US output, inventory hold the key to oil’s rally

There is a tremendous euphoria over crude oil touching $70 a barrel. While decline in inventory and geopolitical tensions combined to trigger the price rise, positive investor sentiment exacerbated the price action. Investors seem to believe that the market will tighten further on the back of production cuts and robust demand. No wonder, net-long futures positions are at a record high on the bourses.

How long will the rally last? This is the multi-million dollar question everyone is asking; and the answers are divergent. Currently, while prices appear to have stopped rising but are edging down, there has not been any marked decline; not as yet, in any case.

There are reports floating in the market that given the price situation, OPEC may gradually withdraw from the production cuts. At this point in time, such a move appears far fetched as the market is seen somewhat vulnerable to correction.

At the same time, there is belief that the oil market fundamentals are tightening. The steady fall in the US oil inventory in recent weeks is lending support to prices. Yet, the latest data suggest that December OPEC production has actually risen and non-OPEC production too is likely to follow suit. Large producers such as Iran and Iraq exceeded their quotas last month. Some African producers like Nigeria, Algeria and Angola are producing more, offsetting decline in troubled-countries like Venezuela.

The months ahead will likely see increase in production in North America. An increase in the US oil production to 10 million barrels per day is most likely very soon — possibly as early as next month, according to the US Energy Information Administration (EIA). What’s more, by the end of next year, production of 11 million barrels per day is anticipated.

The key to future behaviour of crude oil market is clearly the level of US inventory and rate of increase in shale oil output. As long as stocks decline or do not expand, prices are likely to stay firm; but that picture may not last long. The EIA seems to be bullish on the US’ ability to ramp up production soon.

Also, in the weeks ahead, refineries are likely to process less crude because of routine maintenance work, according to analysts. This can lead to an inventory build. Importantly, the oil market will have to reckon with a host of supply side possibilities – rise in US shale oil output, reversal of US inventory drawdown as well as increase in non-OPEC production the weeks and months ahead.

If this materialises, the OPEC target of reducing the OECD stocks to their five-year average by the end of this year will be tough to achieve. This is sure to put downward pressure on crude oil prices going forward. The sustainability of the current price levels is surely open to challenge.

The question is when, and not if, crude oil prices would start correcting down. On current reckoning, it is likely that it may happen sometime in the second half of the year subject to the caveat that no bullish developments such as geopolitical instability occur.

The author is commodities market specialist. Views are personal.

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