Oil
© Spencer Platt / AFP

Crude has been on the rise since an agreement was brokered to cut output across a host of OPEC and non-OPEC members.

However, we now find ourselves caught between a cut in OPEC and a rise in US output. Whichever shouts the loudest, at the earliest stage, will determine the path of oil prices going forward.

Oil prices don’t seem to know whether they are coming or going at the moment, with 2017 being particularly choppy so far. Many of us were surprised to see a deal put together by OPEC, which was reflected by the significant rise in crude price in the aftermath of the announcement. However, the market is currently caught between two forces and the speed at which each occurs is likely to effect the price of oil over the coming weeks and months.

Output cut progression

The first, most obvious, side to the argument is whether OPEC and non-OPEC members adhere to the output reductions that have been agreed to. The implementation of these cuts is expected to be difficult to measure, with significant incentives for nations to misreport their actual production. However, markets are likely to take data on face value unless told otherwise, as should we hear from a number of major producers saying there has been a sharp fall in production, this could provide a near-term driver of bullish price action.

Recent reports highlight that the likes of Russian and Saudi Arabia have already started gradually implementing cuts, yet further is to come. This set a blueprint for future announcements from other major producers. Should everyone play by the book and implement their required cut, it would likely spark further upside for oil prices.

However, should we hear of nations failing to follow through or respond to another nation’s failure to cut by raising output once more, this would undermine the whole process.

US resurgence

The one obvious nation that was not around the table for OPEC/non-OPEC discussions was the US, who is happy to let its producers react to the changing market environment. The recent boom in shale oil production means states such as Texas and North Dakota are full of smaller scale rigs dotted across the landscape. The initial Saudi plan to price out these producers has failed miserably, owing to their nimble and flexible nature.

Having brought down the cost of inputs in the recent crude downturn, many have been waiting patiently for crude prices to rise once more before turning the tap on. Now that we have seen the price of crude rising to a more respectable level, will we see more production coming out of the US?

Should the US raise production to the extent it starts making headlines, it is highly likely this will undermine the OPEC/non-OPEC production cut by simply swallowing up its reduced market share. Given the likes of Saudi Arabia and Russia raised output hugely as a precursor to cutting them, any rise in US production could spark a surge in OPEC output, meaning in total there is more oil than ever. In which case, the race to the bottom could once more be on for crude.

The chart below highlights the rise in US rig counts, which have grown over 60% in the past six months. Typically we see rigs follow price, with a four-five month delay between shifts in the two.

Given the recent rise in oil prices, we have seen rigs (a proxy for US investment and future output) begin to rise. This recent rise has been the longest consistent rise in US rigs since 2014.

Next we see the impact this rise in rigs has upon production. It goes without saying that an increase in investment is synonymous with the desire to be more active as a producer and this of course bears out in reality. The chart below highlights the impact a sharp drop in rigs eventually had upon output back in early 2015. The rise in rigs we have seen since May has also begun to have an impact upon output, which has now been rising for five months.

Finally, we cut out the middle-man and see the fall in oil prices back in 2014 ultimately led to a fall in investment (rigs). However, with oil prices on the rise as of Q1 2016, there has been a consistent rise in rigs, which will ultimately cause output to rise and likely spell the end to crude gains.

This is summed up in the flow diagram below, which shows this goes around in circles and highlights that perhaps the crude gains could be behind us soon enough.

The chart below highlights what is currently happening in Brent crude, which has struggled to follow through on its December inverse head and shoulders completion. That failure to push on is a worrying sign and despite announcements from various nations that cuts are gradually occurring, we are seeing a greater focus on bearish side.

Ultimately, we are caught in a battle between US production increases and OPEC/non-OPEC member decreases. Typically a rise in oil prices can take a relatively long time (circa one year) to feed into a change to US output. With that in mind, keep a close eye on global production levels, as this will likely determine the next move for crude prices.