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Making sense of the recent rally in oil prices

This post first appeared in the Energy and Carbon Bloghttp://energyandcarbon.com/making-sense-recent-rally-oil-prices/

Normally a rise in inventories is a signal of excess supply in the market and usually prices fall in response to that demand-supply imbalance. However we do not live in normal times. For the week ending 30 January crude oil inventories across the United States rose to a record high of 110.40m barrels. On that same day, oil prices began to rise and by the close of trade on Friday the 6th January they were up 19% with West Texas Intermediary (WTI) oil futures closing the week at $51.69 and Brent at $57.80.

Source: EIA

This begs lots of questions. Why did this happen? Have we seen an oil price bottom? Has the market turned? What will happen going forward?

From a fundamental point of view nothing has changed. We still have weak demand for oil globally. There is too much oil inventory out there. Production is still greater than demand, and we are still not seeing any real declines in U.S. oil production despite the rhetoric about decreasing capital expenditures from producers. So if the fundamentals don’t support the recent oil price rise, what does!

The most likely reason for the price rise is technical. The oil price has fallen by over 50% over the last six months and at some point speculators who have positioned themselves for the price fall need to lock in profits. Now of course this closing of short positions might trigger positive sentiment towards the oil price which could cause the oil price to rise further, but this is most likely to be only temporary until the fundamentals for oil improve. If this is demand driven we may need to wait 12-18 months but that also assumes that the global economy improves. The most likely scenario and cause of any sustained oil price increase is a reduction in U.S. and non-OPEC oil supply which is likely to take place over the course of this year as unprofitable producers begin to shutter production. Until then the market is likely to remain volatile as the oil market gravitates towards a new equilibrium.

That all said, this may happen even sooner, if Saudi Arabia decides to cut production. This does not seem likely however given the Saudi view that “the market should stabilize itself”. It is also clear that the Saudi’s have a different agenda and whether their goals are political (pressure on Iran and maybe Russia) or economic goals (pressure on higher cost producers such as shale and deep sea) is not clear. What is clear is that the Saudis have not achieved those goals yet so we will likely see no agreement amongst OPEC to cut oil production. It will also be unlikely that there will be an emergency OPEC meeting, despite the pressures being put on the Saudis by some countries, and so we will not hear any news on this regards till June when the next OPEC meeting is planned.

Until then the key to improving fundamentals for the oil price will be U.S. oil inventories which are published every week by the EIA athttp://www.eia.gov/petroleum/supply/weekly/.

This post first appeared in the Energy and Carbon Bloghttp://energyandcarbon.com/making-sense-recent-rally-oil-prices/