Oil price recovery: the next level

Oil prices have staged a recovery since early 2016, but remain at around half the level they were in the middle of 2014.

Given the recent improvement in oil prices, many investors are wondering how far the current rally will go. Are we soon going to see Brent crude climb further, moving up from the current $57 per barrel, past the $60 per barrel and then onwards beyond $70?

Or, is oil destined to stay lower for longer, perhaps remaining in the $50-to-$60 range for some time to come?

Oil´s big drop

The answer to this question lies at least partly in understanding why oil plummeted so quickly from a peak of $115 per barrel in the middle of 2014 to as low as $28 per barrel at the beginning of 2016.

Most big historical slumps in oil prices have been caused by falling demand during times of recession or economic slowdown. This was just such the case during the recent Great Recession, with oil dropping from over $140 per barrel in the middle of 2008 to trade at under $40 per barrel at the beginning of 2009.

But the most recent downturn in oil prices doesn´t fit into this category. The global economy was still in an upswing when oil began to fall in 2014 and the global economic outlook has generally strengthened since then.

The reason for the most recent big pullback in oil prices was in fact due to a glut of supply rather than a major slowdown in demand.

OPEC

Glut pressure

Oil prices began to come under pressure early in 2014 as big OPEC producers ramped up production in a bid to grab market share.

The oversupply was then compounded by falling production costs in the US and the emergence of the latter as an exporter.

US federal law had forbidden the export of domestic crude to all markets with the exception of Canada. This all changed in 2015, when the law was altered to allow US producers to export far and wide.

Data from the US Energy Information Administration (EIA) shows the nation´s exports have risen dramatically this year.

US crude exports for the first half of 2017 hit 784,000 barrels per day (bpd), a near 60% increase on the same period of 2016.

Total US crude production is currently running at around 9.5 million bpd, with the vast majority of output still earmarked for the huge domestic market.

Bullish developments

While most of this sounds quite bearish for oil, there have recently been some bullish developments in the market.

First and foremost, OPEC and allies such as Russia have come together to curb supply, with the aim of driving up prices.

One of the group´s problems, of course, is that it can do nothing to stop US producers, which are also now exporters, from raising their own output.

However, OPEC and its allies still reign supreme in the oil market; Saudi Arabia, the leading figure, usually produces somewhere in the region of 10-to-11 million bpd in its own right.

As the world´s biggest single exporter, Saudi Arabia typically exports somewhere in the region of 7 million bpd.

Saudi Arabia

OPEC progress

Given these latter figures, it´s little wonder that oil prices have picked up over recent months amid signs that OPEC and its allies have made progress in curtailing their production.

Based on an agreement drawn up last year, OPEC along with Russia and nine other producers, have managed to cut their collective output by around 1.8 million bpd since January.

The group´s pact runs until March 2018 and they could well extend their agreement beyond that date.

Saudi Arabia, by far the most important member of the grouping, is currently targeting a major reduction in global inventories.

Once inventories are down to what it sees as a more acceptable level, oil prices could well become more sensitive to any increases in demand as well as marginal reductions in output.

The collective claims to have so far reduced global stocks by around 180 million barrels, but says it still has another 160 million barrels to go.

Compliance among the members of the group is thought to be on the increase, standing at around 86% for the year.

Further to go?

At present, there´s still a lot of pessimism in the oil market. On the one hand, US producers that have only recently emerged as exporters have been benefiting from lower-cost drilling techniques. In some cases, US producers can now break even with oil prices as low as $40 per barrel.

Then there are other longer-term factors depressing sentiment such as the increasing popularity of electric cars and moves to encourage such technologies by governments around the world.

However, it would be foolish to discount further rises in oil prices over the next couple of years. Brent crude has climbed from lows of around $45 per barrel in June to the current $57 level mainly on signs of progress by OPEC and its allies.

There has also been news of higher demand from China, Europe and the US to support the market.

Chinese industry fueling demand for oil

Big numbers

Given the sheer scale of their output, much will depend on the determination of countries such as Saudi Arabia to further rein in supply.

But once they reach their target of lowering global stock levels, oil prices will be so much more sensitive to any upturn in demand as well as any further supply reductions.

At present, no one appears to believe that oil will ever get back to $100 again. But could it? Yes, it could.