Oil Rally Disconnect – Expectations vs. Reality

By ,   May 7, 2015

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Since the middle of January, oil prices (Brent Crude) hit bottom and rallied significantly – from 45 to 69.  The problem is that the futures market looks to be well ahead of the physical market.  Such speculation is common, but the caution is that if the assumptions do not come to fruition.  We could see a decline in the short term as the market reprices. 

Brent Crude 2 Yr Chart

In response to falling prices, oil producers have shut down rigs, cut or delayed projects, and slashed labor to circle the wagons.  These reactions should help curb production and help stabilize prices in the future.  Storage levels have also moderated, which has encouraged many speculators.  The problem is sovereign nations like Saudi Arabia in particular are not interested in cutting back their production, even though prices have declined substantially.  In fact, OPEC and the International Energy Agency reports surplus world production of 1.5 million barrels a day.  

Traders cite increased demand expectations as Europe recovers and the U.S. enters the summer driving season.  Yet, in the physical market, buyers in Europe are still hard to find.  European markets have been strong this year, but moving an economy takes time.  Unemployment remains over 11%, so while things are looking better, it will likely be awhile before the momentum takes full root in the economy.  

China is another wildcard on the demand side.  Many question whether or not China will begin buying for their strategic reserve this year.  Growth has slowed to 7%, so it is difficult to count on anything there.  

Remember, investing is about probabilities, and a lot of positive news is being priced into the oil market.  When you have large disconnects in the prices and market fundamentals, it is best to be cautious and prepare for the possibility that those expectations may be unfulfilled.  

– Charles Freeman, CFA

References:

Dmitry Zhdannikov, Ron Bousso and Libby George “Oil’s bull run hides a deep disconnect, crude traders warn – RTRS”  May 6, 2015