The No.1 Challenge To The Oil Rally

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The oil price rally could get derailed by “explosive” growth from U.S. shale in 2018, and “substantial gains” in Canada and Brazil will also add to the supply woes.

The International Energy Agency (IEA) acknowledged in its latest Oil Market Report that the recent rally in oil prices came on the heels of significant tightening, but that the supply picture still looks ominous.

The rally in Brent prices to $70 was driven in part by some unexpected interruption and geopolitical tension, including the possible unraveling of the Iran nuclear deal, the closure of the Forties pipeline a few weeks back, disruption in Libya, and the steep decline in Venezuela’s oil production.

Inventories also continue to decline (for the time being), and even picked up pace at the end of last year. The IEA said that OECD commercial stocks declined by 17.9 million barrels in November, a pace that was twice as fast as the five-year average. And, in December, preliminary data suggests the declines were even stronger.

In fact, inventories declined in three consecutive quarters in 2017. On average, inventories fell at a rate of 630,000 bpd, which the IEA said was exceptional. “[S]uch a threesome has happened rarely in modern history: examples include 1999 (prices doubled), 2009 (prices increased by nearly $20/bbl), and 2013 (prices increased by $6/bbl).” This time around, the stock draw pushed up Brent prices by almost $25 per barrel. “The oil market is clearly tightening,” the IEA wrote.

In this sense, it is not as if the surge in positioning from hedge funds and other money managers is unjustified — the underlying fundamentals point to a real tightening underway in the physical market for crude oil.

However, soaring supplies from the U.S. and other non-OPEC countries threaten to stall the rally. The IEA raised its forecast for U.S. oil production growth this year from 870,000 bpd to 1.1 million barrels per day (mb/d). That comes on the heels of sharp upward revisions from the EIA and OPEC, not to mention a slew of investment banks. Everyone is in agreement on one thing: U.S. shale is set for serious growth, much more than analysts predicted just one month ago.

“The big 2018 supply story is unfolding fast in the Americas. Explosive growth in the US and substantial gains in Canada and Brazil will far outweigh potentially steep declines in Venezuela and Mexico,” the IEA wrote.

“It is possible that very soon US crude production could overtake that of Saudi Arabia and also rival Russia’s.” Russia produces more than 11 mb/d. The U.S. EIA predicted earlier this month that the U.S. would top 11 mb/d by the end of 2019.

But it isn’t just the U.S. adding new barrels to the market. Brazil and Canada are two other non-OPEC countries expected to post strong gains, although, unlike short-cycle shale, both countries have projects set to come online that were planned years ago.

Even after factoring in some non-trivial declines in output from Mexico and China, the IEA sees non-OPEC production rising by 1.7 mb/d in 2018, a figure that represents “a return to the heady days of 2013-2015 when US-led growth averaged 1.9 mb/d,” the IEA wrote.

For oil bulls, that should be a pretty threatening figure because demand is only expected to grow by 1.3 mb/d this year. The IEA acknowledges that its demand estimate could be conservative, but it takes into account the fact that some demand destruction could occur from higher prices. OPEC pegged demand growth at a healthier 1.5 mb/d, but even that figure is swamped by the 1.7 mb/d of new supply.

The result could be a return to increases in inventories, testing the current rally in prices. The IEA sees a “modest surplus” in the first half of the year, followed by a “modest deficit” in the second half.  As such, forecasts for $60-$70 for Brent seem reasonable, but that “we should expect a volatile year.”

For now, oil prices are struggling to hold onto their gains — Brent has hit the $70 per barrel threshold, but has fallen back at that resistance level.

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