Higher than expected US crude inventories, relatively weak global demand in Q1, and re-emerging concerns around Chinese financial conditions have put the bears in control of the oil market. Speculative longs threw in the towel as prices fell below the 200 day moving average of $49.01 and broke the year’s lows of $47.01. Are we back in a period of oil price weakness or is this simply a correction?
Volumes have been high on this move down, as the momentum has pushed specs to stop out of long positions. The market seems to have fully priced an OPEC and Russia extension, as no amount of jawboning seems to affect price trajectory. The bad news is, OPEC needs to extend the deal just to keep prices stable given such high expectations. The market has completely “round tripped” the move from the November 30 OPEC cut announcement.
The market is looking for substantial inventory draws as evidence that the OPEC cuts are indeed driving global rebalancing. US inventory numbers released on May 3 did not provide that evidence, instead they showed combined commercial crude and product stocks building. While the OPEC cuts are larger and more impactful than US production growth, US product demand continues to come in weaker than expected. The total four week average US product demand contracted by 490 kb/d y-o-y to 19.58 mb/d (-2.4%). This included a 259 kb/d drop in demand for gasoline. We continue to believe that the weakness in gasoline demand is a result of price elasticity, as retail gasoline prices have averaged about 24% y-o-y. The y-o-y retail gasoline 2Q17 price change is likely to be much narrower, thus having a lower effect on demand. Distillate demand continues to be a bright spot, confirming that the US manufacturing sector has firmed. I do not believe this “demand miss” is a systemic problem and feel we will see a seasonal re-acceleration in global demand in coming quarters.
However, there seems to be a reemergence of concern around Chinese financial conditions and their implications on the commodities market. China’s tightening monetary policy, which started in October of 2016, has gradually intensified in 2017. So far China has stepped up supervision on off-balance sheet credit risk through asset management products, limited market leverage by tightened the bond repo eligibility rules, and enacted guidelines to control local government debt. As short term repo rates creep higher, the China Monetary Conditions index continues to edge lower, putting pressure on base metals and taking the overall commodities complex lower.
2017 oil price recovery will not be a straight line given the points I mentioned above. I continue to see evidence that the market is rebalancing and on pace to draw about 200 million barrels of oil from storage by year end. Despite extremely poor sentiment, I see a slow but steady improvement in global fundamentals that suggest higher prices in the months to come. However, supply is likely to become a problem in 2018 and 1H2019 as US production growth and OPEC production normalization overtake demand. Oil prices will likely rally from here, but not beyond 3Q17.
Source: J.P. Morgan Asset Management, EIA Short Term Energy Outlook, IEA Oil Market Report as of April 31, 2017.