Sentiment can trump fundamentals in driving the oil price in the short term.

After an early August surge (on speculation producers would stitch together an output deal at this week’s Algiers meeting), prices have eased recently. Weakening demand, rising Opec supply, high inventory, potential rate rises from the Federal Reserve and uncertainty over a producer deal now seem to hold sway. Opec has successfully squeezed non-Opec growth out of the system, but long-awaited market rebalancing is proving slow, placing a $50 ceiling over prices.

Moreover, a modest weakening in demand growth, plus resilient and price-responsive US shale supplies, will probably cap price recovery in late 2016 and 2017. However, suggestions that US shale producers can take on Opec’s erstwhile swing supplier role are unrealistic. Such a proposition overlooks the heterogeneous nature of shale and a likelihood the US will remain a sizeable net importer of crude for the foreseeable future.

US shale supply may moderate price swings but it won’t change oil’s inherently cyclical and volatile nature. Lower global spending on oilfield development between 2015 and 2017 will see markets tighten again in the medium term. Modest inventory draws are already possible from late 2016.

There may be bumps in the road to rebalancing, though, if recent output recovery from Libya and Nigeria persists, or Iran and Iraq surprise the market with further short-term export gains. So it might take until late next year before inventories approach historical levels again. But how relevant are historical OECD inventory (or stock) levels, anyway? And is it possible that prices can rise if OECD stocks remain substantially above historical norms?

Historically, there was a clear inverse relation between crude prices and OECD stocks. Through the 1970s, 80s and 90s, OECD oil demand accounted for 65 per cent to 75 per cent of the global total, conferring validity on OECD inventories as a reliable market barometer.

Today, OECD demand is below 48 per cent of the total and falling. Analysis that fails to take account of emerging market stocks is therefore incomplete. Stock builds in mature markets normally denote a surplus, and tend to be price bearish. But in the emerging markets, like China and India, where economic growth entails rapid construction of new refineries and oil storage tanks, stock accumulation represents extra demand and can be price bullish.

The simple fact of high stocks is not, by itself, necessarily bearish. It depends where, and for what reason, stock is accumulated

So the simple fact of high stocks is not, by itself, necessarily bearish. It depends where, and for what reason, stock is accumulated. A lack of detailed emerging market stock data muddies the waters further.

The parallel role of inventory — for strategic use during supply disruption — is also worth considering. Storage is not only a “sink” for surplus supply, but also a potential market buffer during a crisis. Most OECD countries are required by IEA mandate to hold 90 days of net import demand as inventory, precisely for this reason.

Traditionally, a co-ordinated stock release (such as during the Libyan crisis in 2011 and hurricanes Katrina & Rita in 2005) is preceded by examination of prevailing market dynamics and an assessment of whether alternative supplies can be arbitraged into the region of temporary shortage. That includes consideration of Opec spare capacity. Historically, the IEA shied away from a stock release if Opec producers were seen able and willing to boost supply first.

Today, OPEC’s — or Saudi Arabia’s — willingness to fulfil an outright swing supplier role to the market is in question (although this may become clearer after the Algiers meeting). In any case, Opec producers are currently maximising output to reclaim market share from higher cost non-OPEC barrels. By definition, this means Opec spare capacity is limited — potentially only 1-2m b/d. Not many other global industries operate with barely 1 to 2 per cent of spare capacity.

Consider, too, that 2016 has already seen a spate of unscheduled supply stoppages (Canada, Yemen, Libya, Nigeria), amounting to 4m b/d at peak. The price impact has been muted, precisely because oil inventories are high and alternative supplies available. Looking ahead to when the market eventually “rebalances”, if neither Opec nor US shale can fully respond to future unplanned stoppages, what is left?

For decades, the oil market has operated with an adjustment mechanism comprising some combination of swing producers.

That might now be a thing of the past. If so, refiners and governments may prioritise higher levels of stockholding, over and above an arbitrary 2010-2014 norm. As inventories draw down in 2017, and when market psychology reboots toward this new reality, prices could surprise to the upside.

David Fyfe is Head of Market Research & Analysis at Gunvor Group

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