The Price Rally Right Around The Corner

Oil’s rally has seemingly hit a wall at $40 a barrel. Concerns about demand due to increasing rates of coronavirus cases are taking a toll, but oil’s ability to hold near $40 despite headwinds bodes well for the market.

A better sign was that crude futures contracts recently flipped into backwardation for a spell this month. Backwardation is the market dynamic where the current price is higher than the futures price, and it typically occurs when there’s a supply deficit. 

Backwardation sends a signal to refiners to draw cheaper barrels from storage rather than purchasing new ones on the spot market. That action is critical to reducing the massive inventories built up this year during the Covid-19 demand shock. 

Evidence that global inventories, which the International Energy Agency estimated earlier this year at a record 4.2 billion barrels, are being whittled down is necessary before crude prices can move closer to $50 a barrel.

The oil market became so oversupplied earlier this year that producers and traders resorted to storing oil offshore on tankers as onshore facilities neared capacity.

Now, this oil in floating storage is draining fast as the oil market has substantially rebalanced through massive supply cuts by OPEC-plus alliance producers and market-driven curtailments by North American producers. 

Although the recent flirtation with backwardation proved brief, it was significant because it followed six months of “super” contango conditions – where oil for immediate delivery costs far more than future delivery contracts.

That structure encourages market players to store crude because they can sell it later at a higher price and earn a more significant profit. 

The flattening of this forward curve is bullish for oil as analysts expect a sharp supply deficit in the second half of the year, barring another demand shock or a breakdown in OPEC-plus member compliance. 

According to IEA forecasts, stockpiles are on track to diminish rapidly over the next six months, and – in theory, they decrease during each quarter of 2021. Next year, global demand is on track to exceed supply, with the projected recovery in oil production to be less than a third of the increase in fuel use, at 1.7 million barrels a day.

Investors and commodities analysts are on the same page. Bank of America now forecasts that “a pattern of falling inventories across most regions should emerge as we move into H2 2020. As a result, we expect the full Brent crude oil curve to return into backwardation by year-end.” 

As such, Bank of America has increased its oil price forecasts. It now sees international benchmark Brent crude oil averaging $43.70 a barrel in 2020, from its previous estimate of $37. In 2021 and 2022, the bank forecasts average prices of $50 and $55 per barrel. 

Recent bullish predictions about the demand recovery from oil trading giants Vitol and Trafigura – who told Bloomberg that they expect a rapid recovery – have also spurred a more optimistic sentiment among investors. Nobody has better insights into the market than the world’s biggest oil traders, who can see firsthand how oil is moving in and out of the storage facilities they own, operate, or lease. 

Besides demand and OPEC-plus compliance, the other risk to bullish market expectations is rising U.S. production in response to higher prices. 

With U.S. benchmark West Texas Intermediate (WTI) hovering around $40 a barrel, more than a third of shale explorers polled by the Federal Reserve Bank of Dallas say they’ll restart most of their idled output by the end of this month, ending production curtailments made during the crash in oil prices earlier this year.

All told, more than half of the 56 executives who participated in the survey said they planned to turn the taps back on by the end of July.

The fear is that rising U.S. production will eat some of the cake that OPEC-plus members expected to share once their supply cuts eased. Such concerns could cause cohesion within the producer alliance to fracture and possibly even see it blow up spectacularly, as it did in March. That catastrophe resulted in the Saudi-Russia price war. 

But while prices may be sufficient to bring back curtailed volumes, they are nowhere near the $50 to $60 levels needed for U.S. shale producers to ramp up investment in new drilling and fracking projects that would indeed fire up the growth machine in production.  

For now, oil is in a good place. The futures market is looking at deficits in the second half of this year, which should flip it to backwardation, stock draws, and hopefully, another sustained price rally.