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Where is crude oil heading its way?

The near 80% rebound in oil prices from its February lows has finally started to fizzle and we believe more correction is on the cards in the near term as some of pillars of the price rally start to give away. Investors were reluctant to buy at higher levels and prices could not sustain above $50 for much long. One of the biggest factors driving the recent rally was unexpected supply outages which pushed out ~2.5-3.0 million bpd of crude oil out of the global market. Adding to that, slowdown in U.S. oil output and a weaker dollar exacerbated the price strength.

The oil market was oversupplied by nearly 1.8-2.0 million bpd until the end of Q1 but unexpected supply outages brought the market in balance over the past couple of months. If it wasn’t for the cushion provided by the record level of inventories globally, the extent of current outages (~2.5-3.0 mbpd), would have pushed prices close to $100 in a very short time in any other period. Pipeline attacks in Nigeria have cut total oil output by nearly 1 million bpd and Nigeria’s total output is now near 0.8 mbpd compared to 2.0 mbpd a few months ago. Prior to that, wildfires near Alberta oil sands in Canada reduced nearly 1 million bpd of Canada’s oil production. Adding to that, U.S. crude oil production has dropped by nearly 0.5 mbpd so far in 2016 and is near 8.71 mbpd currently. U.S. oil production is down almost 0.9 million bpd from its peak of 9.6 mbpd. U.S. shale oil output is also expected to fall in July for the seventh consecutive month. As per EIA data, total shale output is expected to fall to 4.72 million bpd in July from a peak of 5.5 million bpd in March 2015. The interplay of these supply related factors in the last two months led to the quick snapback of prices from their lows seen during the panic of February.

Looking ahead, we believe that oil prices have seen their top at least from the short to medium term perspective as some of the factors underpinning price strength have started to wane. Firstly, even as Nigeria’s output still remains affected due to repeated pipeline attacks, Canada’s output is in track to resume partially by end-June and to its normal level by the end of July. Secondly, there is some evidence that US oil drillers are comfortable in re-starting drilling if prices stay around $50. Rig counts have increased in the five out of the last six weeks but we will still have to see if the trend has actually turned. Thirdly, Iran’s oil production has resumed quickly in the recent months and is likely to reach pre-sanctions levels in the next two to three months. Iran’s oil exports are on track to hit the highest in 4 years in June as shipments to Europe recover to near pre-sanctions level. Therefore, we will see the impact of supply outages fade in the next couple of months which will act as a headwind to prices. Importantly, global market sentiment also looks fragile at the current juncture with a Brexit vote looming large over global financial markets. A risk-off sentiment could dent oil prices all the more.

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