After OPEC’s surprise production cuts in April, which caused oil prices to reach $80 per barrel, hedge funds and others resumed selling on account of slowing growth and recession fears. Most commodities (excluding precious metals and a few agricultural products) were affected by the growth slowdown and have corrected accordingly – with energy being at the center of it all. However, despite the fact that the OPEC production cuts only offered temporary relief in oil prices, a number of fundamental indicators in the oil market are indicating that the tide may be turning.
Oil prices have faced significant headwinds over the last year or so. During recent times, the Chinese economy was held for over 200 days, while North America and Europe saw warmer winters. Russia released much of their own energy supplies onto the market before their sanctions came into effect, and the global economy slowed down. Yet, during all these woes, inventory levels only moved into bearish territory for a short period of time. Many of these headwinds are no longer prevailing, and the shift back towards inventory drawdowns is perhaps indicative of the structural demand and supply imbalance in the market. Additionally, the actual impact of OPEC’s production cuts will not be felt for some months until May.
Analysts can use inventory changes and levels to assess the supply and demand dynamics of the market. The shift from inventory builds to drawdowns is certainly a bullish development in crude oil. Last week’s 12.54 million bbl drawdown was the ninth largest in US history, and the inventory levels have recently gone below seasonal average levels. The futures term structure remains in backwardation, which indicates a supply deficit – where market participants are willing to pay a premium for immediate delivery. Backwardation incentivizes the drawdowns of oil inventories but does not incentivize producers to increase production or capacity, as they would have to sell it forward at lower costs than they are receiving today. The shape of the term structure for a physical commodity such as oil provides insight into the underlying supply and demand dynamics, with a backwardated term structure being more supportive of higher prices.