Energy Monitor September – Postponed stress

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  • Oil prices decline despite geopolitical tensions
  • Nevertheless, geopolitical tensions do have an effect on oil prices
  • Current overproduction and possible future production difficulties lead to changes in the forward curve

Oil prices decline

Following the advance of ISIS in Iraq, oil prices rallied to levels above USD 115/bbl in June. Not long after, it seemed that oil production would remain unaffected and the market calmed down. This triggered the start of a declining trend in oil prices. Weak demand, combined with more than enough oil production, caused the Brent oil price to drop below USD 100/bbl – the lowest level in fourteen months. Iraqi Kurdistan increased oil production and Libya also reported higher oil exports. As a result, OPEC oil production ultimately reached 29.91 million barrels per day (mb/d) in July. This, together with increased oil production in non-OPEC countries, such as the US and Canada, created sufficient oil supply. The price of West Texas Intermediate (WTI) declined as well. However, this decline was not as strong, given the significant drop in inventories in Cushing, Oklahoma in recent months. These inventories were partly transported via recently opened pipelines to the US refineries in the Gulf of Mexico region for processing. Because this could lead to shortages in other parts of the US, prices did not decline as much as one would expect. The price difference between Brent and WTI (the Brent/WTI spread) dropped to the lowest level since September 2013.

Geopolitical tensions do have an effect

Many investors wonder why oil prices failed to rally as a result of all the geopolitical tensions around the globe. There are tensions all widespread, and many large oil producers are directly or indirectly involved. Still, fear that political decisions may lead to oil production shortages have eased. As a result, oil prices have not appreciated much, and the impact of these geopolitical tensions therefore seems limited. However, in a normal situation, the effects of oversupply would have resulted in a much stronger price decline. We believe that geopolitical tensions are having an impact. Prices may not be increasing, but nor are they declining.

Oil price forecast

Geopolitical tensions are hard to predict. However, normal supply and demand ratios can be fairly accurately forecasted. The effects of geopolitical unrest are included in risk scenarios. Lower tensions could result in increased oil production and, therefore, a lower risk premium. This could trigger a faster and further decline in oil prices. At the same time, increased geopolitical tensions could lead to limitations in oil production and/or oil exports. Still, we largely ignore this in our base case scenario for future oil price developments. This scenario of a moderate decline in oil prices (table 1) over the next two years is based on several arguments. We expect that demand for oil will rise at a moderate pace. Meanwhile, the oil supply will increase at a similar pace, mainly due to increased production in non-OPEC countries and despite the oil production potential in some OPEC countries. Finally, we expect the US dollar to appreciate, which would have a negative impact on USD-denominated commodities, including oil.

Stress postponed

In the previous paragraph, we talked about the downward pressure on oil prices. This concerns oil for delivery in the near term, for instance in September or October (figure 2, arrow 1). While tensions in oil producing countries do have a supportive effect on oil prices, the greatest impact is on oil with delivery in the longer term (figure 2, arrow 2). Until recently, prices for delivery in the near term (short end of the curve) were significantly higher than those for delivery in the longer term (back end of the curve). This was the result of temporary uncertainty regarding oil production due to increasing violence in oil producing countries. However, since oil prices at the front end of the curve declined, and oil prices at the back end of the curve rallied, the price difference narrowed. In other words, the forward curve (series of oil prices with delivery at different time horizons) has flattened compared to six months ago.

Near-term contango

The fact that the price of oil with delivery in two to six months is higher than the spot oil price (contango, figure 3) is, we believe, the result of lower tensions. This has led to the closure of many speculative long positions (speculating on price increases). Trade volumes of Brent oil declined by more than 40% compared to three months ago. Nevertheless, investors remain somewhat cautious. They are keeping open the possibility that there will be some type of escalation after all, and/or Russian sanctions on the EU. This is part of the reason why oil prices are higher for delivery in 2-6 months. How long this situation will continue is uncertain. Some investors will try to benefit from this contango by buying oil now, storing it, and hoping for higher prices in the future. Too many of these speculative positions would result in a higher spot price, which would wipe out the contango.

Long-term backwardation

For now, oil prices with delivery in the near term are down as a result of weak demand and oversupply. In addition, prices with delivery after six months are in backwardation (future price below current price (figure 3)). It seems that the market expects the demand for oil will be balanced out by the amount of oil produced in the next few years. However, in the longer term (> 2 years), the effects of the crisis in Iraq as well as the sanctions against Russia could lead to significant problems. The uncertainties investors perceived for the near term appear to have been postponed and now could emerge at the back end of the curve. Iraq had the ambition of tripling its oil production in the coming years. To meet the rise in global oil demand, Iraq needs to double its oil production over the next five years. Due to the recent emergence of ISIS, oil production has not yet been affected. However, uncertainty about realising the needed significant increase in Iraqi oil production has risen. Iraqi oil production would have to double to help meet the rise in global oil demand, which is not fully covered by the oil production potential (spare production capacity) of Saudi Arabia and the expected increase in non-OPEC production. Besides, a situation in which Saudi Arabia needed to use all of its oil production capacity would be unwelcome. This would mean that Saudi Arabia could no longer fulfil its role as swing producer. As a result, the market, and therefore oil prices, would be left to the whims of geopolitical tensions and temporary oil production disruptions.

In addition, the sanctions imposed on Russia by the EU and the US will hurt investments in the Russian energy sector. The energy infrastructure is already outdated and overdue for maintenance and the funds needed to cover these costs are not available. Meanwhile, large investments are needed to increase knowledge for exploring new oil and gas production wells in untapped areas (for instance at sea, or in the Arctic). The fact that these investments are also lacking could hurt Russian oil production in the future.

Based on the current situation, a U-shaped forward curve would seem to be the most likely scenario. This means that the market should price in lower oil prices in the near term, mainly as a result of overproduction. However, in the longer term (>2 years) the curve should start to point upwards due to possible production shortages. For now, the price at the front end of the curve may be too high, and the contango could disappear in the coming weeks. Furthermore, prices at the back end of the curve seem to have some upside potential. However, the lack of liquidity for long-dated Brent oil contracts will likely prevent such a rally.