Energy

Oil Markets: Driven by Fundamentals or Speculation?

Paul Ausick

Published: April 29, 2016 1:50 pm

Last Updated: January 13, 2020 10:05 am

Brent crude oil for July delivery traded as high as $48.29 on Friday before dropping to below $47 a barrel on various reports that OPEC production had increased in April. The December futures contract traded as high as $49.65 on Friday, not a large spread, but as close as Brent futures have been to $50 a barrel in some time.

At that price, U.S. shale producers may begin to hedge their production for the first quarter of 2017 and begin completing some of their drilled but uncompleted wells. If that happens, the price of crude may not rise much higher very quickly.

Part of the reason for that is that Brent prices well above $50 a barrel are not in Saudi Arabia’s interest. The kingdom has invested tens of billions of dollars in driving high-cost producers (mostly in the United States) to shut down production, and the effort has paid off. But if Brent rises much past $50 a barrel, the Saudis’ leverage diminishes, unless it also raises production to drive prices down again.

For the past two weeks, hedge funds have been dumping short West Texas Intermediate (WTI) crude contracts. Short covering and a weakening dollar add up to higher spot crude prices. The Baker-Hughes rig count released Friday afternoon showed that the U.S. has dropped another 11 rigs drilling for crude, and that typically pushes spot prices higher. WTI crude opened Friday at $45.90 and topped out at $46.78. Shortly after the rig count was released, WTI cut its daily loss by about 11 cents a barrel to $45.72.

Non-OPEC production will be lower in 2016, mostly due to lower U.S. production. Because oil markets, like all commodity markets, look forward, part of the recent price increase is due to higher demand. Balanced against that is crude oil in storage that can also act as a drag on crude prices if they rise too much too fast.

One important thing to note here is that the fundamentals of supply and demand recently have mattered less in oil markets than has speculative trading. As supply and demand continue to rebalance, we can expect to see more volatility in crude markets and, perhaps, a lasting price rise to around $50 a barrel by the end of the year.