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Oil prices—is the worst over?

Supply-demand balances are tightening and sentiment is turning, but the next two quarters will be decisive

"Lower for longer" has been boilerplate podium-speak at industry conferences for the past two years—almost now an industry cliché. The consensus view is that whatever Opec does oil prices can't rise much beyond $55-60 a barrel, because tight oil producers will leap to the pump and smother any rally.

But another rally is indeed underway and—say nervous whisperers—this one might have some staying power.

On 25 September, Brent was trading in London above $57 a barrel, a 25% gain since threatening to push below $45/b on 21 June. WTI's performance has been less bullish, but the benchmark, above $50/b as Petroleum Economist went to press, has still posted a 16% rise in the same time. A pause is likely—Nasdaq's technical analysis on 20 September was that "momentum remains positive but is decelerating". Recent price oscillation reflected "consolidation", it said. Is the worst over?

Demand is mustering some steam. In September, the International Energy Agency (IEA) raised its forecast for consumption growth in 2017 by 90,000 barrels a day to 1.6m b/d. In the second quarter, the year-on-year increase came in at a startling 2.3m b/d. The comparable figure for 2016 was just 1.3m b/d. The sources of this strength were unusual too: not the developing nations but OECD countries. Cheap gasoline sent Americans—more of whom are also in work—back onto the roads in the driving season. The IEA described European demand in the summer as "exceptionally strong".

0.83m b/d - IEA estimates of the Q417-Q118 drop in oil demand

The data for global stocks, even accounting for the havoc of a brutal hurricane season in the US Gulf, have been bullish. In July, when they usually start to build again, OECD inventories remained flat at 3.016bn barrels. Between June and July, the OECD stock surplus to the rolling five-year average fell by 24m barrels, and is now just 190m above the benchmark.

Although rumours of an extension to the Opec cuts deal beyond the first quarter of 2018 continue to circulate, now is not the time to confirm the decision. Compliance with the cuts is still satisfactory, bumping up in August by about seven percentage points to 85%. The committee monitoring the cutters' performance met again in Vienna on 22 September, but was careful to say nothing afterwards that might affect the market's mood.

Opec can be pleased with the forward curve too. Contango in the past two years has both reflected the size of the glut and also made it more difficult to reduce.

But the structure has shifted in recent months and is now backwardated. Stashing crude for later is no longer profitable: Opec reckons crude in floating storage, a good barometer of the appetite for the storage trade, has fallen by 30m barrels this year.

Tightening test

It won't be clear until later which factor has tightened the market. But Saudi Arabia's decision earlier this summer to cut exports, not just production, has certainly helped. In September, it is said to have reduced its allocations to customers by 0.52m b/d; and would cut 350,000 b/d in October. Production in these months has remained fairly stable, at around 10m b/d, in line with its Opec quota. Peak domestic summer demand explains where some of the non-exported barrels went; and the kingdom may also have been putting some oil in storage. But Saudi exports to the US—seen as crucial, given the market's focus on inventory data there—have been unwinding rapidly: down by more than 300,000 b/d since the beginning of the year.

Three forces will now decide whether this market momentum will continue or if this rally will fade like the ones before. First is a fast-approaching period of refining maintenance and historically weaker demand in the last quarter of 2017. In the very near term, some of this depends on the pace of refinery restarts in the US Gulf. Not all hurricane-affected units are firing at full speed yet: 2.3m b/d of capacity was affected, about 400,000 b/d remains shut in, and another 1.4m b/d is in the process of restarting, according to Barclays. This should mean product stocks keep drawing. But if their return in October reverses that recent trend, the market will get twitchy.

For the rest of the year, the balance depends on refiners' attitude. Strong refining margins should tempt them to keep their plants firing. The IEA expects refinery throughput to rise counter-seasonally by 400,000 b/d in Q4.

Assuming the market gets through Q4 unscathed, Q1 2018 is the next hurdle. The forecasts look ugly. The IEA reckons demand in Q118 will be a whopping 0.83m b/d lower than in Q4 of this year. By comparison, the drop between those quarters in the previous two years was just 330,000 b/d (Q416 to Q117) and 220,000 b/d (Q415 to Q116).

So what Opec does in early 2018—with these numbers in the background—is the second decisive market force. Few observers expect the group to stop cutting as planned in Q2 2018, because the implied restart of 1.2m-1.8m b/d of supply after a rough demand quarter would demolish prices. One Opec source told Petroleum Economist that the group would extend by "one or two quarters". Either way, Opec needs to engineer a soft landing. The IEA forecasts demand for the group's crude will average 32.4m b/d in 2018 (and just 31.8m b/d in Q1). But, including Libya and Nigeria, it was already producing 32.67m b/d in August. Opening the taps again would overwhelm balances. Expect an extension.

The last factor is the response of non-Opec producers—and the jury is suddenly more divided here than it was. The IEA expects non-Opec supply to rise by 1.5m b/d next year, or more than double the increase in 2017. On its own, this is enough to account for forecast global demand growth. Yet some new doubts about tight oil, a major component of this expected supply increase, are starting to surface. The Energy Information Administration has lowered its forecast for US oil output this year by about 100,000 b/d. Wall Street is less gung-ho than it was about its exposure to drillers.

If all this points to further market tightening, investors should tread carefully. Some sentiment is turning. But the EIA, even after revising down its US crude forecasts, still thinks the country's output will hit 9.8m b/d next year, its highest-ever level. And a sustained rally now will bring other consequences. Opec's compliance has been high during the trough, but tends to fade as prices rise. No one anymore doubts that, in a more buoyant market, there's enough oil to be produced quickly. As of August 2017, the US had more than 7,000 drilled-but-uncompleted wells awaiting that price signal.

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