- Oil price has enjoyed stable performance for two months amid conflicting OPEC-US oil production dynamics
- Brent oil price forecast revised down for H1 2017
- Moderately rising oil price still in prospect for the longer term
Caught between supply and demand
Over the past two months, the Brent oil price has moved within a relatively narrow bandwidth of about USD 53-58/bbl. The usually fairly volatile oil price has barely budged for two months, the reason being conflicting dynamics in the market. A floor is being formed by the production reduction agreed by OPEC and several non-OPEC oil producers (including Russia). This output cut, which has been in force since January, has raised expectations of an improving supply-and-demand balance in the oil market. This, in turn, would justify a higher oil price. At the other end of the spectrum, a ceiling is being created by the stepped-up shale oil production in the US. A higher oil price makes it profitable for many of these producers to up their output again. At the same time, however, this higher oil production is putting a brake on further price increases.
OPEC producers want the market to believe they will stick to the agreed production freeze. But lessons from the past have made the market deeply suspicious. So it is eagerly looking to independent parties for evidence as to whether production has genuinely been cut or not. The first signs from tanker movements and storage data point to 60% to 70% compliance with the agreed production reduction in January. S&P Platts has even suggested that over 90% of the planned cuts have been implemented. The monthly oil reports from IEA, EIA and OPEC itself will provide a better understanding. But even then, it will still be too early to draw firm conclusions. Further confirmation must come from the February and March output figures. Finally, there is also uncertainty about whether non-OPEC producers will stay true to their word.
However, regardless of whether compliance is 70% or 90%, it is at least clear that, on this occasion, OPEC means business. The plans for the current production restrictions were made public months before the official announcement, so the market was amply forewarned. And despite some lingering suspicions, the promised production cuts also already appear to be entirely priced in. It is no coincidence that the oil price doubled in 2016 from USD 27/bbl in January to USD 55/bbl. That said, the first actual cuts in January did not spark a further price increase. And it is precisely this absence of continued upward momentum that harbours a big risk.
Brent forecast revised, but long-term scenario unchanged
We have reduced our Brent oil price estimates for the first half of the year from USD 55/barrel to USD 50/barrel, while allowing for a possible temporary dip towards USD 45/barrel. Similarly, our WTI forecast for the first quarter has been lowered to USD 45/barrel, but the second quarter seems to present fewer downward risks due to the possible imposition of a US border tax (see next page).
From a technical perspective, the Brent oil price could – after breaking through the 200-day average around USD 50/barrel – undergo a further correction to about USD 45/barrel, while still remaining in an upward trend (Figure1). WTI has less downward latitude before moving into a downward trend. But that scenario seems less probable in view of the proposed border tax.
Although the downward risks have increased somewhat in the short term, we are sticking to our long-term vision of a moderate oil price recovery. Global demand for oil will continue to grow by 1.0-1.5 mb/d. US supply will pick up, but non-shale supply will come under further pressure owing to a lack of investment and the OPEC/non-OPEC production cuts. With high and slow-moving stocks, it may take longer for the oil price to find support. And even if the oil price rises in due course, the upward potential remains limited as production will receive a considerable impulse if oil prices manage to stay at a higher level for a prolonged period. In this light, we have left our expectation for the Brent year averages unchanged at USD 55/barrel in 2017 and USD 65/barrel in 2018. The forecasts for WTI are: USD 55/barrel in 2017 and USD 60/barrel in 2018.
Significantly higher downward risks in the short term
Our revised oil price forecast for the first half of the year is mainly based on the following increased uncertainties:
- The production reduction agreement could fail. Although the OPEC (-1.2 mb/d)/non-OPEC production cuts (-600 kb/d) have not yet been fully implemented, the market seems to be banking on OPEC delivering on its promises this time. Full compliance, however, is by no means a foregone conclusion. Libya and/or Nigeria could ramp up production unexpectedly and other producers could implement more modest output cuts. Also, Russia has promised to lower production by 300,000 barrels per day. But that is a normal seasonal pattern for this time of year. The big question is whether Russia will keep output at this lower level towards the end of the quarter.
- Production in the US could rise (even) faster than expected. A strong increase in the number of drilling rigs has already boosted oil production in the US (Figure 4). As long as oil prices remain well above USD 50/bbl, this growth is likely to be maintained, all the more so when US oil producers are able to hedge their selling prices and the forward curve prices (prices for future delivery) start gravitating towards USD 60/bbl. This could partly cancel out OPEC’s efforts to nudge the market towards equilibrium.
- The flattening of the forward curve shows that the evaporation of the oil glut has been largely priced in. This raises the risk of disappointments and/or profit-taking if the assumed production decline is realised.
- Oil and refined product inventories in the US are at record levels (Figure 4). Despite OPEC’s recent action, the continuing surge in US inventories is in the news every week. The upshot is that, even if production falls, there are still ample stocks of oil and refined products to prevent significant price rises.
However, the risks that could lead to a higher oil price are also on the rise.
- For one thing, the Trump administration might slap a border tax on oil. The final budget will only be presented in June, while the budget debates are due to start in March. A border tax could give WTI extra support by fuelling demand for local oil and put downward price pressure on Brent which, due to the tax, would be more expensive for Americans to use.
- Moreover, heightened tensions between the US and Iran could prompt fresh sanctions against Iran. This could inflate oil prices, depending on whether the sanctions hit dollar-denominated transactions or prevent the exportation of oil from Iran.
Backwardation makes a comeback
For the first time in three years, the forward curve has partly returned to backwardation territory (Figure 5), meaning that prices for future delivery are lower than the current spot price. For a long time, oil oversupply kept prices for direct delivery below those for future delivery. So the current gradual flattening of the curve, and its partial return to backwardation, signifies that the market has largely priced in the disappearance of the oversupply – yet another sign that the OPEC/non-OPEC production reduction has already been priced in.
Speculative long positions at record level
Hedge funds and speculative market participants/investors are already positioned ahead of the future. In fact, they have massively ‘gone long’ (i.e. purchased contracts that anticipate rising prices). This is expressed in the number of outstanding contracts for both investors (net non-commercial positions; +60% since early December) and hedge funds (net managed money holdings; +100% since early December). Both positions are at record levels and are showing no signs of breaking the upward trend (Figure 6). In short, most market players foresee a further increase in oil prices.
In the past months, there has been much speculation about the market achieving equilibrium between supply and demand. The signs from OPEC and the production reduction in the US due to the low oil price were seized upon as harbingers of a change in the cycle. It was thought that, after years of oversupply, the market would come back into balance, thereby paving the way for a higher oil price. Reality, however, is a little more complicated – witness the fact that the oil price recovery has already halted at a lower level than most analysts, hedge funds and investors had anticipated. Experience shows that investors reduce their positions when they are unable to drive up the oil price any further.
So the market is poised for further price increases. This is clear from the record positions of both speculative investors (non-commercial positions) and hedge funds (managed positions). Looking at previous unwindings of such speculative positions, we see that, in the past two years, an increasing number of contracts has been necessary to generate a price movement. In the second half of 2014, a decline in the net position by an average of 3,000 contracts was needed to trigger a price fall of USD 1/barrel. By mid-2016 and beyond, that number had already risen to about 25,000 contracts. In other words, the net position would have to decrease by about 25,000 contracts to push down the price by USD 1/barrel.
The current net non-commercial position (speculative investors) is at a record level of about 544,000 contracts. The five-year average for this position is about 335,000 contracts. A period of profit-taking and position-closing towards an average level could then possibly bring about a price decline of a rounded USD 8/barrel. The managed positions (hedge funds) currently stand at 380,000 contracts – also a record – and an average of 210,000. A movement towards the average outstanding position could lead to a price fall of a rounded USD 7/barrel. This confirms our suspicion that, if a correction occurs, the Brent oil price could be pushed towards the lower end of the upward trend line.
Natural gas prices have risen fast
The price of natural gas has soared in Europe in recent months. TTF currently fetches around EUR 20/MWh versus EUR 10.77/MWh in August 2016. This price spike was mainly driven by the market anticipating an electricity shortage in Europe after a large number of French nuclear power stations unexpectedly had to be shut down for inspection and maintenance in the second half of last year. The market assumed that these shortfalls would necessitate substitution imports from surrounding countries, causing a considerable rise in gas and coal prices in North-West Europe. Although only a few of these French nuclear power stations are still closed, the price of natural gas has not fallen because local demand is currently higher than in previous years. The colder winter this year has fanned demand for natural gas. We expect the TTF gas price to fall back as soon as the end of winter dampens demand, so that the traditional restocking activities can take place from the end of March.
In the US, by contrast, the price of Henry Hub has decreased compared to the peak in the last week of December. Even so, at about USD 3.20/mmBtu, the price of natural gas is still on the high side. As in the oil sector, the production of natural gas is also likely to pick up. In addition, seasonal demand will decline gradually, giving Henry Hub more downward potential in the course of the second and third quarters.