Five factors driving the price of oil

Monitoring Desk

Oil prices have risen as high as $75 a barrel for the first time in four years. But what has driven the rally and will it continue? Here are the five key areas to watch: 1. Supply and demand The simplest reason for the rise in oil prices is that markets have tightened markedly over the past 18 months.

Inventories of crude that had built up during the glut of 2014-16 have largely been worked off because of strong demand driven by a booming global economy and supply cuts by Opec and Russia. The International Energy Agency said last week that Opec could soon declare “mission accomplished” if it were targeting reducing global oil inventories back in line with the five-year average. Some believe that underestimates how tight the market is as demand has soared by more than 5m b/d, or more than 5 per cent, in the past three years, with global crude consumption expected to top 100m b/d for the first time later this year.

That means higher inventories should be required to provide the same number of days’ cover for oil refineries. “The overhang has largely been cleared,” said Olivier Jakob at Petromatrix. “The market is not extremely tight yet but with the glut taken away the conditions are there for the price to improve.”

2. Opec and Russia So if oil inventories are back to near normal levels will Opec and Russia look to end their supply cuts, which have removed at least 1.8m b/d from the market since the start of 2017? Most traders and analysts think not. While Moscow has expressed greater concern about the impact of $70+ oil on stimulating rival supplies like US shale, it seems content for now to stick with Opec, whose de facto leader Saudi Arabia has indicated it believes there is more work to be done.

Khalid al-Falih, Saudi energy minister, has spoken of the need to stimulate greater investment in new supplies. The kingdom is also preparing a listing of state oil company, Saudi Aramco, which would be likely to benefit from higher oil prices. It is also introducing widespread social and economic reforms in the highly conservative country. “There’s been no sign from Opec that they want to cap this rally,” said Bill Farren-Price at Petroleum Policy Intelligence “Saudi Arabia has short-term interests in higher oil prices for multiple reasons, including Aramco. But it’s also going through a delicate period of reform and there are constituencies who will find these very difficult. Having additional revenue at this time definitely helps.”

3. Geopolitical risks: The oil market always watches closely for risks of supply disruptions that could upend the delicate balance of supply and demand. But when supplies are already relatively tight they can take on an outsized importance.

The most immediate risk is the very real possibility of Donald Trump, US president, choosing to withdraw from the Iran nuclear deal and reimposing sanctions on its oil exports. He will make a decision next month and Emmanuel Macron, France’s president, said this week that he expects the US to do so. Second is Venezuela, where oil output has already fallen by at least 500,000 barrels a day because of the economic and political crisis in the country, with little sign that the state oil company PDVSA will be able to reverse the trend. There is also a risk of additional US sanctions on the government of Nicolás Maduro, which could target oil supplies, following elections next month.

Third is the conflict between Opec kingpin Saudi Arabia and Houthi rebels in Yemen. The Houthi’s, who enjoy support from Iran — a fellow Opec member and Saudi Arabia’s chief rival in the region — have stepped up attacks targeting Saudi Arabia’s oil infrastructure in what is seen as a direct attempt to disrupt the lifeblood of its economy. With Houthi-fired missiles also aimed at Riyadh, the chance of either a direct supply disruption or a flare-up of tension between Saudi Arabia and Iran is real.

Finally Libya, where oil output has recovered to about 1m b/d, remains highly unstable seven years after its civil war broke out. All these scenarios have helped keep a bid under oil prices, with one senior oil analyst warning that geopolitical risks in the oil market were as high as he could remember. “This is an incredibly bullish set-up where we have Iran sanctions being revisited, Venezuela elections on May 20 and the situation in Yemen and Libya,” said Gary Ross, head of global oil at S&P Global Platts and the founder of Pira Energy. “The risk of an asymmetrical supply disruption materialising now is even greater than it was during the Arab Spring.”

4. Hedge funds: Hedge funds and other speculators have been attracted to oil this year but only partly because of the geopolitical risks. Investors were already heavily long the market, having built up a record position in crude at the start of the year. While a large speculative position is normally a warning sign that the market has become unbalanced, increasing the risk of a sell-off if traders take profits en masse, so far this year that has not happened.

The reason, bankers say, is that much of the money coming into oil is longer-term cash trying to play in so-called “late cycle” assets like commodities, which tend to do well after a prolonged period of economic expansion. The argument is broadly that while equities may have become overextended after being in an uptrend since 2009, commodities do best late in the economic cycle when surging growth tests the ability of supply to keep up with demand.

Hedge funds are also reaping the benefits of a shift in the market structure caused by tightening supplies, which is causing spot contracts to trade above those for future delivery. That lets investors earn a regular yield by rolling contracts forward each month.

5. US shale: US shale is outstripping expectations for growth, with total US output expected to expand by roughly 10 per cent, or 1.4m b/d this year. Producers in the US are also generating free cash flow because of higher prices.

But so far it has not been enough to derail the rally, with increased output largely being absorbed by rising demand. “Shale oil economics are no longer the most important price-setting factor,” said Paul Horsnell at Standard Chartered. Infrastructure constraints in the Permian shale basin are also making it difficult to get barrels out of west Texas to refineries, storage tanks or to the coast for export.