Crude pulls back from three-year highs

By David Morrison  |  17/01/2018 16:32

This article considers crude oil in the light of its ongoing rally

On Monday WTI and Brent hit their highest levels since early December 2014, although trading volumes were lower than usual due to the Martin Luther King Day. But both contracts pulled back sharply yesterday and the retreat continued this morning.

Crude slips on profit-taking

The current pull-back looks like little more than profit-taking for now. Chart-wise, there’s little evidence that the rally since June (which has seen both contracts tack on over 50%) can’t continue. Focusing on WTI (which is the more technically-traded of the two) upside momentum accelerated in November once prices smashed above a band of resistance that had built up between mid-December 2016 and the end of February last year. Last week WTI broke above another strong band of resistance between $62.50/63.00, this time one which had built from May through to June 2015. If WTI can continue to consolidate above here then further gains look possible, although it’s fair to say that the rally is looking long in the tooth. Certainly, some of the recent fundamental drivers for higher prices (political unrest in Iran and the North Sea Forties pipeline shutdown in December) have disappeared although news that Venezuelan output is now at its lowest in 15 years is countering the good news.

Correction overdue?

Nevertheless, there’s growing speculation that oil is ready for a pull-back. There’s an expectation that US shale output will rise sharply if crude prices continue to bed in above $60. At the end of last week, it was reported that the US oil rig count rose by 10 to 752 – the highest level in over six months. This suggests that an increase in production is imminent. However, it has been suggested that US producers could prove less gung-ho than they have been in the past and choose to temper output for fear of killing the golden goose and seeing prices tumble.

US shale output

US output is now higher than at any time since the early seventies and is expected to top 10 million barrels per day this year. Yet despite this US inventories continue to decline. The American Petroleum Institute (API) will release its latest US inventory update after tonight’s close. This will be followed tomorrow afternoon by the official numbers from the Energy Information Administration (EIA). Last week both the API and EIA recorded the eighth successive week of drawdowns in US crude as stockpiles fall towards their 5-year average.

Backwardation

Also boosting prices is the overall market structure which is now in backwardation. This is where oil for future delivery is cheaper than near-term contracts. This means that there’s no incentive for producers to sell forward contracts as there’s no premium to lock in. It also means that there’s an incentive to roll long positions as a new forward position can be initiated at a discount to the spot price.

Production cut deal

On top of this there seems little doubt that the OPEC/non-OPEC output cut agreement is helping to reduce global stockpiles. Overall, producers appear ready to keep a tight rein on supply even as there’s increasing evidence of strong global demand going forward. The latter is in little doubt as we’re seeing a synchronised pick-up in global growth across the US, Euro zone, China and Japan. As to the former, it’s worth bearing in mind that there’s nothing to stop US producers from going all-out to take advantage of higher prices, even if it results in a sustained pull-back. As far as other major producers are concerned, Saudi Arabia needs high oil prices ahead of the Aramco IPO and last week the UAE energy minister said OPEC would commit to production cut deal for all of 2018. Obviously this is price supportive, but rather goes against speculation that Russia could look to end the agreement as early as this summer. Russia is said to be anxious to lift output as soon as global inventories hit their 5-year average.

Bullish positioning a worry

So it’s fair to say that there are plenty of reasons why crude could rally further from here and maybe even close in on $80 per barrel as some analysts are suggesting. But it’s also fair to note that crude is a favourite market with speculators and is overdue a significant downside correction. As of last week bullish speculative positioning stood at an all-time record high. While there’s no law which says it can’t go higher, such positioning means that a slight change in sentiment can lead to a dramatic move lower. 


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