Have oil prices hit bottom?

published 26 February 2016

Oil prices jumped last Tuesday on news of a deal to freeze production between Saudi Arabia and Russia, but finished the week pretty much where they started it. That's "probably a fair reflection" of the deal's significance, says Malcolm Graham-Wood on MalcysBlog.com. A freeze on production, while "laudable, ain't going to change the market". There is still a glut, which will look even worse next month when refiners do their usual maintenance ahead of the driving season and thus cut back on buying oil in the market.

Even the agreement not to raise output at record highs in both countries depends on other countries signing up, adds the Financial Times. Heavyweight producer Iran, keen to secure market share as sanctions are eased, hasn't exactly rushed to endorse the deal. "Short of a revolution in Riyadh", says Nick Butler in the same paper, it's hard to see prices going above $50 a barrel for three years.

But is the bearishness in the oil market overdone? An immediate price surge may be off the table, but prices could well have hit bottom. They've held above $30 for a month; the glut increasingly looks to be "priced in"; and the Russia-Saudi deal (the first between a member of oil cartel Opec and a non-member for 15 years) shows producers are willing to explore ways of eventually cutting output.

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Meanwhile, drilling activity, and hence future output in America, continues to fall. The number of operational oil rigs has fallen to just over 500 from 2,000 a few years ago, says Liam Halligan in The Sunday Telegraph. With the International Energy Agency expecting supply and demand to rebalance by 2017, prices may begin to tick up as investors look forward to the glut disappearing.

And once they do turn the corner, they could rise faster than everyone expects, says the FT'sJohn Dizard. This is due to the structure of the oil futures market. At present oil producers have heavy debt loads or large populations to keep happy, so they have kept pumping oil despite ample supplies. This has fuelled demand for storage and driven up the price of oil futures compared to spot prices, creating a pattern called "contango".

This in turn has prompted speculators to reinforce the trend and price pattern via an oil "cash-and-carry trade": selling short-dated oil and buying long-dated futures. But once investors think the spot price is set to rise, they will unwind their positions, sending futures prices down and spot prices up just as currency carry trades can quickly unwind and move prices. If oil has hit "peak bear", you may be surprised at how fast it snaps back.

Andrew is the editor of MoneyWeek magazine. He grew up in Vienna and studied at the University of St Andrews, where he gained a first-class MA in geography & international relations.

After graduating he began to contribute to the foreign page of The Week and soon afterwards joined MoneyWeek at its inception in October 2000. He helped Merryn Somerset Webb establish it as Britain’s best-selling financial magazine, contributing to every section of the publication and specialising in macroeconomics and stockmarkets, before going part-time.

His freelance projects have included a 2009 relaunch of The Pharma Letter, where he covered corporate news and political developments in the German pharmaceuticals market for two years, and a multiyear stint as deputy editor of the Barclays account at Redwood, a marketing agency.

Andrew has been editing MoneyWeek since 2018, and continues to specialise in investment and news in German-speaking countries owing to his fluent command of the language.