Oil Supply Remains Resilient, Prices Heavy

Oil prices are lower for the seventh consecutive session.  
Light sweet crude prices had fallen 10.3% over the past two weeks, and with
today’s losses are off another 1.6% already this week.  There are two main
considerations.  The imbalance between supply and demand has not adjusted
as much as expected, and the market positioning is extremely long, with many
bank analysts still nursing bullish forecasts.  

The April light sweet contract is trading at its lowest level since the
end of last November. 
At $47.20 would have retraced 61.8% of the
rally since shortly after the US election.  Below there the risk extends
to $45-$46.  Over, the slightly longer term, a return toward $40-$42
cannot be ruled out.  

The sell-off has been very sharp, and today could be the fifth successive
session that prices close below the lower Bollinger Band (~$48.15 today).
 
The last time this took place was early last November.  After the fifth
close below the lower Bollinger Band, the price of oil bounced for three-four
sessions and then fell to new lows.  

OPEC’s cuts, if fully implemented would have brought the cartel’s output
back to where it was in early 2016. 
There were several members exempt
from output cuts, and they seem to take full
advantage of their allowances, if not more so.  It is offset the loss of
around 13% (~100k barrels) of Libyan output due to conflict.  At the same
time, non-OPEC producers, including the US, Canada, Brazil, the North Sea and
Russia have increased output by around one million barrels, according to
reports.  

US crude inventories are at record levels.  This not only reflects the increased US output,
which is the highest in more than a year but
also increased imports.   The US Department of Energy expects next
month’s output to rise by nearly 110k barrels a day, which would lift US output
to near 9.2 mln barrels a day.   The Bloomberg survey found a median
expectation of another three million barrel build last week when the EIA
reports tomorrow.  The US rig count has steadily increased and now is at
its highest level since September 2015.   Moreover, US shale
production costs are estimated to have fallen by around 40% over the past three
years.  

Many investors were skeptical of OPEC’s reported cuts.  The
history of “non-compliance” and a vested interest in exaggerating the
cuts in order to have a favorable impact
on prices cast doubts.  These doubts were born out today.  OPEC had
claimed Saudi output fell further in February to 9.8 mln barrels a day.  However,
Saudi Arabia’s own report showed that it
had boosted production by 263.3k barrels to 10.011 mln barrels a day.  In
effect, this reversed about a third of the output cuts reported in
January.  

Although Saudi Arabia has still cut a little more than had been agreed at
the end of last November, it still appears to be a reluctant leader of the
output cuts. 
Energy Minister Al-Falih warned last week that it cannot ” bear the burden of
free-riders” forever.  Russia, Iraq and the UAE have not delivered what
the Saudi officials believe was agreed.  Several members, including Saudi
ally Kuwait, have called for an extension
of the agreement.  So far, Saudi Arabia has not endorsed an
extension.  

The EIA expects US shale producers to boost output by several hundred
thousand barrels this year. 
The Permian Basin area has added 172 rigs
since last May.  And the productivity of those wells is rising.  The
EIA projects output from the Permian Basin to increase 79k barrels a day in April, or 3/4 of the overall anticipated
increase in US output.  Since October, US output has grown 600k barrels a
day.  That offsets almost half of the cuts that OPEC had
negotiated.   Recent comments from the Saudi oil minister suggest
officials may have been caught out by how fast US shale output has
grown.  

The shape of the oil curve is understood to be an important reflection of
expectations and key for hedgers and producers.
  Think of it like a yield curve.  Yield curves are
mostly positively sloped.  Long-term interest rates are typically above
short-term rates.  An inversion is often a worrying sign.  In
commodities, including oil, a positively sloped curve (e.g. oil for delivery
in several months is more expensive than the nearby contracts) is called
contango.  This rewards those with
inventories and who can afford not to bring a product
to the market today.  That is the situation now.  The May contract is
near $48, and March 2018 contract is a
little below $50.  The situation that encourages the drawing down of
stocks is when the short-term price is above the long-term price.  This is called backwardation.  
Engineering backwardation likely takes
some pressure off prices.   

Nevertheless, the important point here is that OPEC seemed to have the upper hand for three months (December
2016 through February 2017).
  However, shale producers have not been defeated by any means.  Instead, they
are punching back.   It is a simplification to be sure, but the drama in
the oil market can be seen as a battle
between Saudi Arabia and US shale producers.    

In a larger sense, the rise in oil prices was part of the global
reflation story.
  If our bearish outlook is justified, that reflation
story will be challenged.  We
suspect Europe is more vulnerable than the US. The increasing rig count and output
support the economy, while the Fed looks through the price impact by focusing
on the core rate of inflation.  The rise in headline inflation in the euro
area has prompted ideas that the ECB could hike rates (from minus 40 bp
to minus 30 bp) late this year or early next year.  The drop in oil
prices reinforces our ideas the eurozone CPI will peak shortly.  

Disclaimer

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