How to tell if oil’s rally can continue

Image of oil pumps

Almost unnoticed, oil is trading near four-month highs at $67 a barrel for Europe’s Brent crude benchmark and $59 for America’s West Texas Intermediate. According to OPEC’s latest monthly report, demand is holding firm at between 97 and 98 million barrels of oil a day.

This suggests that any tightness in the market is the result of supply, a view which seems logical enough in view of (limited) American sanctions on Iran, a sharp drop in output in Venezuela (thanks to economic and political chaos) and apparent Saudi determination to stick to the production cuts outlined by Riyadh at last December’s Vienna OPEC summit.

Besides these geopolitical and economic issues, four further, more tangible and easily measured, factors are at work:

  • Global oil rig activity
  • Inventories
  • US shale output
  • Positioning in the financial markets

Thankfully, they are all a little easier to judge and measure than the affairs of state in Caracas or the workings of President Trump’s foreign policy.

Rig work rolls over

A slowdown in growth in American and global oil rig activity would also point to a better balance between supply and demand and one suited to the plan formulated by Saudi Arabia and Russia late last year to support the price of crude. Growth in active US rigs looks to be slowing while the global rig count is now up by just 2% year-on-year.

Growth in global rig activity is slowing down

Source: Baker Hughes

American oil inventories may have also stopped growing, at least if a recent unexpected drop is any guide, with stockpiles now just 4% higher than they were a year ago.

Growth in US oil stockpiles also seems to be moderating

Source: US Energy Information Administration

Shale surprise

This could be seen as reasonably bullish for oil but seasoned commodity watchers will know it is never as simple as that.

American shale output remains a major wildcard. Rig activity may not be rising but output per rig is and shale production in the USA continues to advance as a result. It now stands at 8.4 million barrels of oil a day, up by 1.6 million barrels a day when compared to March 2018, a surge that offsets much if not all of the loss of Iranian, Venezuelan, Saudi and Russian production.

There is no sign of shale output slackening any time soon, either, and this is a potential cap on the price of crude, at least on the other side of the pond.

US shale output continues to power higher

Source: US Energy Information Administration

Intriguingly the fourth and final factor is the one whose influence is most frequently underestimated – how financial speculators are positioned via the futures market, where each contract is worth 1,000 barrels of oil.

Following this last summer could have spared bulls of oil a lot of pain. According to data from the CME the number of long futures contracts in early July, where traders were betting on oil price increases, was 771,350 against just 68,994 that were short and betting on oil price declines. That made for a net long exposure of 702,356 contracts – so, surprise, surprise, oil promptly plunged from nearly $80 to barely $40. When it looks like everyone is already bullish it can be hard for an asset to do well, at least in the near term.

The picture is now a lot less clear cut. Long positions have been cut to 473,621 contracts but shorts are still rare at just 99,757 for a net bullish position of 373,864.

Net long oil futures positions are down to 2.5-year lows

Source: CME, Refinitiv data

On balance that is still toward the top of the historic range for net ‘longs' but the message seems to be that even the professionals who look at oil all of the time do not necessarily have a strong view right now.

Pump up the dividends

Taking a punt on oil via a handful of oil producers or explorers, an industry-related exchange traded fund (ETF) or a tracker that follows the stock market of an oil-related region or country, such as the Middle East, Saudi Arabia or Russia, therefore looks risky, to say the least.

But perhaps advisers and clients with exposure to UK equities can draw some degree of comfort from oil’s latest ascent. After all, BP and Shell between them represent 15%, 18% and 19% of the FTSE’s market cap, forecast profits and forecast dividends for 2019. And the more firmly the oil price is underpinned, the better their dividend cover and, by implication, the 4.7% dividend yield currently on offer from the FTSE 100, according to analysts’ consensus forecasts.

So whatever you think of Brexit, at least advisers and clients are being paid to sit patiently as they wait for the negotiations to conclude, helped by oil’s latest rally.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.