A major driver of oil prices is the balance between global demand and supply. Unfortunately for those looking to guess at where oil prices will head next, both are much harder to accurately measure than much of the commentary would imply.
Oil market rebalancing has been underway for some time, since oversupply peaked in Q2 2015. According to IEA estimates, the global excess supply has already shrunk to only 0.3 million barrels per day during the second quarter of this year. The signs indicating that this rebalancing will continue into the future are both convincing and unsurprising – after all the best remedy for low oil prices is indeed low oil prices.
Low oil prices have clearly stimulated demand, with North American drivers among those taking advantage. On the supply side, low oil prices have decisively hurt major producers, with Venezuela perhaps most visibly affected. While the Ministry of Energy recently released data showing an oil production recovery in July, the factors that drive production lower persist, including Venezuela’s rig count being down 30% year-on-year in July. We assume that if there is any production rebound, it is likely to be transitory.
Regarding wider OPEC oil output, there is now more tangible progress towards putting the cartel back in business. In November 2014, Saudi Arabia led OPEC to defend market share, notably against US shale oil producers, at the expense of high oil prices. Nearly two years later, as the International Monetary Fund estimates that the kingdom will suffer a fiscal deficit equal to 13.5% of gross domestic product this year, the kingdom is signalling it may be ready for a U-turn.
Overall, many market observers expect supply and demand shifting to a draw in the fourth quarter. With the market balance moving toward deficit, the risk of price weakness based on oil market fundamentals looks low compared to the upside.
Does this situation warrant getting invested in oil-related assets? Most investors can only invest in oil through the futures market and derived products. As a result, the investor’s return is not directly linked to the spot oil price movement but instead the futures price curve. At the moment, whilst expectations have normalised a bit since reaching extremes at the beginning of 2015, markets are still pricing in a significant rebound.
There are, however, various factors that should limit the upside potential of oil prices in the medium term. Oil storage capacity has increased decisively over recent years and stocks are at record levels. Whilst China’s Strategic Petroleum Reserve (SPR) filling program is still ongoing, there is a diminishing relationship between SPR storage capacity plans and the fill rate. In the future, China’s SPR oil demand may be more doubtful.
Regarding OPEC exports, Saudi oil demand growth is slowing because of weak economic growth, the removal of subsidies and the implementation of energy efficiency measures. As a result, OPEC production cuts will not filter through in full to the refined product and crude oil exports from the kingdom.
In the short term, the oil price can be driven by many factors like speculative positioning. In the medium term, it is oil market fundamentals that matter. The global oil supply-demand realignment process is in progress and is shifting oil price risks to the upside. Our tactical overweight positions in UK equities and US high yield credit should also benefit from a rising oil price, with both areas indexing heavily in oil-related companies.
Mark Flynn is a director for Barclays for Wealth and Investment Management in Aberdeen.
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