Brent crude has successfully consolidated its position above $60 per barrel this week, and WTI is approaching $55 per barrel, which would be the highest oil price in more than two years.
The gains come after OPEC officials have all but signaled that they will extend their production cuts in a few weeks at their meeting in Vienna. But crucially, an extension would occur at a time when the oil market has significantly tightened, bolstering the bullish momentum exhibited for crude prices.
Evidence that the oil market is tightening can be found in the oil futures market. The futures curve for Brent has already been in a state of backwardation for some time—a situation in which near-term contracts trade at a premium to futures dated six months or a year out. The result is a downward sloping futures curve (i.e. longer-dated contracts are cheaper than near-term contracts).
The reason the curve is important is because a state of backwardation traditionally accompanies periods of time when the oil market is tight, whereas contango—the opposite of backwardation—crops up during surplus times. A contango allows for stashing oil in storage because it can be sold at a higher price at a later date. We have seen plenty of that over the past three years as the market buckled under the weight of too much supply.
Brent has been in backwardation for much of this year, but the backwardation has become more pronounced recently, with the December 2017 Brent contract recently trading $2 per barrel higher than the December 2018 contract, the strongest differential in more than three years. The December 2018 contract, in turn, is trading at a $1.50 per-barrel premium to the December 2019 contract—which is, again, the largest spread since early 2014, Bloomberg reports.
But, as many might recall, oil prices were trading in triple-digit territory in 2014, so the current state of the Brent futures market is an incredibly bullish sign. “It’s not much more complicated than this: stockpiles are falling, the market is bullish,” Tamas Varga, an analyst at brokerage PVM Oil Associates Ltd., told Bloomberg. “The whole change in structure was triggered by the perception that global inventories are falling.”
Adding fuel to the bullish fire is a recent piece of data from the EIA that backs up the case that U.S. shale is not preforming as well as everyone thinks. The EIA recently released August oil production data, which showed that total U.S. oil output actually fell from a month earlier, dipping from 9.234 million barrels per day (mb/d) in July to just 9.203 mb/d in August.
As I have written in the past, the EIA’s weekly figures, which are more up-to-date but diverge quite a bit from the more accurate monthly figures, may be overstating output from the shale patch. For example, in June, the weekly estimates pegged U.S. output at about 9.3 mb/d. A few months later, when the monthly data came out, the EIA said June production was actually just 9.096 mb/d.
The same thing seems to occur every month—the weekly figures are undercut by lower monthly totals. But because the monthly figures come out on a several month lag, the market seems to overlook the correction. The same thing happened in August, the latest month for which data is available. At the time, the weekly estimates looked like this:
August 4: 9.423 mb/d
August 11: 9.502 mb/d
August 18: 9.528 mb/d
August 25: 9.530 mb/d
So, in August, we are to assume that the U.S. produced something like 9.5 mb/d, right? Yet, just a few days ago, the EIA released its more accurate retrospective monthly estimate, and put total U.S. output at just 9.203 mb/d for August—a discrepancy of about 300,000 bpd.
In other words, it’s quite possible that U.S. shale is performing worse than everyone seems to think. With rising costs, a falling rig count, production problems, and lots of debt, the shale industry is on the verge of a slowdown. Or a “midlife crisis,” as Bloomberg puts it.
As the market wakes up to the fact that U.S. shale won’t be the huge drag on prices that most forecasters have assumed, there will be much more room on the upside for prices. And with bullishness already picking up, that could translate into real price gains.
By Nick Cunningham of Oilprice.com
