Has The OPEC Rally Gone Too Far?

In January, oil prices were melting down, dropping below $30 per barrel. The industry was panicking, slashing spending and jobs, and it was hard to see any evidence of a rebound. By December, things look much different. The industry is adding rigs back to the shale patch, oil prices are rising, the market is moving closer to balance, and the OPEC deal could accelerate that adjustment. The consensus is that oil prices will post further gains in 2017. But even as WTI trades above $54 per barrel – the highest price since the summer of 2015 – there are several reasons why oil should be trading much lower.

1. Doubts over OPEC deal. The OPEC deal is set to take effect in a few days, but the promised cuts are not inevitable. First, the cuts are an average over a six-month period, and won’t be delivered immediately in January. Second, some cheating is to be expected, as OPEC has a long track record of non-compliance. Third, non-OPEC cuts, particularly from Russia, are also not a given. It will take time to see if participating countries actually deliver reductions, but the oil markets should be more skeptical than they have been to date.

2. Libya and Nigeria will add output in 2017. Two key OPEC members – Libya and Nigeria – are exempted from the OPEC deal, and they have every intention of ramping up production. Libya has already added around 300,000 bpd in output in recent months and with its largest oil export terminal – Es Sider – finally back online, it hopes to add another 300,000 bpd in production in 2017. Nigeria also has a few hundred thousand barrels still offline, relating to attacks from the Niger Delta Avengers earlier this year. Nigerian officials are also planning to restore that lost output. Together, Libya and Nigeria could offset roughly half of the entire promised OPEC reductions.

3. U.S. shale comeback. Everyone is watching to see how quickly U.S. shale will rebound. Output is already back up by more than 300,000 bpd from a low point in July, according to EIA data. But that is just the beginning. The oil and gas rig count is already up by more than 60 percent since bottoming out in May. Estimates vary on how much additional production can be added in 2017, ranging from 500,000 bpd to 1 mb/d of new output. It is unclear which projection will be closer to the mark, but by and large, everyone agrees that U.S. shale will add production in 2017, adding to global supplies.

4. Dollar strength. The U.S. dollar has strengthened by more than 20 percent in the past two years and is now at its highest level in more than a decade. The Federal Reserve increased interest rates in December and further rate hikes are forthcoming. A strong dollar hurts demand as it makes crude oil – which is priced in dollars – more expensive for much of the world. Some analysts have even raised the question of a knock-on problem for oil prices from dollar strength: OPEC will be more likely to cheat to take advantage of dollar-denominated sales because the upside of doing so will be larger. That would be bad news for prices if the deal starts to fall apart.

5. Demand growth slows. The IEA projects oil demand climbing by just 1.3 million barrels per day (mb/d) in 2017, the lowest level in years. China, in particular, is seeing its demand growth slow as its strategic petroleum reserve starts to fill up. Weak demand will stretch out the time it takes for the market to balance.

6. Inventories still elevated. Crude oil inventories are still at very high levels, well above long-term averages in both the U.S. and around the world. Oil stocks in the U.S. fell in the third quarter, but rose again in the fourth, dashing hopes of strong drawdowns to close out the year. Inventories now stand pretty much where they were a few months ago. In 2017 they are expected to resume their decline, but high storage levels provide a large cushion against higher prices.

7. Oil speculators already stretched. Hedge funds and other money managers have already built up the most bullish position on crude oil since 2014, which has helped push up oil prices in recent weeks. The mass accumulation of net-long positions raises the risk of a snap back in the other direction should bearish news arise. In other words, oil prices could already be higher than is justified, and bad news could spoil the rally.

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