Robert Blews, 27 July 2017

Like all good stories, the narrative that has emerged to explain recent oil price weakness contains some truth. However, not all the data supports the consensus view that rising US production is driving oil price weakness. This note explores an alternate reason for oil price weakness and explains why we think this trend is starting to reverse.

Summary view

  • Market participants have accepted the somewhat questionable view that higher US production and a growing oil rig count are the key reasons for recent oil price
  • In our view, a far more likely explanation is that bullish positioning in energy equities and oil futures became too one-sided (crowded). As speculators have unwound their positions, prices have fallen.
  • Meanwhile, the outlook for oil supply and demand has actually improved over the past few months, and will likely improve further as we move through the
  • With speculative positioning in US oil markets having unwound significantly, we see scope for oil price gains as we move throughout the year.

Testing the consensus view
Over the past several weeks, a consensus view has emerged to explain the recent price weakness in global oil markets. The narrative goes something like this – rising production from the US and Libya is offsetting the production cuts that OPEC has undertaken in an attempt to stabilise the market. As a result, oil inventories should continue to build and the market will remain over supplied.

Like any good story, there is some truth to this narrative. However, a closer look shows the data does not necessarily support this view. To begin with, the US rig count has been rising for over a year now. Meanwhile, US production has been rising for nearly 9 months.

US rig count and increased crude oil production - not new news

US rig count

If we are to believe that a growing rig count and increased US production are the primary factors driving oil price weakness, we have to ask if the market has suddenly hit a tipping point where it can no longer accommodate rising US production.  Does the inventory data bear that view out?

US inventories have been declining over the past several months...


The answer is an unambiguous no. Oil inventories in the US have been declining rather than rising over the past 3 months, and are not materially higher than this time last year (when oil prices were entering a strong bull market).

So then how do we explain the recent weakness in crude oil prices? Our view is that being long energy simply became crowded. The first chart shows a remarkable correlation between oil prices and net speculative positions (we use non-commercial net futures positioning as a proxy for investor and speculator positions in oil markets). At the start of this year, net speculative positions were at all-time highs. Put differently, everyone wanted to own oil.

What caused the reversal in sentiment, positioning and oil price momentum? It could have been any number of things. Market participants may have simply tired of waiting for further gains in oil while watching technology and defensive companies make strong gains. It is also possible that positioning reached a natural limit, where there were just no more incremental buyers. Either way, once selling starts and positions are stretched, selling can lead to more selling as speculators attempt to unwind a position as prices fall. We think this is the primary reason for the recent weakness in oil prices.

The medium-term outlook for oil is constructive

The bear case for oil is pretty well known – rising US production will keep a lid on prices and lead to a market in chronic oversupply. Allow us to lay out a bullish view in response.

Prior to the shale oil revolution in the US, Saudi Arabia maintained production of 2 to 3 million barrels per day (mbp/d) in idled capacity. As the de-facto leader of OPEC, Saudi Arabia could use this swing production to influence prices. As US shale gained in prominence, Saudi Arabia recognised it had lost the ability to control prices, and made the decision to produce at full capacity to avoid losing market share to US producers. Now that Saudi Arabia is producing full-out, there is no longer any excess swing capacity left.

But isn’t the US shale industry the new swing producer and thus the price setter? The answer is yes in theory, but unfortunately there are practical constraints.  It is true that within the US a shale oil well should be able to be brought on-line in a matter of months. However, the US labour market is extremely tight, and finding trained and experienced rig workers is a practical constraint on how quickly shale oil production can respond to oil price increases.

Meanwhile, there are several OPEC producing countries that are both critical to global oil supply, and have very shaky political foundations at present (Venezuela and Nigeria come to mind). Any unexpected outages from these countries could result in the oil market going from a state of modest oversupply, to materially undersupplied very quickly.

The energy sector in global equity markets us currently out of favour. However, we are starting to see a strong case for oil prices to rise in the medium-term as the speculative trade begins to unwind.

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