We have often made the argument that although the nature of the Covid shock makes this macro cycle unique, it is important not to lose sight of the fact that this remains a cycle. The same is true of the oil market. Back in April 2020, when demand was in freefall and “storage wars” sent WTI crude prices into negative territory for the first time ever, we published a piece of research setting out the conditions necessary for the market to turn the corner. Our concluding remark was: “By this time next year, do not be surprised if the market’s focus has shifted to upside oil price risks… the playbook might be different, but the cycle will still play out.” Here we are today, with prices back at January 2020 levels and oil outpacing industrial metals to lead the commodity rally over the past four months amid talk of a new “supercycle”.
The drivers behind this oil price recovery are well known. The market bottomed out last spring shortly after a brief Saudi-Russian price war had given way to large-scale coordinated supply cuts. Strong Chinese demand provided much-needed support as the pandemic spread in the major Western economies over 2020 H1. But the game-changer has been the arrival of effective Covid-19 vaccines, raising hopes of synchronized global reflation taking hold during 2021 and thereby allowing oil demand to turn the corner for good – not least as it paves the way for the transportation industry to get back on its feet again. With oil demand on the mend and supply constrained (OPEC+ quotas; the timid response from a US shale industry that is in flux), this is a recipe for inventory drawdowns that underpin prices. A soft dollar and increased portfolio flows to real assets against the backdrop of depressed bond yields and rising inflation expectations have added to the positive mix. In all, it is hard to argue against the view that the glass still looks half full, at least in the near term.
Because of how bullish sentiment is at present, it would not take much for prices to spike higher (say, to the mid-$70s, i.e., levels last seen in mid-2019) on positive news about economies’ reopening. Yet validating those gains would require concrete evidence that we are on a path to normality in oil consumption, i.e., a cyclical acceleration in actual demand that goes beyond vaccine-driven expectations. At this juncture, bullish sentiment is projecting a “one-way” market just when things are about to become more balanced from a fundamental standpoint, i.e., supply starts to respond.
Just as mini-tantrums in long Treasury yields will test the Fed’s ultra-dovish stance, so accelerated oil price gains from here on will expose the main producing blocs’ reaction functions. Higher prices will raise questions about the output discipline of US shale operators: evidence that producers are ramping up hedging activity suggests that the risk of a stronger response is real and rising. They will also set in motion the phaseout of OPEC+ supply restrictions and challenge the cohesion of the Saudi-Russian alliance over time. In other words, the oil cycle’s clock is about to start ticking louder.
My sense is that for the time being, OPEC+ will take pains to stay the course on its supply strategy. Now that demand appears set to turn around and the dollar is on the back foot, it is exactly the time for Riyadh and Moscow to stand firm. Voices urging for more barrels to be released to the market have strengthened of late, however; and the reductions agreed in 2020 are gradually going to be reversed – not least as Russia is minded to pump more oil. The question marks are about forward guidance. Like with the Fed and its asset purchases, any oil supply “taper” talk will no doubt be carefully crafted to strike a balance between vigilance and pragmatism. It is no coincidence that Saudi Energy Minister Abdulaziz bin Salman has already called for “extreme caution”, even as the price paid by the cartel for trying to control the market is shrinking market share.
All this does not preclude further oil price gains in the near term. But it means the easy gains are behind us and it raises the bar for the level and pace of incremental demand needed to take the market to higher ground and keep it there. In other words, preserving the positive price momentum will soon enough require demand increases to turn into positive demand surprises. Oil prices have already come a long way and a lot of the optimism is arguably already in the price. The front part of the forwards curve (e.g., up to three months) is now as backwardated as it was at the end of 2019 and stands at the high end of its long-term range. Speculative positioning has become stretched, with the combined net length in WTI and Brent contracts hovering around levels not seen since October 2018. However, the fact that price advances have failed to attract much additional buying recently suggests that this oil rally is now long in the tooth.
What is more, while global floating oil storage has normalized (down by around two-thirds from the summer 2020 high), it has failed to break lower since mid-December even though it remains above pre-virus averages. This is consistent with reports that China’s oil reserves are close to reaching storage capacity. Further, calls for a “big round number” oil price ($100 this time around) – one of our favourite contrarian indicators – are grabbing the headlines. Finally, the pattern of this rally has so far broadly tracked the rebound from the February 2016 bottom; if history is any guide then a period of consolidation is due sometime in the not too distant future.
Bottom line: TS Lombard remains constructive on oil prices near term but would not chase at these levels. A lot of optimism is already in the price; and there are reasons to think that the market will soon shift down a gear.