Is The Current Oil Price Rally A “Head Fake?”

With oil prices at their highest level since 2015, the next stop along the way seems to be $70 per barrel. However, some analysts see the more likely scenario as a retracement back down to lower levels.

A "perfect storm of events" helped push oil prices to their current levels, according to Barclays analysts in a recent research note. However, those factors-cold weather in North America, unrest in Iran, strong economic growth and technical buying from hedge funds and other money managers-may not be enough to keep the oil rally going, the investment bank says.

The risk to oil prices is "skewed to the downside from here as fundamentals on the horizon suggest a reversal is in order," Barclays analysts, led by Michael Cohen, said in a January 5 research note. While the recent oil price rally was bolstered by some unexpected events, the forces that will spark a reversal are more predictable-rising U.S. oil production will lead to another surplus of inventories in 2018.

WTI rising up above $60 per barrel only magnifies that trend, a price level that will likely spark a deeper drilling response. A recent survey of U.S. shale industry executives by the Dallas Fed suggests that the rig count will "substantially increase" with crude prices between $61 and $65 per barrel. At the start of this week, WTI stood at about $61.50.

The line preached by a long list of shale companies at the close of 2017 was one of capital discipline-a renewed focus on profits and not simply one of growth-at-all-costs. Pressure from shareholders has raised the prospect of a more conservative approach to drilling, which could limit the response from shale companies even as oil prices rise. Several high-profile shale drillers said that they would maintain a prudent drilling position even in the face of rising prices. Related: Soaring Indian Oil Demand Grabs OPEC's Attention

But that remains to be seen. Barclays, for its part, is skeptical. "We think that some of the incremental cash flow received from higher oil prices will filter down" to higher spending on drilling, the bank argued. If the shale industry calibrates its drilling campaign to $60 per barrel, as opposed to $50-$55 per barrel as it had previously, the result could be much higher production this year. Barclays says the U.S. could add 1.4 million barrels per day (mb/d) in 2018 compared to the baseline assumption of 1 mb/d. An extra 400,000 bpd is equivalent to nearly a quarter of the combined OPEC/non-OPEC cuts.

That supply response poses pitfalls for the current oil price rally. But the demand side of the equation would also undercut prices. Demand could end up being weaker than anticipated precisely because prices have moved up so quickly.

Barclays had predicted that global oil demand would rise by 1.6 mb/d this year, but that assumes an oil price of $55 per barrel. "[C]urrent prices pose a strong headwind to price-sensitive demand growth, which could be cut by more than 300 kb/d," Barclays analysts argued, putting demand growth at just 1.3 mb/d. If Brent averages $70 per barrel, the result will be a decrease in demand of 400,000 bpd. "These factors suggest that sustained high prices over the near term will only exacerbate stock-builds in the coming months."

Adding to the danger is the extreme net length in the futures market. Investors are overstretched on the long side, and as sentiment shifts, the unwinding of those bets could cause a near-term correction for oil prices. Related: Bioplastics Threaten Big Oil

Even if prices were to avoid a price fall in the short run, Barclays argues that OPEC cohesion could start to break down, which, in turn, could quickly force prices down.

There are plenty of good reasons why prices could continue to rise. Ongoing tension in Iran, the accelerated declines in Venezuela, rising demand, and extremely high assumptions about the response of U.S. shale-these are all factors that go in the bullish column.

But the recent rally could be a "head fake," according to Tom Kloza of Oil Price Information Service. "We probably have about $10 downside at least in Brent, and maybe a little bit less than that in WTI," he told CNBC.

Some others agree. "(I expect) the price of oil to correct by at least 10 to 15 percent over the coming months because the current fundamentals are not justifying this kind of strength," Eugen Weinberg, head of commodities research at Commerzbank, told CNBC.

By Nick Cunningham of Oilprice.com

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