Geopolitical tensions have escalated in the Middle-East with the Saudi 'purge' over the weekend and intensifying Riyadh-Tehran verbal exchanges.
Firstly, we are a long way from armed conflict between Iran and Saudi Arabia. Secondly, the purge is a very domestic issue. There is a tendency with perceived geopolitical events, especially when the politics are not necessarily fully understood, for speculative fund managers to pile in and buy oil futures contracts sending the price higher, in hope the rally will continue.
Further, shorts (those who profit from selling high and then buying-back low) tend to remain on the sidelines fearing they might be caught out by price surge. This creates a path of least resistance – upwards!
There are also a bunch of statistics to suggest the oil market was already 'stretched' (fancy term for saying too bullish) before the Saudi goings-on. And this all ignores the recent Mexican onshore discovery (estimate 1.5bn barrels – 350mn 'proven possible reserves').
Two petrocurrencies that would be expected to appreciate, the Rouble and Norwegian Krone, are yet to strengthen – suggesting a lack of conviction in oil's rise. There is therefore a high risk the crude rally misrepresents the reality of the global physical market – in this case indicating that it is too tight.
If the fundamentals do not support this, funds can bailout very quickly, sending the price lower. Fast. The Brent market is in something called backwardation (i.e. near-term prices are higher than future prices) supports fund buying of oil as they can earn positive carry when the prompt month rolls.
Meanwhile, Opec continues to point out that the production cap deal negotiated last November is 'working'. Global inventories have indeed fallen from the pre-deal peak and the 5-year moving average is also converging with the actual level of inventories; a major aim of the accord.
However, the laws of averages mean that this must occur - if actual inventories remain above the average, then the latter will necessarily be pulled higher. This is not the same as the physical market becoming balanced in the longer-term, which is probably why there is a push to extend the production accord beyond March at Opec next meeting on 30 November.
What happens once inventories and the 5-year average converge at a significantly higher level versus history is another matter. Much here depends on the marginal producer, which is the US. Saudi Arabia has said it will cut exports to the US by 10%.
This doesn't mean this oil won't be produced – just that is won't head to the US. Trouble here is the vast amount of drilled but uncompleted wells in the US.
If these are tapped then production will increase rapidly not only filling the void domestically, but also exported to offset any fall in exports onto the global market by the signatories to last November's production cap.
Evidence also suggests plenty of producer hedging in the US, which in layman's terms means drillers are guaranteeing themselves a price for next year.
This allows these companies to produce/sell as much as they want at a certain price regardless what happens to oil prices next year. If production plans are elevated, as-long-as costs are covered, there could be a large jump in US oil output which just forces a renewed production accord every 3-months or so.
Currently at least, it seems that unless there is a more significant output cut, the longer-term oil supply/demand does not favour Opec/Non-Opec producers who signed up last November. And the longer this situation occurs, the greater the chances of countries abandoning the deal.
Marcus Dewsnap is a senior research analyst at Informa Global Markets (IGM), which he joined in 2010. He primarily spends his time looking at the global macroeconomic landscape, monetary policy and the impact on global fixed income and foreign exchange markets, with a good dose of commodity markets thrown in. Prior to IGM, Marcus spent 10 years producing live business and financial TV programmes at CNBC and Bloomberg, during which time he also attained a masters degree with distinction in economics.