Energy Monitor November – What will trigger an oil price recovery?

by: Hans van Cleef

111115-Energy-Monitor-Nov.pdf (299 KB)
  • Oil prices caught in the middle between speculation and hedging
  • Upward pressure on oil prices possible as investors phase out short positions
  • Winter weather to have little impact on gas prices

Oil price moving sideways while awaiting trigger

Since early September the price of Brent crude has been moving within a relatively narrow bandwidth of approximately USD 46-51/barrel. A momentary surge occurred in early October as the market took in the news of a production fall in the United States and anticipated increasing global demand for oil. However, this upturn proved to be short-lived as the markets soon turned their attention back to the persistent oversupply of oil.

At present, we are seeing that whenever oil prices fall, hedge funds are seizing the opportunity to trim their short positions. This suggests that they are no longer so certain that prices will continue to fall. At the same time, however, we see that whenever prices rise, oil producers, particularly in the US, take advantage of the momentum to hedge their exposure down the line (2017 and further) to exclude the price risk. In the past year, the forward curve (series of sequential oil prices) has dropped significantly (figure 2). When prices rise, the entire forward curve is raised slightly, thereby causing forward prices to move closer to USD 60/barrel. This is evidently a level at which US oil producers can generate a sufficient cash flow to make oil production profitable.

Oversupply keeping prices low for longer

As the oil market still has a huge oversupply, oil prices have now more than halved. This is due in part to OPEC’s strategy of seeking to protect and, if possible, even expand market share. Although the oversupply may possibly have lasted longer than OPEC had initially foreseen, the consequences of this strategy are becoming increasingly apparent. Not only have oil prices fallen dramatically, but oil production in non-OPEC countries is also under serious pressure. Countries such as Russia, which have elected to maintain production levels, are experiencing the consequences in other areas, namely government spending.

OPEC is scheduled to hold its next meeting on 4 December. Unity would seem to be a long way off as smaller OPEC members are advocating a reduction of production levels to restore prices. However, there is virtually no chance that Saudi Arabia and its supporters (and hence OPEC) will change their strategy. It is also important to take into account the role of Iran, another OPEC member. If the European and US sanctions are gradually lifted in 2016, Iran will seek to restore its (pre-sanctions) market share. The other OPEC countries, particularly Saudi Arabia, will be loath to reduce their market share for the sake of Iran. This situation would seem likely to maintain the oversupply for a while longer. To what extent this will actually happen, however, will depend on how total global output evolves, not just OPEC’s production.

‘Normalisation’ balance between supply and demand…

In the end, however, the oversupply of oil is bound to be corrected. First of all, continuing global economic growth will boost demand for oil. Owing to increasing efficiency, demand in Europe and the US will not rise quickly and may even fall slightly. It follows that global growth will have to come mainly from the emerging Asian economies (China and India). For example, the transport sector alone is expected to grow at a tremendous rate if the level of prosperity in these countries continues to rise. Demand for refined oil products such as diesel therefore looks set to rise considerably.

However, this normalisation of the oversupply will also be facilitated by developments on the supply side. As noted, oil production in some non-OPEC countries is under pressure. In recent months oil production has also fallen in the most important producer country, the US. This has ended the upward trend of the past four years. In our view, the production level in the US is crucial. This was, after all, the ‘black swan’ which had disrupted the entire global energy market through its production of shale oil and gas. A further fall in the level of US oil production could speed up the process of normalisation.

As oil prices now seem likely to remain low for longer, oil producers must focus on (a) production efficiency, (b) cost price and (c) financing. Production efficiency is increasing now that the processes are being critically examined and improved technology is making it possible to pump more oil from a single well. The cost price could be lowered by renegotiating contract prices with suppliers and the level of tax remittances with governments. Finally, the downturn in profitability is now making it much more difficult to fund new projects. The question is therefore to what extent a producer is able to maintain its production output. Oil producers with large financial reserves may be able to capitalise on the problems of smaller producers as they come under pressure due to reduced liquidity.

… should boost oil prices

The oversupply need not disappear completely for oil prices to recover. After all, if the market anticipates rising demand for oil and output stabilises or even falls, oil prices are bound to rise in the end. At present, this is to some extent being offset by the strength of the dollar. But as the dollar is not expected to appreciate much further, the inhibiting effect of the stronger dollar will diminish.

Until the introduction of investment instruments for small investors, the net speculative position in oil was, on average, zero. Or, to put it another way, there were about as many outstanding short as long positions. After the commodities market also became accessible to smaller investors, the balance increasingly shifted towards long positions. Following the steep fall in oil prices in the past year, the net position has undergone a sharp correction. The number of long positions has declined and the number of short positions has risen (figure 4). As oil prices have moved within a relatively narrow bandwidth in the past two months, we are now seeing the number of long positions gradually starting to rise again. In other words, the number of investors who believe that the market has bottomed out is on the increase. Nonetheless, the number of short positions is still at an excessively high level. If these short positions are phased out as these investors come to realise that the oversupply will not depress prices further, this could have a really positive effect on oil prices.

Geopolitical tensions also continue to play a role in determining oil prices. Obviously, tensions in the Middle East tend to be the rule rather than the exception. Nonetheless, changes are perceptible here too. The role of Saudi Arabia in particular is changing. Factors causing uncertainty are Saudi Arabia’s active role in the conflict in Yemen, its attitude towards the US following the conclusion of the nuclear deal with Iran, its stance on OPEC’s policy, policy changes accompanying the transition to the new generation of rulers and the increasing local social unrest. Uncertainty about one of the world’s largest oil producers can itself fuel unrest and hence lead to higher oil prices.

Seasonal demand for gas will have little impact on prices

Gas prices are expected to rise less than usual this winter for a number of reasons.

On the supply side

Stocks of gas in Europe in early November were at much the same high level as in 2014. These ample stocks, combined with the possibility of weak demand, are putting extra pressure on gas prices. Moreover, the agreement between Ukraine and Russia about gas supplies to Ukraine has reassured the market. Whereas geopolitical tensions and uncertainty about gas supplies from Russia to Europe caused geopolitical tensions and uncertainty in past winters, prices are no longer being driven up by these factors this year. Finally, the market is anticipating an increase in supplies of liquefied natural gas (LNG). After years of production, there will be a substantial increase in the supply of LNG in the period ahead. As demand for LNG from Asia is also being depressed, the price of LNG is becoming more and more competitive with gas from Europe and Russia. This too is exerting downward pressure on gas prices.

On the demand side           

Demand for gas for electricity generation is steadily declining owing to the increasing efficiency and greater supply of alternative energy. Whether the coming winter will be less severe than average (as has been the case for the past two years) remains to be seen. The powerful El Niño has little influence on the winter weather in Europe, but in other parts of the world the winter will be milder than normal (e.g. in the US). This can put pressure on international gas prices, for example Henry Hub prices and the price of LNG. A low LNG price, in particular, could in due course have a knock-on effect on gas prices in Europe (TTF/NBP) if it comes to be regarded as an alternative for gas from Europe and Russia.

Link with oil prices

Although spot prices of gas tend to be driven by such unpredictable factors as the weather and geopolitics, forward prices of gas are still closely linked to oil prices (figure 5). With oil prices at their current low level (particularly in comparison with prices in the past four years), the pressure on gas prices has increased. Given the large oversupply, oil prices are unlikely to rise significantly in the near future. Nonetheless, the market can start to prepare for a better balance between supply and demand (rather less supply and rather more demand) as soon as there are any signs of this happening. This can raise oil prices slightly and this can also be reflected in the forward price of gas. Nonetheless, we think that the price will not even come close to the average level of approximately USD 100/bbl in recent years.