Reasons for optimism over oil prices?

Near-term prospects look brighter than the headlines might suggest.

Andrew Hepburn 26 July, 2017 | 5:00PM
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It's arguably the world's most important commodity. So, where is the price of crude oil going?

Prices as of late have been sliding. West Texas Intermediate, a widely quoted benchmark which traded for over US$54 per barrel in February, now sells for roughly US$45. Market sentiment is increasingly pessimistic, with some influential Wall Street investment banks slashing forecasts amid fears of continued oversupply. Goldman Sachs, for example, recently warned that crude could fall below US$40.

Harry Tchilinguirian, global head of commodity market strategy for French bank BNP Paribas, says that "oil prices are probably going to remain in a US$40 to US$50 range on a WTI basis in the foreseeable future." He cites "the slow elimination of surplus oil supply" from the market as limiting price gains, arguing that efforts by OPEC and Russia to rebalance the market are proceeding slowly as other nations pump more oil.

As with any commodity, the question of oil's prospects really depends on the time frame in question. In short: the near-term prospects actually look brighter than the bearish headlines might suggest. In the longer term, oil faces serious headwinds.

The short run: Reasons for optimism

There are a number of reasons to believe oil could stage a meaningful rally from current prices. For one thing, investors in the futures market have cut their bets on a rally substantially. While still bullish overall, these speculators are nowhere near as optimistic as they've been in past years. What this means is that should market players reembrace oil as an investment, there's (no pun intended) significant fuel for a rally. In addition, speculators have significantly increased their short positions, or bearish bets, on the oil price. Consequently, there's the potential for fireworks on the upside if the bears rush to buy back their positions.

Investors aside, the market may be too pessimistic on the state of world oil inventories. A massive glut of crude was a key cause of the crash from late 2014 onward, which saw prices collapse from the US$100 mark to their current level. Ever since, analysts have been focused on bulging stockpiles, particularly in the United States.

Analysts at Raymond James certainly believe the market is overly concerned about world inventories. In a report to clients dated July 17, the firm says it expects "massive global oil inventory reductions" during the second half of the year. For the full year, they see inventories falling by an average of 1.2 million barrels per day, driven by strong global demand growth and shrinking supply. In turn, Raymond James says that this will take stockpiles below "normalised" levels by the third quarter of this year. If correct, this means that market fears of oversupply could soon evaporate. Higher prices could then be expected.

Central to the oil supply equation, of course, is output from OPEC countries. Last November, in an effort to stem the fall in prices, the cartel agreed to freeze production. All told, the evidence suggests that OPEC producers are adhering to this pact rather than pumping larger volumes than their agreed-upon quotas. Having increased supply by over a million barrels per day in both 2015 and 2016, total OPEC supply is now forecasted by Raymond James to fall by 300,000 barrels per day over the course of 2017, contributing to a tightening market.

Michael Tran, director of energy strategy for RBC Capital Markets, notes that, "The goal for OPEC is still to drive down inventories." That said, he adds that the process is somewhat slow. "We don't see inventories back down to their historical averages until the middle of next year."

Tran suggests that for Saudi Arabia in particular, elevated prices in the near term could be counter-productive, given that a partial initial public offering of the state oil company, Aramco, is planned for 2018. Indeed, in a recent report, RBC argued that "a sub-optimal outcome for Saudi Arabia would be a situation where a 2017 rally destroys the 2018 recovery by facilitating a flood of production from the U.S." In Tran's words, "Do the Saudis want higher prices today? Sure, but not at the expense of higher prices next year." RBC sees scope for prices to move into the low US$50s by the end of 2017. For 2018, it is more bullish, forecasting average WTI prices of US$58 per barrel.

The longer run: Demand in question

While the oil market has largely been preoccupied with rising supply, oil's problems in coming years may not result from soaring production, but rather stagnant (or shrinking) demand.

One bearish possibility that can't be ignored is that China finally experiences what economists term a hard landing. For years, there have been warnings by experts that the Chinese economy is too reliant on rapid credit growth and investments in infrastructure. Any serious recession in China would surely cause a dent in its demand for industrial commodities such as oil. With the nation's daily oil demand having grown from 7.6 million barrels in 2007 to just under 12 million this year, any sustained decline in demand would likely weigh on prices.

China aside, the other major threat to oil demand is that automobiles increasingly run on alternative energy. Case in point: a report this year from the Grantham Institute at the Imperial College of London predicted that by 2020, electric vehicles will displace 2 million barrels per day of oil demand. Strikingly, the report suggests that by 2040, electric vehicles could reduce demand for oil by over 16 million barrels per day.

While the ultimate effect of alternative energy sources on oil consumption is yet to be seen, carmaker Volvo made headlines around the world when it announced in early July that, from 2019 onward, all of its new models would have an electric motor (some will still have a traditional internal combustion engine as well). In the company's words, they are "placing electrification at the core" of their future business.

The trend toward electric cars and the implications for crude demand probably won't get in the way of oil prices in the near term. But investors looking to add oil to their portfolios should keep in mind that in the long run, demand, and hence prices, face an uphill battle.

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About Author

Andrew Hepburn

Andrew Hepburn  Andrew Hepburn is a freelance financial writer based in Toronto. He writes about investments, market trends and personal finance. He has written for Maclean's, the Globe and Mail, and Canadian MoneySaver.

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