Drivers of Oil Prices Prove Slippery to Grasp

Drivers of Oil Prices Prove Slippery to Grasp

by Charles Wilson, PhD & Charles Roth, Thornburg Investment Management

Currency movements more than a failed "freeze" deal explain volatility in crude prices. But energy market fundamentals will ultimately determine price levels more than currency effects.

Headlines predicting the retreat in recently resurgent crude oil prices following the collapse of weekend talks in Doha among the Organization of Petroleum Exporting Countries (OPEC) and Russia quickly became dated Monday, as it became clear that the deal to "freeze" production wouldn't have changed near-term energy market fundamentals much anyway. Saudi Arabia, OPEC's undisputed leader, and Russia are already producing at record levels, while Iran is steadily ramping up its crude output and exports.

The deal never seemed very promising to begin with, as Iran had made clear it wouldn't agree to hold its output at current levels, which are well below those reached before recently lifted international sanctions on the country were first imposed. Meanwhile, Saudi Arabia was clearly loath to restrain its output without Iran, its regional rival, doing the same. Hence, speculation on the deal's prospects may have played a marginal role at best in the spectacular rise in crude prices in the first quarter--jumping from a nadir of some $27 a barrel to north of $40 in the period. Given that developed country commercial inventories are brimming--U.S. crude oil inventories alone hit 537 million barrels in early April, the highest level since 1929--what's driving the rebound in crude prices?

The Doha meeting's failure sent ripple effects through currency markets. That supports the notion that the climb in oil prices this year has been more a currency-driven "risk-on" dynamic--fueled by dovish language from the U.S. Federal Reserve--not a change in energy market fundamentals. In fact, as the Fed held off following its December interest rate hike with another in the first quarter and emphasized that further tightening would only come "gradually," the dollar softened, paving the way for sharp gains not just in oil, but also other currencies and commodities (including industrial metals) and emerging market equities.

As for the oil market fundamentals, some analysts have called an inflection point--always a perilous exercise--in late January, when crude production in the U.S., now the world's de facto swing producer, resumed a downward trend, leaving production at 8.5 million barrels a day (b/d) at the end of March. Output from the U.S. lower 48 states had fallen from 9.2 million b/d last June to level off around 8.6 million b/d in October, before climbing back to 8.7 million b/d in January. U.S. shale producers proved remarkably resilient by focusing on the easy production spots and improving well cycle times. That delayed the turning in the market cycle.

But efficiencies in well completions and the like have become harder to pull off. Shale producer oil price hedges have also been rolling off in greater numbers, and cash flow among many smaller companies has already turned negative with crude prices at current levels. U.S. oil-rig count has lately been running around 440, which is down more than 70% from the October 2014 peak of a little over 1,600. U.S. companies have slashed capital expenditure budgets and laid off tens of thousands in non-essential or less-experienced workers, making a quick rebound in production difficult. Outside the U.S., we have also seen recent potential and actual supply disruptions in Iraq, Kuwait, and Nigeria, not to mention more challenging North Sea production, support prices.

Although the data backing the late-January inflection-point call are compelling, near-term oil market fundamentals are still stacked against a continued rebound in oil prices. The rebound may spur capable U.S. producers to connect drilled but uncompleted wells in an effort to boost cash flows. Aggressive Saudi Arabian, Russian and Iranian production efforts continue, and the current supply disruptions will likely be resolved before too long. Significantly, developed-country commercial stocks "built counter-seasonally" by 7.3 million barrels in February to end the month at 3.06 billion barrels, according to the International Energy Agency's (IEA) April report. "Accordingly, the overhang of inventories against average levels widened to 387 million barrels at end-month. Preliminary information for March suggests OECD (Organization for Economic Cooperation and Development) holdings rose further, while volumes of crude held in floating storage increased," it added.

And on the flip side, global oil demand growth is hardly encouraging, "as notable decelerations take hold across China, the U.S. and much of Europe," the IEA noted, while forecasting that global demand growth will ebb to around 1.2 million b/d this year, down from 1.8 million b/d in 2015.

Currency-driven moves by Fed policy and guidance can certainly impact oil and other risk-asset prices in the short term. But oil market fundamentals will ultimately have a greater impact on crude prices.

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