Oil Prices: Is The Bottom Behind Us And Is It Too Late To Buy?

In the U.S., it feels like spring has finally sprung this last week, along with hopes that the bottom in oil (and stock market) prices is finally behind us. But is it time to buy? There are very clear reasons why oil has bounced hard so far this month, but it is less obvious that these factors are permanent. Looking at the sources of the recent rebound in oil prices, it appears oil won’t reach new lows, but will remain volatile and trendless for several months before climbing again in the second half of the year.

As I mentioned in a recent article “Saudi, Shale & Iran..,” (click here) oil prices have been driven low primarily due to supply factors. As the U.S. producers entered the scene and ratcheted up production, Saudi pumped even more to try to quash the competition, and Iran’s oil came on line after years of sanctions, the world has been awash with oil. In order for prices to rise, the supply of oil has to be curtailed. So has this happened? These are the signs of cuts that have driven the recent rally:

• Nigeria, Iraq, and Turkey have suffered violence and attacks on pipelines, which has caused disruptions in supplies from these countries and from Kurdistan. While these issues are significant they are not permanent. Nigeria’s situation is likely to last until April, and Turkey has indicated it can take months to repair the pipeline. Any oil price jumps stemming from these events are thus rather temporary and confined to near-term oil contracts.
• Russia and Saudi (along with Venezuela and Qatar) announced in mid-February a “deal” that they would freeze oil output at January levels. While markets may be excited at the first non-OPEC/OPEC country agreement in over a decade, in reality, the output levels in January were already at near record highs and the agreement was for a freeze, not a cut. Saudi representatives have indicated that they are still not interested in reducing production, though Russian officials seem to be striving for more aggressive agreements down the road. All in, while it shows that the two largest oil producers are beginning to squirm, it does not promise a permanent decrease in supply.

Crude Oil Stocks (m bbls)

• Industry data released at the end of February showed that finally U.S. production was decreasing. Namely, Texas and North Dakota – the two big shale states – were down significantly. This is what the Saudis and the markets have been waiting for! Overall, U.S. inventories have actually climbed as imports rose and overcompensated. It is too early to tell whether the shale states will continue to lower output, or if this recent rebound in prices has them turning on the taps again. This is one of the key items to watch in the next few months.
• In spring, refineries tend to start their maintenance schedules. As such, production tends to fall on the margin and support prices. While temporary, it can help support prices this month and next.

Supply issues aren’t the only recent drivers. Demand factors are also in play. These seem to support oil prices.

• At the end of 2015, the world’s economic growth rate fell further, and alongside it, projected global oil demand. In February and in early March, better economic data in the U.S. and a jump in Chinese credit data have given markets hope that global growth rates have also bottomed. The U.S. data is rather widespread across indicators, so it’s likely this will continue for the foreseeable future. The Chinese data is just one piece of evidence and there is definitely not a trend yet.
• Gasoline demand has surged, and tends to gain momentum into the summer months. If past history holds true, a surging gas demand often leads to overall oil demand. As demand increases, prices should follow.

Besides the actual supply and demand of oil, the U.S. dollar has also been a contributing factor, weakening decisively against both major and developing market currencies over the past few weeks. A weaker dollar tends to correlate with stronger oil prices. Whether the dollar continues to stay weak likely depends on whether the U.S. economic recovery picks up relative to the rest of the world, and also whether the Federal Reserve continues on its interest rate hiking path. An imminent Fed hike would likely result in dollar strength, and likely dampen oil prices once again.

The Dollar and Oil Prices

Finally, investor positioning in the oil markets is highly relevant to price action. After a record short position in January (investors placed record bets on falling oil prices), the better data and the first round of oil price jumps appears to have caused some serious squeezes on prices. Shorts were liquidated and investors began to accumulate long positions. When positioning is not as extreme, price movements aren’t as volatile. Therefore it is less likely that we witness further large spikes in prices due to capitulation in shorts.

The market still appears to be a supply driven oil market. As is often said, the cure for low oil prices is low oil prices. We probably need to see several more months of low prices in order for producers to curtail production and bring prices more permanently higher. If more regions can follow the U.S. path out of recession, demand can play a larger role.