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Oil rally seen reversing as unstoppable US supply deepens glut

Wednesday, February 18, 2015 - 08:25
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The rebound in oil will reverse because rising US production is deepening the global supply glut.

[NEW YORK] The rebound in oil will reverse because rising US production is deepening the global supply glut, according to UBS AG, Bank of America Corp and Commerzbank AG.

Brent futures entered a bull market this month as US drillers stopped using a record number of rigs, companies cut at least US$40 billion from spending plans and hedge funds turned the most bullish in seven months. None of that will stop Brent slipping back to US$45 a barrel or lower within the next three months, from about US$61 now, the banks' analysts say. Prices fell as low as US$45.19 on Jan 13.

The highest US oil production in three decades won't be curtailed by the idling of rigs and inventories will keep expanding, according to UBS. The rally has been based on sentiment rather than the fundamentals of supply and demand, Commerzbank says. As storage space fills up, producers will need to discount to sell barrels, Bank of America predicts.

"Oil prices should again come under pressure," said Giovanni Staunovo, an analyst at UBS in Zurich who expects Brent to reach US$40 in the next three months. "Production is likely to rise further and inventories will continue to rise. This means the market will remain oversupplied in the first half of 2015."

Brent's advance to a two-month high of US$62.57 on Monday prompted some members of the Organization of Petroleum Exporting Countries to signal confidence in a recovery. Qatar's Energy Minister Mohammed bin Saleh Al Sada said that "a sense of optimism" has returned, while Kuwaiti minister Ali Al-Omair said the supply glut is smaller than previously estimated.

US oil explorers have idled rigs for 10 consecutive weeks, extending an unprecedented retreat in drilling and dragging the total rig count down to the lowest level in almost five years, data from Baker Hughes Inc showed Feb 13.

The cut would need to be deeper to halt growth in output, according to Goldman Sachs Group Inc. The increasing efficiency of drillers and lower costs combined with moving rigs to the most productive areas mean the nation's output won't decline, Bank of America estimates.

The retreat in drilling has made some speculators more bullish on oil prices. Their bets on Brent crude were the most bullish since July in the week to Feb. 10, according to data from the London-based ICE Futures Europe exchange. Money managers' net-long wager on rising prices rose 13 per cent to 158,974 contracts, the highest since July.

The US Oil Fund LP, an exchange-traded fund tracking crude prices, attracted US$1.15 billion of investor money last month, the most in six years.

The threat of weaker US oil production that is helping to drive the rally in prices is genuine, Paul Horsnell, an analyst at Standard Chartered Plc in London, wrote in a report Feb 16. The decline in drilling will be sufficient to halt monthly growth in US production as early as April, and higher-cost output elsewhere in the world will also falter, he said.

US crude production averaged 9.23 million barrels a day through Feb 6, the most in weekly Energy Information Administration records dating back to January 1983.

"Could we already be past the worst? We don't think so," Francisco Blanch, the New York-based head of commodities research at Bank of America, said in a report Feb 13. "We continue to believe that neither supply nor demand will respond materially near-term," said Blanch, who predicts Brent will fall below US$40 in the next two months.

Inventories in developed markets may expand from the highest level in more than four years, completely filling land- based storage by the second quarter, Bank of America estimates. Sellers will need to widen the discounts on immediate supply, known as contango, in order to clear the glut, the bank says.

West Texas Intermediate, the US benchmark, will need to fall below US$30 to really stifle investment in new supply, Ed Morse, the head of commodities research at Citigroup Inc in New York, said in a report Feb 9. The low point for prices will probably come at the start of the second quarter, he said. WTI traded at about US$53 on Tuesday.

The bullishness among hedge funds was driven by a reduction in bearish positions, rather than additional bullish bets, signaling traders are still cautious that the rally will last, according to Ole Hansen, an analyst at Saxo Bank A/S in Oslo.

"The current rebound is very much driven by liquidity, sentiment, momentum and investors and not so much the fundamentals," Eugen Weinberg, the head of commodities research at Commerzbank in Frankfurt, wrote in an e-mail. "The fundamentals do not support this bullish view yet."

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