Energy Monitor August – Summer of Unrest

by: Hans van Cleef

  • Oil prices under renewed pressure as market focuses on oversupply
  • Speculators once again anticipate falling prices… 
  • …but signals point to changes in market fundamentals
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Oil price drops back towards USD 40/bbl

The oil market’s renewed focus on oversupply has pushed a barrel of Brent oil from USD 52.50 in June towards USD 40 now (-21%). WTI even fell by as much as 24%. Lower oil demand expectations alongside noises that temporary production interruptions have been resolved and Libya and Nigeria are set to step up oil production in the coming period are feeding this negative sentiment. The market also remains strongly focused on reports that US inventories of both crude oil and petrol are very high. This despite the fact that crude oil inventories declined for nine consecutive weeks, before showing a single week of limited increases (figure 1). Even more important, perhaps, are the inventories of finished or, rather, refined products. Though still rising, these are now levelling off.

Petrol inventories are high, both in the US and in other regions, causing worries among investors about a potential weakening of demand from refineries. We, too, expect refinery production to come under pressure. Not so much because of slackening demand due to excessive inventory levels, but mainly because oil companies had postponed refinery maintenance work to capitalise on the low oil prices. A low cost price, after all, translates into strong margins. Accordingly, faced with languishing profits from production activities, oil companies decided to keep their lucrative refinery operations up and running for longer than normal. However, this strategy cannot be pursued indefinitely, and refinery shutdowns for maintenance now seem imminent. In this light, petrol inventories are likely to rise less quickly in the coming weeks.

That said, drilling rig activity in the US has been picking up somewhat (figure 2). Oil production in the US seems to be stabilising at around 8.5 million barrels per day. As yet, the rise in the ‘US rig count’ is limited to several tens of added rigs, so it would be premature to qualify this modest recovery as a bottoming-out trend. Even so, this would appear to be an initial signal that US shale oil producers see scope for resuming their activities when oil prices top the USD 50/barrel mark. It may be a while, however, before any effects of this upturn in drilling activity become visible in oil production volumes. Shale oil producers can react more quickly to oil price movements than operators of ‘conventional’ oil wells. The infrastructure can be built more quickly and significantly lower investments are required to make shale oil production profitable. The cost of oil production has decreased and production has become more efficient due to the sharp decline in oil prices. Nevertheless, even if oil prices stabilise at a level above USD 50/barrel, we do not expect the same rapid spike in US shale oil production as witnessed before 2015. Many investors in the sector will remain cautious now that the return on these investments is surrounded by so many more uncertainties.

Short positions returning to excessively high levels

In response to the negative market sentiment, parties such as hedge funds are once again taking speculative positions on further oil price declines (figure 3). The number of outstanding contracts for these ‘short positions’ has soared recently – +70% since June – and is once again heading towards an extremely high level. Earlier this year, we saw that the large-scale closing of these positions gave the oil price a strong upward boost: Brent oil shot up from USD 27/barrel in January to USD 52/barrel in June. All in all, we can say that the volatility in the oil market in the past months was mainly caused by the change in the number of outstanding short contracts.

Oversupply under pressure

The monthly report of the International Energy Agency (IEA) revealed a significant decrease in the global oversupply of oil in the second quarter. The excess supply fell from an average of 1.7 million barrels per day (mb/d) in 2015 to 1.3 mb/d in the first quarter of 2016. In the second quarter, global oversupply dwindled to a mere 0.2 mb/d (figure 4). This sharp drop was partly attributable to temporary disruptions. Forest fires in Canada, an oil worker strike in Kuwait and sabotage of oil facilities in Nigeria all served to dampen oil production. However, even aside of these temporary disruptions, a clear change in the trend is noticeable in other countries.

As noted, oil production in the US has decelerated considerably since the low oil price sparked a strong contraction of investments in the sector. But output in, for instance, Mexico and China is also being reined in. In the absence of a rapid structural recovery of the oil price, production activities are not always profitable (upstream) and refinery margins are narrowing (downstream). This will continue to put a drag on investments in the entire sector for the time being which, in turn, poses an increased risk of stabilising or even falling production growth. And though global growth is also stalling due to the poor economic conditions in diverse regions, organisations such as the IEA and the EIA still expect demand for oil to continue accelerating by more than 1 mb/d per day in 2016 and 2017. As a consequence, all other conditions being equal, the global oversupply could evaporate towards 2017, or even turn into a shortfall.

So what now?

Market sentiment is deeply negative at present. The economic growth outlook is disappointing, the anticipated interest rate hike in the US remains shrouded in doubt, and oil supply is still outpacing demand. Oil and petrol inventories are high. And, finally, there are signals that countries like Libya and Nigeria want to step up their oil production even further (though whether this will actually happen is highly uncertain). Downward risks will continue to weigh on oil prices in the coming weeks. The market is slack due to the holiday period and positive news appears to be largely ignored. Nevertheless, we are convinced that the underlying driving forces are changing. And though this is not yet visible in the current supply/demand ratios, and hence in the oil price, we still foresee an oil price recovery in the fourth quarter. Whether our year-end forecast of USD 65/barrel is, perhaps, slightly too optimistic still remains to be seen.