain
With the effects of adverse weather hurting US supply and strong economic growth in the US, Europe and China driving demand, crude oil prices look set to keep rising in 2017. While US shale supply is likely to start accelerating this quarter, its full impact will not be felt until 2018.
The obvious caveat, based on the projections above, is that these drivers will flip in Q1 2018 based on the IEA’s estimates. Ongoing hedging activity in US futures markets suggests that shale oil producers can profitably supply crude at today’s prices, while demand growth is likely to slow in emerging markets including China. While there is some hope that US demand could increase if Trump can get tax reforms through Congress while enacting a fiscal spending program, US demand is unlikely to outstrip US supply. Once crude inventories start building again in Q1 2018, the 'falling supply' narrative will fall apart. At that point, the commodity is likely to enter another bear market. For now, the current rally can keep going.