Why oil is on the boil
Crude oil is the talk of the town again. Brent crude spot prices breached the $62 a barrel mark on Monday. For some time now, the signs were all there. For the last couple of weeks, Brent prices have been in what the markets call backwardation—an occurrence where the price of a futures contract is lower than the spot price—(see chart 1). Current backwardation signals a propensity to consume more (better demand) today and that Opec’s (Organization of the Petroleum Exporting Countries’) efforts to rebalance the oil market are bearing fruit. A sustained backwardation also suggests that crude oil inventories may continue to fall, thus supporting prices.
Does this mean that the thesis of a cap on oil prices owing to higher shale production is in jeopardy?
In theory, that is right, says Ritesh Jain, chief investment officer at BNP Paribas Asset Management India Pvt. Ltd, adding, “However, even though shale oil is abundant, land cost inflation is creeping up and cheap funding is no more readily available, making shale oil relatively less profitable.” As it is, shale oil producers weren’t making much money. According to Jain, a lot of private equity money and high-yield bonds money that was earlier going into funding shale gas is not readily available any more, as returns haven’t been high.
Consequently, the number of operational US oil rigs remains subdued and has not recovered to pre-2014 levels. Despite the recent gradual rise in oil prices, the rig count has not risen since July this year. Chart 2 has the details. Ideally, rising crude oil prices should have encouraged more rigs to be operational. To some extent, though, the fall in operational rigs could also be owing to hurricanes.
Nevertheless, for now, it appears that Opec’s production cuts and disruptions in the US owing to the hurricanes are winning the war on crude prices. Secondly, with global growth looking better than before, the demand outlook is relatively stronger.
What next? Looking into 2018, three quarters out of four will be roughly balanced—again using an assumption of unchanged Opec production, and based on normal weather conditions, said the International Energy Agency in its October oil market report. “A lot has been achieved towards stabilising the market, but to build on this success in 2018 will require continued discipline,” it said. In that context, Opec’s forthcoming meeting on 30 November will be critical. It goes without saying that comments regarding extending the output cuts will be taken positively.
While the market watches those developments closely, sentiments have certainly improved. Note that the rise in prices is devoid of volatility, suggesting that oil seems to be in a silent bull market, says BNP Paribas’ Jain. “If Brent remains at $60 a barrel for some time, it will create a strong base and I will not be surprised to see prices touching at least $70 a barrel,” he added.
India has reason to lose sleep over this. Higher oil prices aren’t good news, given that the country imports a huge portion of its oil requirements. “Higher oil prices are tantamount to a negative terms-of-trade shock that weakens growth, pushes up inflation and deteriorates the twin deficits,” Sonal Varma, managing director and chief India economist at Nomura Holdings Inc., wrote in a report on 1 November. The firm estimates that a $10/ barrel rise in crude oil prices would increase Wholesale Price Index inflation by around 1.3-1.4 percentage points and widen the annual current account balance by 0.4% of gross domestic product.
The silver lining is that analysts expect the move beyond $70 a barrel to be tougher considering higher prices will encourage ways to improve shale production. Shale oil’s role in capping the gain in crude oil prices continues to be crucial. However, the current rebalancing, pickup in global growth and cost inflation issues in the shale portfolio could well mean that the cap may get revised higher. In the immediate future, investors would do well to stay tuned to the news flow from the Opec meeting.
Tadit Kundu contributed to this story.