31-03-2018

Here’s why crude oil will not sustain its price rise

The recent escalation in crude oil prices to $70 a barrel has taken quite a few traders by surprise. But a close look will reveal that it was caused by a combination of factors, rather than any marked change in market fundamentals. So, there is reason to believe the uptick may not last long.

It is common knowledge that geopolitical tensions — especially when centred in West Asia — tend to drive oil prices higher because of supply disruption fears. When this is combined with output cut by cartels, it is a sure recipe for prices to surge. This is what happened in recent days; and a weaker US dollar has not been helpful either.

Speculation that the US President would bring back sanctions on Iran was the main trigger for the price spike. This was fuelled by some background political activity involving Saudi Arabia. Obviously, higher crude prices involved an element of risk premium.

Interestingly, this came on top of a looming trade war between the US and China when the former imposed tariffs on steel and aluminium imports and the latter started to retaliate. No wonder, prices of several industrial commodities including base metals like copper fell recently with the threat of an escalation in trade war.

While a trade war has the potential to hurt crude demand, prices actually rose counter-intuitively. Whether there will be re-imposition of sanctions on Iran is, at this point in time, only a matter of conjecture. There is belief, the US would be wary of acting unilaterally and may seek the support of EU and China.

However, many believe, even if fears over sanctions come true, crude production is unlikely to fall significantly and Iran’s exports many not fall markedly. If anything, with its large spare capacity Saudi Arabia will step in to fill the void, if any.

Also, will the oil output cut extend to 2019? Many experts believe it is unlikely. Indeed, there is expectation that the OPEC may actually begin to ramp up production as OECD stocks fall to their five-year average as expected by the year-end.

At the same time, with every increase in price, the US is sure to further boost shale output. The number of rigs is sure to rise this year and the next; and US producers are most likely to take advantage of attractive market prices.

Clearly, at higher prices – close to or above $70 a barrel – global supply growth is likely to outstrip demand growth, and result in an inventory build-up. The risk premium will vanish sooner rather than later and the situation is sure to send crude bulls scurrying for cover.

While the technical picture suggests the possibility of crude breaching $75 and move towards $80, the emerging market fundamentals suggest a clear downside risk to prices. It appears a correction is inevitable as crude has overshot to the upside. Further rate hikes by the Fed and potential for the dollar to strengthen will pull the market down as we go along. By the last quarter of this year, Brent crude is likely to trade around $60 a barrel, give or take 2 dollars.

The writer is a commodities market specialist. Views are personal.

Source: The Hindu Business Line

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