Crude oil spike: Overshooting futures market does not mean you should follow the herd

Those bullish, or net long, on oil futures did not have a lot to cheer for much of 2017, even though OPEC's action, in cooperation with 10 non-OPEC producers took out a collective 1.8 million barrels per day (bpd) of crude off the market, and on paper continues to do so. 

However, much of 2018 has seen bullish sentiment skyrocket as the futures market enters the home stretch of the year's second trading quarter. Having first touched its highest level since the fourth quarter of 2014, Brent – the global proxy benchmark – is lurking near $80 per barrel, while the West Texas Intermediate is firming up above $71. 

The bulls are betting that current factors in play – i.e. the ongoing geopolitical tension and OPEC's rigorous cuts – will neuter the effects of incremental US production, which by many accounts is tipped to cap both that of Russia and Saudi Arabia before the year is out. All three major producers are of course pumping above 10 million bpd. 

The geopolitical risk being factored into the price is multifaceted. There’s the Syria and Russia versus the West angle. US President Donald Trump’s recent withdrawal from the Iran deal and of course wider regional complications in the Middle East, including but not limited to Israel’s military actions in Syria, the Saudi-Iranian tussle for supremacy in Yemen and Qatar’s diplomatic spat with its neighbours, continue to hound trading sentiment. 

Bullish bets are predicated on a combination of fewer Iranian barrels finding their way to the global supply pool as well as the return of the geopolitical risk premium, that was so fashionable back in 2012. (See recent importation charts below from Thomson Reuters Oil Research.) 

 

The bulls also point to rising demand, with India leading the importation charge. So if you follow the herd mentality, perhaps taking the view that Brent might hit $100 per barrel is not all that farfetched. Only thing is, in this crude world nothing is simple.

For instance, let's take Iran. According to Moody’s analytics, Trump’s unilateral withdrawal from the Iran deal might well take 400,000 bpd out of the global supply pool. That’s a sizeable amount, but well short of 1 million bpd of Iranian oil knocked out by President Barack Obama’s multilateral action back in 2012.

Additionally, OPEC claims its aim of bringing OECD inventories down to the five-year average is close to being achieved. So the Saudis and their backers within the cartel may decide that the time is right to ease up on the production cuts front.

More so, because the potential possibility of fewer Iranian barrels on the market would add to visible declines from Venezuela, with the country’s headline production currently on the verge of falling below 1 million bpd; a historic low. 

Finally, of the big five global crude oil consumers, only India's demand growth is higher than what it was in 2017. The US is importing less, and largely heavy crude, from the global market, given rising domestic production of light sweet crude. 

China’s demand growth, while stable, is not quite as robust as it has been in recent years, and that of Japan and South Korea is lower than 2017.

So the upside to oil prices is not universal, and visible drags – barring an all out conflict in the Middle East – persist. Furthermore, remember that Brent remains in backwardation, i.e. it’s spot or cash price remains higher than the forward price, indicating – in my opinion – that the long run bearish bias is still intact.

More so, because US oil production will continue to rise for most of 2018. James O'Brien, Chair of international law firm Baker McKenzie's Global Energy, Mining & Infrastructure Industry Group, is among those who believe US production is likely to stay in a healthy place, as some, if not all players, can even manage to break-even at $35-40 per barrel prices.

"US producers are continuing to innovate to push down costs, and the oilfield services companies are looking to manage lower time and cost expectations for their clients. This is leading to the creation of new production margin equations, something that's great for the business and is likely to continue," he said at the recent Baker McKenzie 2018 Oil & Gas Institute in Houston, Texas, US. 

Actionable idea: Trade the news on your weekly spread, based on developments in Venezuela and the wider Middle East. But at the same time, do not lose sight of US production. So be opportunistically short-term long, but perhaps long-term short.

Average oil price is likely to oscilate between $65 to $75 per barrel for 2018, using Brent as a benchmark, unless the geopolitical situation in the Middle East gets really out of hand.