Oil price rally to halt
In July, some US-dollar weakening, US stock withdrawals and the fact that the Fed indicated low rates for longer, pushed oil prices higher. In particular, WTI prices rose, as these drivers were mostly US-related. Nevertheless, Brent crude also traded higher, but the impact was more subdued, as Brent is less affected by US refinery demand. Increased geopolitical tensions – mainly in Egypt – and Fed Chairman Ben Bernanke’s comments made an impression. As a result, the Brent/WTI spread dropped to parity, before it nudged back to USD 2/barrel. During the last week of July, oil prices declined somewhat, based on weak Chinese data (mainly PMI), which raised concerns of slower demand growth. Earlier that week, Chinese officials advised that Chinese growth will not drop below 7%. Recent comments had suggested, however, that Chinese growth would not drop below 7.5%, so this communication added some pressure to oil prices as well. We still forecast Chinese GDP to be 7.5%. Finally, the news that, according to the Energy Intelligence Agency (EIA), crude production in the US hit its highest level since 1990 (7.56 million barrels per day) resulted in further pressure on oil prices. Moreover, US production continues to increase as a result of the boom in shale oil production.
For the near term (August), with volatility elevated and the thin summer markets (lower liquidity) being in a relatively positive mood, some upside within a sideways trading range cannot be excluded. In particular, the release of stronger-than-expected data could stir hopes of economic recovery and, therefore, a possible rise in crude demand. Furthermore, reports of above-average temperatures or production disruption-related news could add support as well. Nevertheless, US crude oil prices should be capped at the previous 2013 high of between USD 110-115, with Brent capped at USD 120.
In the medium-to-longer term, however, ABN AMRO does not expect this rally to continue much further. This is because we forecast: 1) supply to continue to outpace the rise in demand. 2) a stronger US dollar in the coming years. 3) the Fed to unwind stimulus measures at some point (even now Bernanke has indicated that rates will remain low for longer). 4) the global economic recovery to be moderate, with oil demand in developed regions staying at neutral levels. These drivers will not only cap oil prices, but could even add downward pressure in the coming years, as commodities/oil become less interesting as an investment. In addition, fundamental drivers will result in extra pressure, as more production capacity becomes available in the coming years. Especially in Iraq and non-OPEC regions, such as the US and Canada, a strong increase in production is expected, which will outpace the rise in crude demand related to the economic recovery. As oil price rallies continue to be unlikely and with the global economic recovery being modest, inflation is expected to remain low during the coming years. (figure 2). For further details on the longer-term forecast, please consult our Quarterly Commodity Outlook, which was released on 25 July.
Brent/WTI spread should remain around USD 2-5
After having reached USD 23.18/barrel in February 2013, with even higher levels seen in 2011 and 2012, the Brent/WTI spread turned negative on 22 July for the first time since August 2010. Before 2011, WTI trading above Brent was common, due to quality differences and transportation costs. We believe, however, that this is (or at least, should be) unlikely to recur for years to come. During the past weeks, inventories of US crude stocks dropped significantly, because both demand from US refineries somewhat increased and pipeline capacity also slightly increased. The stock withdrawals totalled almost 30 million barrels in just three weeks’ time. Although stock withdrawals are quite normal for this time of year, the pace of the drop in inventories triggered investor worries. Nevertheless, from a historical perspective, EIA US crude stocks are still at very high levels (figure 3). In fact, the rising uptrend of US crude stocks is still intact, with the US producing more crude domestically and imports from Canada and Mexico even expected to increase.
Although quality differences still exist, the impact on prices should be less. After all, US refineries are still largely equipped for the heavy Canadian or Middle-East crudes instead of the lighter sweet crude that is mainly stored in Cushing, Oklahoma. To make switching to using another type of crude more attractive, a discount is needed now. Furthermore, higher US transportation costs (mainly rail, as there is still limited pipeline capacity) should result in a USD 2-5 discount for WTI. Otherwise, it would be cheaper for US refineries to import crude from other regions. It will still take many years before enough pipeline capacity is available to justify the spread being at par. Currently, with the Brent/WTI spread already at par, the move seems to be overdone and therefore should correct higher.
What about geopolitics?
With geopolitical tensions easing somewhat and fading to the background in the media, the main question is whether there is still a risk premium attached to oil prices. Our answer is yes.
The overall risk premium dropped compared with two years ago. Nevertheless, tensions in the Middle East prevail, with Iran being the major risk. With the outcome of the Iranian elections, there was increased hope that the negotiations regarding Iran’s nuclear programme would resume shortly. However, Israel could increase tensions if it continues to stress that Iran is nearing the red line that Israel has drawn as required for diplomatic talks with Iran. Although a major shift in Iran’s nuclear policy stance cannot be expected, constructive talks may somewhat ease pressure on the risk premium, resulting in lower oil prices. In addition to the US shale revolution, OPEC – and mainly the Gulf region – is facing increasing headwinds. The impact of the Arab spring will continue to be felt in coming years. Ongoing political uncertainty, such as seen in Egypt, will be the major factor in some of the countries involved, leading to worries of contagion risks for the major oil producers. Egypt is, with approximately 600,000 barrels/day production, not a major oil producer. However, tensions in Egypt have triggered worries about a possible spillover to surrounding major oil producers or possibly affecting transport routes through the Suez canal or the Sumed pipeline. In our view, this appears unlikely. Finally, oil production disruptions in South Sudan/Sudan, Libya and Iraq may have a bigger impact. But these declines in oil output are mainly countered by increases in non-OPEC and Saudi oil production.
Until the Iranian issue is completely resolved and the effects of the Arab spring disappear, several US dollars’ worth of risk premium (~USD 5) will continue to be added to oil prices.