Picture from Bloomberg

The recent rally in crude oil, though totally not unexpected, caught many analysts by surprise as to the scale and speed of the price appreciation. The West Texas Intermediate (WTI) Crude Oil, traded on the New York Mercantile Exchange (NYMEX), has risen more than 21% since mid- March. Crude oil futures have appre-ciated 45% since the beginning of 2021 on a host of bullish fundamentals that have relentlessly driven the price of this commodity to heights that were unimaginable at the begin-
ning of this year. With Brent Crude trading above US$70 ($92.70) a barrel (as of June 7), prices are back to pre-Covid levels.

On the one hand, the bullish optimism for economic recovery in the second half of 2021 has helped to restore oil demand growth, reduce bloated inventories and hasten the rebalancing process. On the other hand, the seemingly unrelenting global pandemic continues to rear its ugly head and ravage several regions of the world through a constant resurgence in infections.

Although the two key drivers of crude oil are inextricably linked to one another and the outcome of one will, by default, impact the other, this latest wave of Covid-19 has been especially devastating to India, which is experiencing a record-breaking rise in infections and loss of life. The country has had to deal with record surges in daily infections. A large number of Indian regional states have locked themselves down and health systems are overwhelmed with the influx of patients and inadequate medical supplies and equipment.

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India is the second-most populous country in the world and the third-largest oil importer, and therein lies the importance of the country to the oil market. Until this key demand growth driver of crude oil is normalised, global economic recov-
ery would be considered muted. Yet the price of crude oil continued to appreciate, with traders choosing to lend only a little weight to the fact.

Even Indian stock indices are booming as traders pay extra heed to the vaccination drive in the subcontinent to help the nation recover.

The complex nature of this dynamic is due to the fact that unlike a number of commodities, crude oil contracts, even nearby ones, trade on future expectations rather than the present reality. Crude oil traders look ahead to the horizon to envisage what the supply-demand dynamics and inventories levels would be in the next few months and then gauge the present price of crude oil which they would be comfortable with.

Presently, the economic picture in the OECD countries continues to brighten, especially in the US. China, the world’s largest importer of crude oil, is another bright economic spot. With the wide and effective rollout of vaccination programmes in these countries and a vast influx of central bank and government economic stimulus measures, life is slowly but steadily returning to normal again. Oil traders are optimistically looking ahead to better times.

Even major oil exporters and their allies in Opec+ are optimistic about the outlook for crude. At their recently concluded monthly meeting which lasted only about 20 minutes, the organisation noted the ongoing strengthening of market fundamentals, with oil demand showing clear signs of improvement and OECD inventories falling as the economic recovery continued in most parts of the world. Opec+ has grown from what was considered an enigmatic and acrimonious alliance to one that understands benefits of conformity among members. The 100% conformity level reported by the organisation technical committees is expected to continue into the next half of the year or at least till the pandemic stops ravaging countries.

The Opec+ alliance, which at its June meeting agreed to hike output in July, may need to keep adding barrels to the market towards the end of Q3 to meet the recovery from the pandemic. More countries are starting to get a hold on the Covid-19 spread, economies are gearing to handle pent-up consumer demand, especially in air travel. While it is noted that the rebound remains patchy in parts of Asia, the sharp recovery taking shape in the West is already spurring calls for Opec+ to ensure the market does not overheat.

The other factor that would be supporting crude oil prices is the expectation that US shale oil output would lag even as prices appreciate. Although, as crude oil prices have climbed to their highest level for more than two years, US shale producers have added only a limited number of extra rigs and production, opting rather to push for higher prices and profits instead.

It is debatable whether current prices are rising mostly because of the declining responsiveness of the shale sector or because of the discipline and production restraint from Opec+. For the first time in decades, oil drillers are not rushing to increase production to chase rising oil prices as Brent crude tops US$70. Even in the Permian, the prolific shale basin at the centre of the US energy boom, drillers are resisting their traditional boom-and-bust cycle of spending.

US crude futures are at their highest since October 2018 while frontmonth Brent futures prices have hit the highest level since April 2019, signalling the need for more drilling and production. Since the middle of February, however, the rate at which rigs have been added and total number employed have both started to lag behind previous recoveries. The number of rigs drilling for oil in the US has already more than doubled from its cyclical low in August 2020, yet the rate of growth is slow.

Over the last decade, US shale producers have normally captured market share from Opec+ whenever prices were above US$55–60 per barrel. The shale sector’s muted response so far to higher prices implies a larger production-consumption deficit later this year, a faster drawdown in inventories, higher spot prices and a larger backwardation of the forward curve.

The short-term oil market in the next half may be volatile with frequent pullbacks as crude prices struggle with lower Indian demand. There is also a large possibility of additional Iranian barrels flooding the market on expectations of a nuclear deal. In May 2018, when the former American president withdrew from the nuclear deal, Iran exported an estimated 3.2 million barrels of oil daily. An agreement may not be on the table before Iran’s June 18 presidential election.

Another bearish fundamental driver that could increase the number of oil barrels in the market is the cessation of hostilities in Libya that has allowed Libyan crude production to increase to over 1 million barrels per day. No doubt the return of these barrels to the market may affect the supply demand dynamics of crude, but we opine that Opec+ may adjust their tapering effort to re-balance the oil market and prevent prices from backsliding.

Although oil prices have run up at quite a fast pace and a minor pullback may be technically healthy as deep pullbacks may provide opportunities for buying the dips, the major uptrend is still intact and WTI prices may reach US$80 a barrel in the second half of 2021.

Avtar Sandu is senior commodities manager at Phillip Futures


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