Oil Prices At A Ceiling, Or Just Getting Started?

Oil moved back into bull market territory this week, with Brent prices jumping to a more than two-year high at $58 per barrel. A confluence of events has given a jolt of optimism to oil prices, with market sentiment at its most positive arguably in years.

The proximate spark from earlier this week was the Kurdish referendum, which raised the specter of a sizable supply outage when Turkey threatened to cut off Kurdish oil exports through its territory, and Baghdad joined in by calling for an international boycott of Kurdish oil sales. So far, there are no signs of an actual supply disruption, but oil traded up at the start of the week on the heightened geopolitical risk.

But Brent prices have only moved up into the upper-$50s because the underlying fundamentals have improved markedly in the last few months. Oil demand is robust and continues to grow even as global supplies have stagnated. The OPEC deal seems to finally be bearing fruit in the form of a sharp decline in global crude oil inventories.

The oil market could finally be breaking out of a depressed pricing environment after three years of sluggishness, according to Trafigura Group, an oil trading company. "We are nearing the end of 'lower for longer' oil," Ben Luckock, co-head of Group Market Risk at Trafigura said at the S&P Global Platts APPEC conference in Singapore on Tuesday. Luckock cites the fact that the oil market could lose some 9 million barrels per day (mb/d) by 2019 just from well depletion. That could leave the world short on supply, pushing up prices significantly.

Citigroup said that the supply crunch could come as soon as next year, arguing that so many OPEC members are already producing at their maximum, despite nominally restraining output. Libya, Nigeria, Venezuela, Iran and Iraq might not be able to add new supply next year, Citi says. And in fact, the risk of a slide in production is probably a more likely outcome for some members. "Fear in the market has been that OPEC production will rise dramatically," Citi's Ed Morse said in Singapore. But, "there could be a supply gap emerging, which could point to a tighter market." Much of OPEC is failing to invest in its upstream capacity, Citi argues, leaving little room for higher output. Related: Is This The End Of U.S. Dominance In Global Energy?

Goldman Sachs added its voice to the growing chorus of bullishness this week. The investment bank argues that the backwardation exhibited in the Brent futures market-a situation in which near term oil contracts trade at a premium to futures dated further out-is a clear sign that the market is on its way to rebalancing. Backwardation will help drain inventories at a faster rate in the months ahead. "[T]he combination of very strong demand, potential greater cohesion among OPEC and growing pains for shale suggests that backwardation is likely to remain in place in coming months," Goldman wrote in a note.

However, not everyone agrees that there is further room to run for oil prices, and just because oil has rallied in the past few weeks, does not mean that greater price increases are a foregone conclusion. There are several roadblocks ahead.

With Brent prices back towards $60 per barrel, there could be a temptation by some OPEC members to add some barrels back onto the market, undermining the group's collective compliance rate. The original six-month OPEC deal was much easier. The market looked much less stable, and cuts came at a seasonally advantageous time-Russian output tends to decline in winter months, for example, while it ticks up in summer months. Russia's numbers look better recently, but only because of field maintenance.

With oil back (almost) at $60, the rationale for the OPEC cuts could lose some of its urgency. $60 has sort of been the informal target for the cartel, and participating countries are much more likely to cheat with prices firming up at that level, according to Olivier Jakob of Petromatrix. Related: Oil Analysts Baffled As Venezuela Ditches Petrodollar

At the same time, many argue the OPEC cuts still need to be extended because a $60 price signal will spur more shale drilling, putting downward pressure on the market all over again. "Brent could go above $60 a barrel in the fourth quarter," Giovanni Staunovo, a commodity analyst at UBS Group AG, told Bloomberg. "It would send the wrong message to U.S. shale production to hold above there-drill and produce more."

Moreover, Chinese oil demand soared earlier this year but has since cooled. U.S. shale continues to add output, and they also have a huge backlog of drilled but uncompleted wells. The fracklog, coupled with a step up in drilling, could lead to production growth of about 400,000 bpd over the next four months, Alexandre Andlauer, an analyst at AlphaValue SAS, told Bloomberg in an interview.

Finally, the financial positions of hedge funds and other money managers are starting to look a bit overdone. The recent surge in bullish bets from investors opens up more downside risk. As has been the case numerous times in the past two years, when bets on futures go too far to one side, the pendulum swings back. "The market is apprehensive about pushing [Brent] to $60 a barrel," Geordie Wilkes, a research analyst at brokerage Sucden Financial Ltd., told The Wall Street Journal.

As always, there's much disagreement among oil analysts on what happens next.

By Nick Cunningham of Oilprice.com

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