Have we seen the end of Cheap Crude Oil prices?

Back in February 2016 when Brent Crude was hovering around the $28/bbl mark, most analysts had almost written off oil as a commodity. Leading brokerages were already talking of a new era when Brent Crude will be available at less than$20 /bbl. Things changed drastically in the last 4 months as oil has rallied nearly 75% from the lows of February. Does it mean that the world has seen the end of cheap oil? Where exactly is oil headed from here on?

The supply side argument…

Over the last few months, economic turmoil has led to supply disruptions in various oil producing countries. Protests in the Niger Delta in Nigeria and a virtual economic collapse in Venezuela have affected oil substantially as both are key members of the OPEC. Outside the OPEC, the US is seeing steady drawdown in its strategic oil reserves as local shale companies are finding it increasingly difficult to stay financially solvent. The tipping point, perhaps, came from the forest fires in Canada which has disrupted large parts of Canadian sand oil output. With a daily contribution of 5 million barrels of oil, Canada is a very important alpha producer of oil. The combination of these factors has led to global supply constricting by nearly 2.6 million barrels per day. This has more than compensated for the daily oversupply that crude oil was seeing over the last 2 years resulting in steadily higher prices.

The demand side argument…

If supply equations are critical, so is demand. Oil demand is typically driven by growth and that is showing signs of picking up in select pockets. India is still growing at 7.5% and China at 6.5% is still the biggest contributor to annual accretion in GDP. The good news is that after years of loose monetary policy EU is finally seeing signs of a pick-up in growth. The US NFP data was negative in the month of May but that may be more of an exception than the rule. The IMF has lowered the global growth forecast but oil demand will come from a turnaround in growth in EU and an expanding China and India. With a virtual freeze in supply from OPEC and Russia on one side and disruptions in Nigeria, Venezuela and Canada, the daily oil surplus has already moved to neutral territory and may shortly move into deficit zone. That is good news for oil prices.

Alternate fuels may be further than imagined…

The Sun Edison case has highlighted one basic point that alternate sources of energy may be farther than originally anticipated. In the absence of robust business models in alternate fuels, companies as large as Sun Edison had to resort to financial engineering which eventually ended up in bankruptcy. This could mean three things for the future of oil. Firstly, governments the world over may taper their enthusiasm for alternate energy sources and will take a hard and close look at their financial viability. Secondly, the pace of countries moving out of fossil fuels may not be as rapid as envisaged, notwithstanding the Paris Accord. Last, but not the least, investment in hydrocarbons may be back in vogue. This will also help sustain oil prices at higher levels.

The recent strength in oil prices is not just a dead-cat bounce but a lot more needs to be read into it. Brent crude prices have already crossed the $50/bbl mark and could move higher towards the $60 mark. It is hard to look beyond that level as a sharp rise in oil prices requires a spurt in demand. While green-shoots of a recovery in demand are visible, it is nowhere close to the demand frenzy for oil that was seen in 2007 or 2012.

To cut a long story short, oil may have seen its bottom in this cycle at around the $25-30 range. It would be difficult to imagine oil prices again moving towards those levels. Countries across Africa, Latin America and the Middle East have paid a steep price for trying to flood the market with oil. They would not want that scenario to repeat again. In most likelihood, oil may have seen the bottom in February. Of course, a bull market in crude oil may still be some time away! At least, till there are suppliers in the sidelines waiting to pump oil at higher crude prices.

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