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Why the Oil Rally May Not Last Long

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Bank of America Merrill Lynch says Brent crude oil prices could reach $90 to $100 a barrel next year or maybe sooner. Goldman Sachs forecasts Brent crude at $82.50 by summer.

Both forecasts top Friday’s $70.70 close in U.S. crude oil prices, which trade at a roughly $5 to $6 discount to Brent crude. U.S. crude oil has already gained 17% year to date and 48% from a year ago. Why would oil prices move that much higher from current levels, which are already elevated?

They’ve soared in the past few weeks ahead of President Donald Trump’s decision on the Iran nuclear deal and continued to rise after he announced the U.S. was dropping out of the deal.

“In the short term, higher oil prices will probably be sustained,” said John Velis, macro strategist at State Street Global Markets, noting multiple reasons for the price support.

They include Trump’s decision to withdraw from the Iran nuclear agreement, Saudi Arabia’s desire for $85-a-barrel oil prices (a level the IMF says it needs to balance its budget), a production cooperation agreement between OPEC members (led by Saudi Arabia) and non-OPEC members (led by Russia) to support oil prices, the upcoming U.S. driving season (which tends to increase demand) and the upcoming intital public offering of Aramco, Saudi Arabia’s state-owned oil company.

“There are valid reasons for oil prices to be as high as they are right now, but they are potentially temporary,” Velis tells ThinkAdvisor.

John LaForge, head of real asset strategy at the Wells Fargo Investment Institute, agrees. “The trend tells me there is a little more left on the upside, but that may be only $1 a barrel.”

Determinants of Future Oil Prices

How much higher oil prices can go depends on several factors, many linked to supplies in the aftermath of the U.S. leaving the Iran nuclear deal, according to analysts.

Iranian exports, which total around 2.5 million barrels per day, could decline by 500,000 to 1 million barrels per day as a result of Trump’s withdrawal from the nuclear pact, which would be bullish for oil prices. But how much those exports fall will depend on the reaction of the countries that import Iranian oil: China, France, Russia, U.K. (the other five permanent members of the UN Security Council), Germany, Japan, India and South Korea.

The White House has said it will impose sanctions on companies that continue to purchase Iranian oil but allow them six months to wind down those contracts. South Korea, according to The New York Times, will seek an exemption from U.S. sanctions so that it can continue to import Iranian oil. China, already embroiled in trade disputes with the U.S., could potentially ignore or try to circumvent U.S. sanctions. And Iran could try to block oil shipments from the Mideast through the Strait of Hormuz, although the U.S. naval presence in the area would make that difficult to do.

Saudi Arabia, the largest crude oil exporter in the world, has said it will help fill the gap if U.S. sanctions on Iranian oil importers creates shortages, but it may not be willing to act alone. An OPEC source told Reuters last week that Saudi Arabia “will not in any way act independently of its partners.” Those partners now include Russia, one of several non-OPEC members that along with OPEC forged the so-called “Vienna Agreement” to monitor production in order to maintain balance between supply and demand.

“The Saudis are keen on holding production cuts, enjoying high prices, but are increasingly under pressure from Russia to bring back production,” says Eric Lee, energy strategist at Citigroup.

Production levels will be a key topic of discussion at the upcoming June 22 OPEC ministerial meeting where the Vienna Agreement, which began in 2017, is expected to be discussed. The production agreement with Russia and non-OPEC members is slated to run through year-end but it could potentially end earlier, be modified or even extended beyond beyond 2018. The Vienna pact has removed about 1.8 million barrels of oil per day from the global market.

Venezuela’s continuing economic crisis has also removed oil from the market. Its oil production level is now at its low since 1988, excluding strikes at its state-owned oil company in late 2002 and early 2003. Market observers will be watching the country’s May 20 presidential election to see any signs of plans to increase production.

They’ll also be watching the results of Iraq’s parliamentary elections, which are expected to be announced Monday and could, according to S&P Global Platts, “reshape its oil ministry and delay output expansion projects in OPEC’s second-largest member.”

Oil Futures Suggest Lower Prices

While there are many reasons oil prices may continue to climb in the short term, that is not the picture the market is painting for the long term.

Since late 2017, longer-dated U.S. oil futures contracts are trading at prices lower than nearer-term contracts, a configuration known as backwardation, indicating that the market at least currently doesn’t believe prices will continue to be as high as they are now, longer term.

Changes in oil supply and demand are expected to weigh on prices in the future. On the supply side are expectations that as prices continue to rise so will production, including U.S. oil and shale production.

“By 2019, U.S production can pick up as pipelines are expanded and OPEC and Russia can bring back production,” says Lee. He explained that shale supplies from the oil-rich West Texas Permian Basin are now caught up in bottlenecks because the current pipeline capacity cannot handle the increased supply, but that could change as more pipelines are built.

LaForge, from Wells Fargo Institute, says the supply-demand balance in the oil market is already shifting toward oversupply, given that growth in demand is limited by an economic expansion that at least in the U.S. is in its later stages.

BofA analysts, however, expect that strong global demand and supply constraints will support higher prices for at least the next 18 months “as long as global demand does not suffer from the ongoing threats of trade wars and policy uncertainty.” That’s a big a if in the political current environment.

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