Rally in Oil Prices is Fundamentally Driven, not Speculation
Oil prices are at their highest since the start of the year, after rising above the key $50-a-barrel mark in September and holding those gains. Rather than pure speculation, this move is rooted in fundamentals: falling inventories and increasing demand. The outlook for crude is no less bright as U.S. fiscal stimulus, in the form of tax cuts financed by additional deficit spending, could also send oil prices higher.
In the U.S., total stocks (excluding the Strategic Petroleum Reserve) are down 5.6 percent from a year ago, with distillate inventories lower by 14.4 percent at a time when economic growth has been solid and diesel demand is likely to remain strong. Plus, heating oil demand will soon kick in as the winter approaches. And if refinery runs increase to meet these product deficits — which seems likely — demand for crude would strengthen, further boosting prices.
Falling oil and petroleum product inventory dynamics is not just a U.S. phenomenon. Commercial stocks have been trending lower all year for the member countries of the Organization for Economic Cooperation and Development, both in absolute terms and in the number of “days of supply.” Due to these declines, OECD commercial stocks are now close to the average OECD commercial inventory levels between 2012 and 2016. These supply dynamics are supportive for oil prices.
Crude oil — like all commodities — is bought and not sold. That means global oil demand is even more important than available stocks, especially for near-term price dynamics. To understand the current demand-side pressures, global purchasing manager indexes (PMIs) for manufacturing are an excellent leading proxy for oil prices.
Despite all the talk of the shale revolution, one of the main reasons oil prices fell so sharply in late 2014, 2015 and early 2016 is that China entered a manufacturing recession. Ignoring the official government gross domestic product data, the Chinese Caixin Manufacturing PMI conveyed contractions, defined as readings below 50, in 18 out of 19 months between December 2014 and June 2016. The index has only contracted once since July 2016, demonstrating that Chinese growth in manufacturing — and overall economic and oil demand growth — are on stronger footing.
Improvements in Chinese manufacturing have occurred against a backdrop of very strong compounding expansions of the U.S. ISM manufacturing index and the euro-zone manufacturing PMI that have recently led to multi-year highs. Although the U.S. ISM eased in October to 58.7, it remained near the September reading, which was the highest in 13 years. The October euro zone manufacturing PMI at 58.5 is the highest in 80 months.
Tax cuts and additional debt-financed spending that spurs U.S. growth would likely have what supply-chain experts call a bullwhip effect through the global economy in a way that strong U.S. growth supports even stronger growth in manufacturing-centric economies such as China, which also happens to be the world’s biggest net importer of crude oil. A stronger pace of growth in China could exert an outsized impact on demand for commodities, which would likely send crude oil prices higher.
Against this price-supportive set of dynamics, trading technicals are starting to contribute to the rise in both West Texas Intermediate and Brent oil prices. For WTI, there has been a trend of higher lows in place since June 2017. Plus, prices have been trading above an important support line of higher lows that held firm from April 2016 until May 2017 (the blue diagonal line in the graphic). That followed WTI’s rise above its 30- and 100-day moving averages, as well as bullish signals in relative strength and volume technicals. It looks like traders and algorithms have fallen in line behind the fundamentals of supply and demand.
Oil prices may not see a linear rise higher, and there is a perennial risk of price volatility around the next OPEC meeting in Vienna, on Nov. 30. Nevertheless, there are further upside risks to Brent and WTI oil prices in the year ahead, as global growth remains strong and inventories are at risk of declining. If U.S. tax cuts go through, that upside risk to prices could be even greater. After all, even if shale drilling increases with higher oil demand and oil prices, the boost to global growth could engender oil demand that outstrips potential available short-term shale production that is subject to sharp decline curves. – Jason Schenker
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