Cautious on rally continuing

Oil markets are tightening as fundamentals are changing. Firstly, demand continues to increase year-on-year, even though at a slightly lower pace compared to last year, and secondly, worldwide supply is being affected by 18 months of low oil prices. Some of the supply reduction is cyclical due to lower oil prices but a large supply reduction has also been driven by unplanned outages and seems to temporarily have accelerated the supply-demand balance.

At the back of these tightening balances, we have other factors such as a significant increase in investor flows, weaker dollar on the back of the dovish fed stance since the beginning of the year and increased geopolitical risk premium which tends to be even more important in tighter markets. Hence, we have revised upwards our Brent and WTI crude oil forecasts for 2016 and 2017.

However, we still think that oil prices have rallied far too quickly in the last four months predominantly driven by investor flows backed by unprecedented outages. Total net long positions in Brent and WTI have increased by 400 million barrels worth of contracts i.e. 3.5 million barrels/day of paper demand between 29 December 2015 and 24 April 2016. Addition-ally, investor positions are being justified by unprecedented outages worldwide. This rally, if sustained, will push back any permanent structural change in the oil markets.

There are, however, downside risks in the second half of this year.

Higher oil prices lead to a reversal in US oil rigs or even cyclical production increase from conventional onshore and offshore worldwide. This is one of the auto corrections key to market balance in 2016-17. Complete or partial resolution of all the outages at once could put pressure on prices.

Other downside risk is strength in dollar on the back of Fed raising interest rates, as indicated in minutes released by the US Federal Reserve.

If oil traders release oil from storages worldwide as the contango narrows both as an opportunistic trade or as economics of storing oil in onshore storage diminish with the contango narrowing or curve flipping into backwardation, it could make a steep rally unsustainable.

Saudi Arabia and its GCC partners Iraq, UAE and Kuwait are unlikely to freeze production. In fact, they may increase production and production capacity as Iran brings in more crude to the markets to maintain their individual market shares.

Investor sell-off on the back of weaker demand or excess supply hitting the market from any of the scenarios above is also likely. We have already seen signs of some sell-off in the last two weeks.

Hence we remain extremely cautious with the current rally.

After revision, now in second half of CY2016, in our base case, we expect Brent to average $44.1 per barrel in 2016 and $54.5 per barrel in 2017, up by $5.9 per barrel and $6.5 per barrel respectively from our previous forecasts.

However, we still remain bearish compared to the forward curve in 2016H2 to reflect our views presented above. This is further driven by the increase in hedging activities (producers selling their production in forwards), and therefore resistance to production cuts. We have also revised our price forecasts towards the back end of 2017 as oil markets will tighten significantly on a structural basis as we move into 2017.

The author is chief oil analyst, Natixis Commodities Research