Why oil is still on slippery ground

Crude recovers from 13-year low - but economic factors fuel uncertain future

Crude oil hit a low of $26.05 per barrel in February, the lowest level since May 2003, but bounced back sharply to hit a high of nearly $49 per barrel on May 17 and is currently lingering near $45 a barrel. Crude's incessant fall has created cause for worry as it dented the inflation outlook for major economies and caused an economic slowdown in oil producing nations. Producers saw dwindling revenues, but chose passivity to maintain market share.
Global economic uncertainty and a weaker inflation outlook caused major central banks to express support to loosen monetary policy to boost growth. This led to a revival in risk sentiment causing a rebound in global equities. Crude, along with other commodities, also rode high on central bank stimulus. Crude also benefitted from signs of a slowdown in crude production. US crude production eased to the lowest level since 2014 while the Opec and its major producers floated the idea of a production freeze.
While recent factors have been able to put a floor to crude oil prices, the gains are still on a shaky ground and may not be sustainable. Global economic recovery is still lopsided and risk sentiment will remain weak. Central banks have turned proactive and are acting fast to support their economies but there is a limit to the measures that can be undertaken as most of them are already holding interest rates near record low levels.
Oil producers have shown willingness to freeze production and reduce supply in the global market. However, it is highly unlikely that all major producers will coordinate and adhere to this sentiment. A sustained rise in price will also cause a flurry in oil producers to increase production and recover the revenue losses witnessed for the last many months. WTI crude briefly moved to a premium to Brent crude as the United States removed the ban on crude exports. However, the premium soon disappeared as record-high stocks in US storage weighed on WTI. Brent may continue to trade at a premium as higher global supply is unlikely to increase demand for US crude exports.
Oversupply and rebalancing
Crude's fall to multi-year lows has been due to an oversupplied global market. A supply glut is expected to continue this year and next. However, prices will be affected by the extent to which oversupply can ease or extend. Demand and supply is expected to rise modestly this year; however, supply outlook will remain pivotal in the near term.
While US crude production is steadily falling, the pace could be affected by price. Any sustained rise in price will rekindle production interest. As per US Energy Information Administration estimates, US crude production averaged 9.11 million barrels per day in February, the lowest level since September 2014. Production is estimated at 8.67 million bpd in 2016, down from about eight per cent a year ago.
The decline in rig count shows weaker production interest. The number of rigs drilling for crude stood at 354 rigs, the lowest level since 2009. The rig count has fallen by 184 rigs so far this year but the pace has been price-sensitive.
US, China demand
Global crude demand is set to see a modest growth in 2016 led by India, China and the US. However, there are certain headwinds which could persist in the upcoming quarters. US economic growth slowed down substantially in the fourth quarter of 2015 and slower activity is seen in the near term.
Consumer confidence and manufacturing activity have also shown signs of recovery. In this report, a key area of focus will be gasoline demand from the US; the US summer driving season officially starts with Memorial Day (May 30) and ends with Labour Day (September 5). As per EIA estimates, gasoline demand is seen averaging 9.38 million bpd in the second quarter, up 1.3 per cent from a year ago. The growth in demand will be challenged by the recent rise price as gasoline prices increased by over 12 per cent in the first quarter.
Chinese crude demand is expected to rise by 2.9 per cent in 2016, the slowest growth since 2001 when it rose by 2.5 per cent. The economic slowdown has affected demand as China's GDP rose 6.7 per cent in the first quarter of 2016, the slowest since 2009.
Higher prices may affect refinery margins reducing demand for crude. Global economic uncertainty caused a scurry in central banks to take action but they are now running out of tools to take measures to boost growth. Central banks' uncertainty also highlights the lack of confidence in economic growth.
US stocks at record high
OECD stocks, which include crude and product stocks held by the member nations stood at 3,103 billion barrels, compared to 446 billion barrels of crude inventories last month, or about 17 per cent higher than five-year average stocks. In days of forward cover, OECD commercial stocks stood at 66 days in February, about 9.6 days higher than the five-year average. The forward cover is expected to widen to near 68.5 days by the end of the year. Of the OECD nations, US petroleum stocks stood at 1,346 billion barrels, up 23.2 per cent from a five-year average.
US crude oil stocks hit record high level of 534.8 million barrels for the week ending March 25. Stocks have surged as production has been resilient even as refinery demand remained high. Stocks may remain high but incremental movement will affect crude price. Stocks are already at a record-high level and a decline will have to be strong enough to ease glut worries.
Summary
Crude oil has witnessed a handsome recovery from a near 13-year low and is trading near $45 per barrel. The question now is whether the demand-supply scenario or market sentiment has changed enough to warrant sustained gains or will we see the price dropping back. With mixed factors at play, crude prices may remain choppy but bearish factors continue to outweigh supportive factors.
On the supply side, US crude production has fallen and this trend may continue. However, the pace will be affected by price levels. Producers may see higher prices as an opportunity to lock in the sell price. The Opec and other major producers have failed to reach a deal on a production freeze and further chances remain slim. A lack of a deal on production freeze also rules out the possibility of a production cut in coming months.
On balance, supply growth will slow down - but not fast enough.
On the demand side, optimism about the US economy is countered by a bleak outlook for the Chinese economy. Mixed economic data from major economies especially the US will keep sentiments weak.
Some factors can influence crude volatility at current levels such as a sharp fall in US production or renewed talks between major producers for a production freeze. Also, a sharp rise in US gasoline demand during summer driving season could also trigger high volatility. Another factor is a potential sharp depreciation of the US dollar if the Fed's rate hike stance remains unclear and outlook improves for other major economies.
The writer is the manager for commodities market at Emirates NBD Securities. Views expressed are his own and do not reflect the newspaper's policy.