Oil prices have benefited from a number of developments in recent weeks, including fresh data indicating declining production and healthy consumption, weakness in the US dollar, and news of supply-cap discussions between select OPEC members and Russia. While some market observers—including the International Energy Agency (IEA)—have suggested the low price reached on February 11 represents a bottom, it remains to be seen whether the factors driving the recent rebound in prices prove to be lasting or fleeting.
The recovery in oil prices, up 46% as of March 31 from the February low, almost certainly has links to the declines in US production. Among the markets most sensitive to prices, US production registered its second consecutive year-over-year decline in January, moving closer to falling beneath the 9 million barrels per day mark, according to US government data released in late March. Non-OPEC production excluding the United States also recently turned negative, as operators in Brazil, China, and the North Sea faced challenges. These declines have been accompanied by unexpected supply disruptions in Iraq, Nigeria, and the United Arab Emirates, which have renewed concerns about political risks, and lower-than-expected production from Iran.
Future production expectations have also been ratcheted down as cuts to upstream capital budgets this year continue to mount—according to research firm Wood Mackenzie, budgets of 121 companies have been reduced by $91 billion. These reductions come as 51 North American oil & gas producers, representing $17.4 billion in cumulative debt, have filed for bankruptcy since the start of 2015, according to one source, with many more at risk.
With falling levels of production, the supply/demand imbalance appears set to narrow as data continue to suggest healthy levels of consumption. In the United States, low prices and mild weather have helped gasoline demand hit a seasonal high, putting it on pace to potentially outstrip the annual high logged in 2007. Gasoline demand expectations for China, the second largest market behind the United States, received support in recent weeks from new accommodative policies from the People’s Bank of China. Despite weak distillate demand and clear downside risks linked to a shaky global economy, the IEA continues to expect global oil demand to rise by 1.2 million barrels per day in 2016.
The recent easing of the US dollar—down by 5% from its year-to-date high according to one prominent index—has also buoyed oil prices. As the value of the greenback falls, sellers of the dollar-denominated commodity require more currency to part with the same quantity of oil, providing a support to prices, all else being equal. While the change in expectations of Fed rate hikes that accompanied the recent period of US dollar weakness has been a boon to oil prices, it may also work to delay the supply destruction needed to restore balance in the market.
Perhaps the biggest headline grabber in oil markets has been the talk of an output freeze between select OPEC members and Russia. Under the initial conditions announced by the Saudis, production would be held at January 2016 levels, levels that were record highs for several producers. Although none of the countries that intend to take part—Iran and Libya have already signaled their intent to sit out—are expected to raise production this year, with the possible exception of Saudi Arabia, discussion of a freeze is likely to have been a factor in recent bullish positioning.
While structural forces are working to correct the oil market’s supply/demand imbalance, new price lows cannot be written off. Inventory levels remain exceptionally high, with some locations near capacity, and the gap between supply and demand is still too wide. A decision to freeze production in select OPEC members and Russia to January highs may not mean very much, given their limited spare capacity to grow production, but news of no deal at their upcoming April 17 meeting would certainly not be helpful to prices.
Kevin Rosenbaum is an Investment Director on Cambridge Associates’ Global Investment Research team.