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Will the oil price rally continue?

Will the oil price rally continue?

By Pascal Rohner – Katch Investment Group CIO

Global financial markets enjoy their best start to the year in a long time. Virtually all asset classes accumulate positive returns so far this year, but one of the most striking is oil. The reference of the North Sea (Brent) has rebounded about 40% from the minimum reached at Christmas and is quoting around 70 dollars per barrel, prices not seen in more than a year. The WTI reference has had a similar behavior.

There are different reasons that explain the recent rebound in prices, but the main reason is a shock in the oil supply. The black gold market is characterized by the frequent collision of supply and demand – like any market – with the difference that close to 1/3 of the world’s oil production comes from the Organization of Petroleum Exporting Countries (OPEC), composed of large market players such as Saudi Arabia.

Although it is difficult to define the oil market under one structure, oligopolistic decisions are still being made with the objective of influencing prices towards desired levels, as in the case of OPEC, since their participation in the market is relevant.

In December 2018 a decision of this type emerged, OPEC+, composed of OPEC and its allies, including Russia, committed to reduce its production by 1.2 million barrels per day (b/d) in the first half of 2019, and so far, the promise has been kept. However, it has been largely driven by Saudi Arabia, which has exceeded its promised cut by 261% according to figures known as of March. This means that instead of cutting its production by 322 thousand b/d, as agreed, during March it did cut by 839 thousand b/d, reaching a production of only 9.7 million b/d, far from the 11.3 million b/d seen in November of last year.

The OPEC agreement allowed exceptions for some countries. One of them is Venezuela that is facing an extremely difficult economic situation. Venezuela does not have to cut its production, but the electricity blackouts and energy rationing, amongst other reasons, led to a total collapse of its oil production. According to a report published by Bloomberg, during the days of blackouts that began on March 7, the country’s oil production plummeted to less than 600 thousand b/d, reaching an average production per day of 890 thousand b/d in March, similar to the Colombian production, which in the first three months of the year reached an average of 892 thousand b/d. In the short term it is difficult to see a recovery.

Venezuela is not the only oil exporter in trouble. Libya that produces about 3.6% of OPEC production is in the midst of a civil war that has worsened with the recent attacks led by Marshal Khalifa Haftar with the aim of taking power and that they could affect oil production.

As a result, it seems that oil producers are over-adjusting the supply, which would be a tailwind for prices. The entities recognized in the global energy sector such as the US EIA and OPEC estimate a deficit in the oil market close to 400 thousand b/d on average for 2019, which is likely to sustain high oil prices.

On the other side of the scale is the United States. President Donald Trump has been a strong critic of the supply cuts by the OPEC members and has made direct comments, in which he expresses his nonconformity. In previous weeks he said that the world is too fragile to face rising oil prices and insisted that the group should “relax and calm down”.

In any case, high oil prices are boosting the US energy production, and especially the booming fracking industry. There is still a lot of value in the sector, which is best illustrated by the recently announced offer of Chevron to acquire Anadarko for 33 billion dollars, a premium of 37% to Anadarko’s market valuation. This may be the first step for confidence to return and stimulate more mergers and acquisitions in the sector.

What does this all mean for oil prices? Supply shocks are not eternal but the production shortage is likely to persist in the short term, supporting higher oil prices. The rally might well continue, at least until June, when OPEC+ meets again to evaluate its agreement. They might signal to reopen the taps to prevent prices to move much higher and to discourage the production increases of US shale oil. Therefore, the second half of the year may well be more volatile, but for the moment, it is best to remain seated and to enjoy the rally.

Oil prices (USD per barrel)

Will the oil price rally continue?

Source: Bloomberg

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