Why oil is due for a ‘sharp correction’

  • Investors are positioned for a bull rally in oil.
  • That leaves the oil market susceptible to a sharp correction should the fundamentals disappoint.
  • Here's why that scenario is likely in 2018.
Oil worker Ohio
Ty Wright | Bloomberg | Getty Images

With oil prices over 30 percent higher since June, oil market bulls are finally getting what they wished for this holiday season. Global economic growth is strong and synchronous, and end-use petroleum demand continues to outperform historical norms.

On the supply side, OPEC compliance is high and Venezuela's production keeps slipping significantly month to month. Other countries including Iraq, Nigeria, and Libya could see disruptions in the coming year. Outages in the North Sea and hurricanes have unexpectedly tightened the market in the past six months, supporting OPEC's longstanding efforts since 2014 to rebalance it.

These fundamental factors and OPEC countries' willingness to keep their production in check have reduced excess inventories by half as the New Year arrives. As a result, investors are positioned for a bull rally, leaving the oil market susceptible to a sharp correction should the fundamentals disappoint.

That is one of several reasons why we are retaining our bearish stance for next year, and we expect Brent prices to average $55 per barrel.

Two key points are important to note. First, the supports mentioned above may not be sustained. Though Barclays Research economists do not expect a recession in 2018, they do expect China's growth to slow, which would exert disproportionate pressure on commodities demand.

"We are retaining our bearish stance for next year, and we expect Brent prices to average $55 per barrel."

And not everyone is covered by the OPEC/non-OPEC deal. Libya and Nigeria's output, though fragile, has the potential to surge 10-20 percent higher, despite high risk of production. The output that was offline in Canada is returning, boosting supplies next year and in 2019. The same goes for Brazil, where new supply is ramping quickly. Demand growth can also vary widely, especially if retail prices are higher on the year.

Second, the past year has shown that prices are determined by the speed and direction of inventories. Barclays Commodities Research's balance indicates a return to surplus on average next year.

We expect historically high demand growth of 1.6 million barrels per day. However, that is more than offset by almost 500,000 barrels per day of new non-OPEC non-US supplies, at least 1.2 million barrels per day of U.S. supply, and some other volumes. Clearly, the market will be in a small deficit during some of 2018, but to sustain current price levels for all of next year, it must tighten further than our balance suggests.

We acknowledge there are many risks to our market balance and price view. First, on the downside, an early end to the OPEC/non-OPEC Declaration of Cooperation could lead to a return of up to 1 million barrels per day of oil supply. Barclays' view has long been that the deal is a signaling mechanism, much like a central bank.

Producers, consumers, and market participants gain from having more certainty associated with the output levels of these countries. Therefore, we expect continued deal extensions, albeit in a form that allows higher production levels. That is their exit strategy, in our view, and that framework might succeed in keeping Russia in the fold.

Another risk is the sensitivity of supply and demand. With Saudi Arabia's budget breaking even at levels close to $70 per barrel, not even including off-budget military spending and economic reforms underway, Riyadh must firm up prices. But they cannot spiral too high without spurring structural demand changes and threatening long-term market share. Perhaps that is not as urgent a concern now, but it will increasingly become so.

A final risk in the same vein concerns U.S. supply. Shareholders want to see the U.S. exploration and production industry focus on capital discipline. We remain skeptical: capital discipline does not equal austerity. With rare exceptions, spending typically exceeds operating cash flow. Small/medium cap and large cap companies have spent an average of 117 percent and 160 percent, respectively, of cash flow in the past seven years.

Barclays' Oilfield Services team recently published the 33rd edition of its spending survey, which noted that North American spending was expected to increase over 20 percent at mid-$50 per barrel WTI and that the rig count would increase a further 9 percent next year. With this in mind, it is our view that these producers, as well as the majors and private companies, will continue to surprise to the upside.

So the New Year's resolutions are clear: U.S. producers are pledging to tighten their belts, and OPEC plans to keep reducing the inventory excess. But the recent higher price environment makes achieving these resolutions more difficult and sets the market up for a tumultuous year.

Commenatary by Michael D. Cohen, director and head of energy commodities research at Barclays.

For more insight from CNBC contributors, follow @CNBCopinion on Twitter.