Oil markets - OPEC restraint needs to stretch into 2018. A supply glut lurks just below the surface.

The old traders' adage ‘better to travel than arrive’ has proved true in 2017. Last year was the year to hitch a ride on oil, Brent near doubling to US$55/bbl from the Q1 lows. Investors piled into oil-leveraged equities through 2016, the MSCI Energy index surging 23% and outperforming the broader market by 18%.

The nagging feeling though was that prices had already made the big move, by year end encroaching on our annual average Brent forecast of US$57/bbl for calendar 2017.

The journey had been pretty smooth in the early weeks of this year, Brent hovering around US$55/bbl - an all together happier state of affairs for upstream operators. But upward momentum ceased, and investors’ appetite dulled. Then on March 8th crude prices suddenly dropped, with WTI falling below US$50/bbl. The sell down of oil and gas shares accelerated, and MSCI Energy has now lost two thirds of 2016’s hard earned relative gains.

Confidence plays a huge role in any market, commodity or otherwise though it’s the fundamentals that ultimately determine price. Last year’s big rally in oil markets was triggered initially by confidence, that two years of financial pain was forcing OPEC to shift strategy and support prices. The fundamentals were taken care of by removing 1.3 million b/d of supply from the market in January, fostering the belief that OPEC and its Russia-led confederates' action would hasten the rebalancing of supply and demand.

So why have oil prices come under renewed downward pressure?

Our Macro Oils team, led by Ed Rawle, sees three main reasons.

First, global demand has disappointed so far this year. Chinese New Year, mild weather in the US, and the effects of de-monetization in India slowed or stalled demand growth in each of these three engines of demand growth. We think these January hiccoughs are transitory, and that global demand growth of 1.3 million b/d is still achievable for this year as a whole.

If we are right, 2017 will be the third best year for demand growth this decade.

Second, growth in US supply. Tight oil operators are putting a lot of capital to work again - the horizontal rig count has doubled from the lows of last year. We have just added another 40 rigs to our assumptions for 2017 and 2018, 70% into the Permian. Our latest production outlook suggests tight oil will recover from the August 2016 lows of 3.9 million b/d to reach the previous peak of 4.45 million b/d in August 2017, a span of just 12 months.

Our Base Case anticipates 0.7 million b/d of net new tight oil volumes by Q1 2018, though around 0.2 million b/d is at risk should cost inflation take off. Even so, the rapid recovery in US production demonstrates the law of unintended consequences at work. OPEC’s resolve to support prices at the expense of its own market share will be increasingly tested by tight oil growth in the coming months.

Thirdly, the market balance into 2H 2017 and 2018 is delicately poised. We already assume in our Base Case that OPEC and partners will extend current production cuts through 2H 2017, driving an implied global stock draw through the second half of this year.

But into next year, one way or another, the market will need to absorb a lot of oil.

In total around 2 million b/d of additional supply is on its way if no new agreement is struck: 0.9 million b/d as OPEC itself turns the taps back on, and 1.1 million b/d from non-OPEC (US tight oil, and Russia). This is roughly double the 1.0 million b/d demand growth we expect next year. The implication is either a substantial inventory build in 2018 or OPEC and partners are forced to reach a new agreement.

Optimism has been palpable across the industry in recent months, feeding off OPEC’s action. But the real risk of a glut lurks just below the surface and won’t go away. Oil and gas companies and investors in the sector will be hoping the financial pressures that led to OPEC to seize back the initiative will continue to have the desired effect.