Since hitting bottom at $42 last summer, West Texas Intermediate (WTI) oil has staged an impressive comeback to trade in the $60-$75 band. Even more impressive is that it is pulling away from almost all other major commodities. Bearing in mind that oil is an input, high oil prices could eventually lift the tide for the commodity universe or get dragged down by the rest. How long can this uptrend last?

In commodity markets, one always has to remember the second-order effect—all the headlines of conflicts, outages, and natural disasters matter, but only to the extent of how they affect the underlying trends in supply and demand.

Commodities have end-users, so when the fundamentals exert themselves, especially on the margin, minor events can create shocks. When sentiment runs ahead of fundamentals, even minor positive news is exaggerated; when sentiment sours, every minor piece of bad news brings intense selling pressure.

In light of remarkably stable demand and the upcoming Iranian sanctions, we argue that oil is poised for a further—albeit limited—upside in the near term, but faces significant headwinds in 2019. Consider the following:

  1. Supply/demand is widely considered to be tight and will remain so until late 2019. American refineries have been running above 95% utilization but are barely catching up. Global fiscal and monetary stimulus remain intact to goose economic growth, though with increased fragility.
  2. The general sentiment for oil among analysts and investors is still extremely bullish. The managed money long/short gap has been very wide all year and strong backwardation shows no signs of reversing.
  3. Seasonality is a headwind as we head into the winter low-demand season but crude inventory levels are trending decidedly lower and are now below the five-year average.
  4. The Saudis are content with the current price level (Brent at $70-$80) because it stabilizes the budget. Although the Saudis have ramped up production since March to counter declines in Venezuela and Iran, President Donald Trump is also expected to escalate the rhetoric for OPEC to “do something” about oil ahead of the midterm election, symbolic gestures in the form of further boost is likely.
  5. America’s European and Asian allies are expected to comply with the November Iranian sanctions. Most have already drastically cut back Iranian imports. India was recently caught offloading an off-grid Iranian tanker but that action should be an anomaly. China, on the other hand, can be expected to circumvent the U.S., especially since it is cutting American oil imports as a result of the trade war.
  6. Saudi Arabia is about the only country with any meaningful spare capacity. This is widely believed to have dwindled to around 1.5 million to 2 million barrels of oil equivalent per day, which at 1% to 2% of overall global demand has reduced the country’s ability to manage prices and creates a potentially disproportionate upside shock.
  7. There are talks that Iranian and American leaders are planning to meet in person and work out a grand bargain. This could check the upside momentum in the short term but Trump’s negotiating style suggests that little ground will be ceded to Iran.
  8. Despite ever-increasing capital expenditure, U.S. shale oil producers are still operating comfortably above their breakeven prices ($30s to $40s) and hedged out for the next few years. They are, however, struggling mightily to increase production, fighting constraints on takeaway capacity, water disposal, sand, trucks and inflation. Production is at a record high but expected to flatten out. Rig counts are revealing: they are declining in the Permian Basin but increasing in other basins, though it will take a few months to materialize into production.
  9. The latest U.S. Energy Information Administration survey showed that the gap between drilled wells and drilled but uncompleted (DUC) wells in the Permian is rapidly widening, signaling a tendency by producers to wait for pipelines to come online at the end of 201

The last two points are not trivial. While OPEC provides the bulk of the world’s oil and the Saudis, with their large spare capacity, manage the production swing, the Permian Basin, by its sheer size and velocity, has become a marginal producer that carries an outsize influence on the direction of trends on the supply side.

We are not sure how much excess DUC inventory will be built when all is said and done, but we do believe that given time, it can develop into a significant drag on prices. If prices break and producers rush to complete the wells and turn on the tap, this could exacerbate any downward movements.

Jeff Lee is principal at Kronos Management LLC, an investment manager specializing in commodity trading.