Energy Monitor August – Short-term swings, long-term concerns

140731-Energy-Monitor-Aug1.pdf ()
  • Lingering risk premium led to rise oil price forecast
  • Impact geopolitical tensions on energy prices limited so far
  • Mild weather and weak demand pushed gas prices lower… maybe too low

Oil price forecast raised; trend unchanged

Last week, we released our new Quarterly Commodity Outlook Q3. One of the main conclusions for oil was that the risk premium had remained higher than expected over the previous months. As a result, we have increased our forecasts for oil prices in 2014 and 2015. Our expected average price for Brent oil in 2014 was set at USD 105/bbl (was USD 100/bbl) and in 2015 at USD 100/bbl (was USD 95/bbl). WTI is expected to draw a similar picture, but at a USD 5/bbl discount.

The unexpected rapid emergence of ISIS in Iraq – OPEC’s second largest oil producer – as well as the ongoing tensions between Ukraine and Russia – the world’s largest oil producer – have kept investors nervous about possible future supply disruptions. As a result, the risk premium did not decline as we had previously expected. On the other hand, however, the risk premium did not increase either. Since both Iraq and Russia are important oil producers, this may seem  rather significant. Nevertheless, as oil exports from Iraq and Russia still continue, the market impact of these tensions on oil prices have been limited so far. This means that investors believe that oil production and/or export disruptions will not occur. And even if Iraqi oil exports are hindered, they can be replaced relatively easy with oil from Saudi Arabia. For Russian oil, no such alternative is available. The fact that the market reaction to the risk premium response is only limited confirm that investors do not believe that extra sanctions against Russia will hurt the energy trade flows. Sanctions against investments in Russian energy infrastructure are likely to have only a negligible impact on the near-term oil flows.

On 29 July, the US and Europe imposed new sanctions against Russia, as a result of its interference in Ukraine. Owing to these sanctions, Russian state-owned banks will no longer have access to the financial markets, there will be an embargo on arms and a ban on the export of goods and technology for – mainly – the oil and gas sector. The export ban will make deep-sea drilling and the use of shale technology even more difficult. If  Russia does not institute counter-sanctions to reduce oil and/or gas exports, the impact on oil and gas prices will be limited. The new sanctions by the US and Europe mean that there will be no investments in the oil sector, which would keep Russian oil production at current levels. This will hurt the difficult situation surrounding the Russian energy infrastructure even more. The energy infrastructure was already suffering from overdue maintenance, lack of investment and lack of knowledge regarding deep-see drilling and shale-technologies. Russia produces around 10 million barrels of oil per day (mb/d). Roughly half of it is exported; and 2.5 mb/d is exported after refining, mainly to Europe. The main destinations in Europe for Russian crude oil are the Netherlands and Germany (figure 2).

TTF Gas prices may have declined too fast

TTF Gas prices fell off a cliff during the first half of this year as a result of weak demand and ample supply. From their peak in early December 2013, until the lowest point reached on 13 July, TTF gas prices nearly halved. In our Quarterly Commodity Outlook we point at the different developments between spot and future prices. While spot prices seriously weakened, future prices continued to trade within narrow ranges. This makes sense as it is almost impossible to predict the level of inventories – the main driver of future prices – after one, or even two, winter seasons.

As mentioned, TTF spot prices fell sharply, perhaps even too sharply. Although the fundamentals pointed towards weaker TTF gas prices, the moves may have been over exaggerated and therefore, an upward price correction would be justified at some point in time. The upward correction of TTF gas prices during the past two weeks could have been the result of some profit-taking on recent price declines under the guise of geopolitical tensions. After the downing of a commercial airplane in Ukraine, market tensions increased even further.

However, near-term gas fundamentals have not changed. There is still weak demand and European inventories are almost completely filled. Furthermore, due to the mutual interest of energy trade between Russia and the EU, gas flows between Russia and Europe are not likely to be hindered in the near term. Therefore, the geopolitical tensions should have had a bigger effect on energy future prices rather than on spot prices. Also see our Energy Monitor June – ‘Price differences in gas explained’ for more details on price differences between spot and futures.

In our Quarterly Commodity outlook, we also introduced Transfer Title Facility (TTF) gas price forecasts. Up until now, we have only produced price forecasts for US Henry Hub gas futures. However, with dividing gas markets and a loosening link between European gas and oil, we found it useful to give price forecasts for TTF as well. Please see table 1 for the most recent oil and gas price forecasts. Based on fundamentals, we expect the moderate decline of TTF gas prices to continue in the coming years. However, on-the-spot market prices have declined too quickly, which will result in a near-term upward price correction before the longer term downtrend can be continued.

Henry Hub gas price hurt by drop in demand

Since mid-June, US Henry Hub gas prices have declined sharply. After the volatile price movements driven by the harsh winter conditions, Henry Hub gas prices entered a period of stable prices. Between March and mid-June, the Henry Hub gas price (first contract) traded in a ‘narrow’ trading range of USD 4.25-4.85/mmBtu. However, while inventories were rebuilt as a result of low demand due to cooler than expected seasonal weather conditions (cool summer results in lower air-conditioning demand), prices fell under pressure (figure 2). Henry Hub gas dropped below USD 3.73/mmBtu this week. We expect that as soon as seasonal demand starts to pick-up, Henry Hub prices will start to recover. Our three-month outlook for Henry Hub gas price is USD 4.50/mmBtu.

Price difference between European and US gas widened again

After a long period of narrowing price differences between European and US gas prices, in mid-July, this pattern began to change. The price difference dropped below a1.50 ratio, meaning that European first contract price are 1.5 times more expensive than US Henry Hub first contract prices (figure 4). At the start of this year, European industries still paid 2.5 times as much, and even 5 times US gas prices in 2012. However, with European gas prices rising, US gas prices declining and the US dollar appreciating, the price difference in the disadvantage of European industries increased to 1.9 times US gas prices. The question is whether seasonal weather events will change the near-term trend. We believe that the ‘normal’ ratio for the remainder of this year should be around current levels. This is based on an expected combination of slightly higher prices for TTF gas, as well as a recovery of Henry Hub gas prices and a further appreciation of the US dollar.