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Crude oil market: too much good news in the price

Global views and trends

BNP Paribas Asset Management

While oil has been the star performer among commodities so far this year, the balance of risks is shifting towards a re-alignment with other growth-sensitive assets. Indeed, the risk/reward profile for crude oil prices appears skewed to the downside.

Crude oil market: too much good news in the price

Oil prices have rallied close to 20% so far this year, marking the biggest gain within the commodities complex and the steepest rise among the liquid assets that macroeconomic investors monitor closely (Figure 1).

Fundamentals have been supportive of oil prices and so have geopolitical developments. However, after such a strong rally we believe there is already too much good news in the price.

Figure 1: Crude oil has been the star commodities performer so far this year

Star commodities

Source: Bloomberg, 22 May 2018


Demand outlook: oil is benefiting from a maturing cycle

Commodity prices in general and oil prices in particular typically perform strongly in the mature part of an economic cycle. This is usually the case when growth is above trend and inflation starts picking up. In other words, growth is strong enough to put upward pressure on scarce resources like commodities.

Unlike equity prices, which discount the future prospects of earnings and dividends, commodities are an asset class where spot prices reflect the clearing of demand and supply ‘today’. This means that as the business cycle matures the demand for commodities increases and so do their prices.

Following the sharp correction in oil prices in 2014-15, investors were sceptical about whether crude prices could experience a persistent rally. This was largely because of the efficiency gains in the extraction of oil from US shale fields that led to the build-up of large crude inventories in the US.

As demand has recovered in the past few years, those inventories have begun to fall again (Figure 2). The growth recovery in other developed economies and more recently in emerging markets also supported crude demand.

Figure 2: US crude inventories falling relative to previous years as demand recovers

US crude oil inventory

Source: Bloomberg, 22 May 2018


Supply: strong US output and restrained OPEC production

On the supply side there are three principal forces at play.

First, US shale production remains strong and continues to be the main driver of US production (Figure 3). According to data from the Department of Energy, US crude production rose by 8.5% this year to end-April, after rising by 12% last year. This trend could continue as higher oil prices incentivise shale supply. A crucial question going forward is whether the low cost phase of extraction is coming to an end as shale production hits bottlenecks such as pipeline constraints, scarcity of production inputs and more challenging oil fields.

Secondly, since OPEC extended its production cuts until the end of 2018, OPEC production has surprised further to the downside, especially in Venezuela and Angola. Now Iran is an additional source of concern as the withdrawal of the US from the JCPOA[1] may put Iran’s production at risk this year. For now, Saudi Arabia has filled the gap compensating for most of the losses from these OPEC producers.

Thirdly, the threat of an escalation of geopolitical tension in the Middle East is also supporting crude prices. This premium is difficult to measure but perhaps the most visible signal is the rapid rise in crude prices since early May. Since then other fundamental factors have not really changed.


Figure 3: US crude oil production continues to rise

US crude oil production

Source: Bloomberg, 22 May 2018


Global crude market currently in deficit, but macroeconomic risks could tip the balance

Given our baseline estimates of robust demand growth and moderate supply growth we expect the global crude oil market to remain in deficit for the remainder of 2018 and potentially into 2019. We see two major macroeconomic risks to this central case. Firstly, demand could disappoint, notably in the non-OECD bloc which accounts for slightly more than half of global demand.

China, for instance, accounts for c. 22% of non-OECD demand and its growth rate has been flat since early 2017. The second principal risk, in our view, is higher-than-expected inflation, notably in the US. This could reflect strong growth which is supportive for crude demand, but also would involve tighter Fed monetary policy and a strong US dollar.

We find it difficult to see Brent crude prices materially above USD 80/bbl (close to current spot prices) in such an environment. As such, we believe the risk/reward for crude prices is currently skewed to the downside.

Crude prices have already discounted our central case of a tighter crude market and also an increase in the geopolitical risk premium. There is thus a decent chance that prices have gone too far relative to the fundamentals. In fact, some market indicators are already showing that prices are vulnerable to a correction.

Firstly, crude prices have risen by c. 20% so far this year, which is much stronger than most risky assets and certainly than most other commodities.

Secondly, positioning (according to future contracts for West Texas Intermediate (WTI) crude oil) is long and historically stretched (Figure 4).

Thirdly, our technical analysis suggests that, considering weekly and monthly cycles, crude prices could be reaching a peak in the next few weeks. In addition, our analysis of quarterly cycles suggests that crude prices are likely to face resistance as they are approaching the 20 quarter moving average.

Figure 4: Analysis suggests investors are overweight futures contracts on West Texas Intermediate (WTI) and stretched on a historical basis (2010 – 18/05/18)

WTI positioning

Source: Bloomberg, 22 May 2018


Asset allocation: crude oil prices look vulnerable as they already discount good news

Conditions in the crude market have tightened fundamentally. This could persist into 2019, but prices have gone a long way in discounting good news on demand and supply. Crude oil has been the star performer relative to other risky assets, but that balance of risks is shifting towards a re-alignment with other growth-sensitive assets.

After such a strong rally, long/stretched positioning and technicals showing signs of peaking in the coming weeks, we believe the risk/reward profile for crude oil prices looks skewed to the downside.

[1] The Joint Comprehensive Plan of Action between China, France, the UK, US, Germany and Iran – the ‘Iran Nuclear Deal’

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