What really killed the oil price rally
The recent rally—unlike other rallies over the past three years—has been underpinned by substantial improvements in the underlying fundamentals. Global refined product stocks are just a bit above the five-year average, having drained significantly in recent months. Crude stocks are also down, oil supply fell in August, and demand has picked up. In other words, unlike the numerous (but brief) oil price rallies in 2015, 2016 and even earlier this year, the most recent run up in prices appears to have been quite a bit more justified by the improving supply/demand balance.
Yet, the rally might already be losing steam, with Brent falling back from the high-$50s to just the mid-$50s per barrel, and WTI back down to the $50-per-barrel threshold.
There are a few reasons for this. First, while prices gathered pace over the past month or so, the gains were magnified by some geopolitical tensions—most notably the Kurdish referendum last week that sparked threats of supply cutoff by Turkey. But the promise by Ankara to disrupt roughly 500,000 to 600,000 bps of Kurdish oil exports hasn’t materialized (at least not yet), deflating some of the angst that initially cropped up.
A second reason why the price rally has stalled is that OPEC may have increased production in September, according to a Reuters survey. The supposed increase in output of about 50,000 bpd suggests compliance may have slipped recently, a fact that some cite as the reason oil prices fell back over the past week.
Third, US oil production continues to rise, with output rising above 9.5 million barrels per day recently (at least according to the weekly surveys), up a staggering 1 mb/d from a year ago. Also, the brief price gains above $50 for WTI might lead to a wave of hedging, allowing shale drillers to lock in prices for the next year, which could lead to more drilling and more supply.
Fourth, and probably the most important short-term factor, is the fact that the recent price gains were egged on by major investors, who staked out bullish bets on crude amidst the rally. Multiple times over the past three years, short-lived bull runs ended in tears as prices retreated just as quickly as they rose. The jarring pullback is often the symptom of herd-like movements from hedge funds and other money managers, who crowd into a one-sided bet only to retreat when things look overstretched.
Bullish bets on Brent futures rose to a record high in the last week, according to Reuters, which many analysts view as a red flag that made a selloff likely. “It’s always problematic when you have this amount of speculative length in the market,” Petromatrix strategist Olivier Jakob told Reuters.
“I think more than anything there was some profit-taking here,” Tariq Zahir, managing member of Tyche Capital Advisors, told The Wall Street Journal last week. “It’s had a heck of a run.”
The price deteriorating that began last week but continued into the start of this week was seen as a continuation of investors pulling back from what many see as a price rally gone too far. “Those levels were deemed as good selling points, and I think we’re seeing a continuation of that today,” Tony Headrick, an analyst at CHS Hedging, said of the price declines at the start of this week, according to the WSJ.
Nevertheless, the progress made toward rebalancing likely puts a higher floor beneath prices. Few predict WTI will tumble back into the $40s anytime soon, and some even see the recent fallback in prices as temporary, and not necessarily a sign of deeper problems with the market. “We are still viewing this as a near term bull market capable of fresh highs,” Jim Ritterbusch, president of Ritterbusch & Associates, wrote in a note to clients. “We expect an upside reversal tomorrow amidst various contract expirations.”
Ed Morse, Citi’s global head of commodities research, concurs. “We think it's for real," Morse told CNBC on Monday. "We're in the middle of a bit of a sell-off, maybe even testing the $50 level for WTI, but the sell-off is profit-taking more than anything else, and the momentum in the physical markets, joined by the momentum in the financial markets, really point to a higher price between now and the end of the year."