Energy Monitor July – Oil price recovery in pipeline

by: Hans van Cleef

  • Oil price outlook: Bigger gap between Brent and WTI
  • Uncertainty over US production growth and future OPEC agreement
  • But market balance appears to be on its way… if not already here
190717-Energy-Monitor-July.pdf (302 KB)

Oil price expected to recover despite small downward adjustment

Our year-end 2017 forecasts have been revised slightly lower to USD 57/barrel for Brent oil (from USD 60/barrel) and USD 54/barrel for WTI (from USD 60/barrel). Negative market sentiment and growing oil production in the US are the main causes for the adjustment and the widening gap between the two leading oil markets. As we near the expiry date of the OPEC output reduction agreement (March 2018), the oil price may come under pressure due to uncertainty over global supply and fears of a renewed glut.

Nevertheless, we foresee a further price upturn from the second half of 2018 as the oil market continues to normalise. We expect this normalisation process to take place in terms of both market balance (supply/demand/stocks) and rising prices for production at less accessible oil fields. Our underlying assumption is that global oil demand will continue to show strong growth (+1.4 mb/d in 2017 and 2018), possibly lifting oil prices towards USD 75/barrel at year-end 2019.

Clearly, the high speculation-driven volatility in the market can spark strong price movements. Such daily swings are not necessarily representative of the long-term trend and could wrong-foot business and financial investors. In this volatile environment, it is very difficult – if not impossible – to monitor the effects of mid-term measures of organisations like OPEC on the basis of weekly US inventory data.

Market sentiment is too negative

Market sentiment is deeply negative at present. As a result, most arguments that point to rising prices are ignored. Concerns about the situation in the US (high inventories and rising oil production) combined with lack of confidence in compliance with the output cuts agreed by OPEC and several non-OPEC oil countries are putting sustained pressure on the oil price. Since the recent price decline, key technical barriers have been broken so that the technical picture offers oil optimists little hope for the time being.

In the past months, the weekly inventory data from the US fed the direction of the oil price. Investors are impatiently looking forward to a new supply-demand balance and are seizing upon every figure as a “latest score” to gain some sense of the market’s likely direction.

The disadvantage of using the weekly US inventory data as a guideline is that these are rather volatile and therefore hard to predict. These volatile data thus cause substantial price fluctuations. For this reason, we do not see the inventory figure as the perfect instrument for monitoring the OPEC’s progress towards achieving its long-term market re-balancing objective. It merely provides a snapshot, whereas OPEC’s policy and the developments surrounding increases in US production are trends and measures of an inherently longer-term nature. Their impact and the resulting changes only become visible after several months.

With US oil inventories at record levels (and therefore above the five-year average), the market is eagerly looking for a significant decline in these levels as part of the market re-balancing process. Interestingly, inventories of both crude oil and petroleum have finally started to fall faster than expected in recent weeks. A price rise would be normal in these conditions. However, though the oil price is finding some support ahead of the definite data, we now see the market shrugging off such sharper-than-expected declines in order to focus on the continuing production growth in the US. Evidently, investors are taking up positions first before checking the newspapers for appropriate headlines to justify their actions.

Another striking phenomenon is the divergence between the market expectations of market speculators and hedge funds. Normally, a strong correlation exists between these different types of investors. This time around, we again saw all investors increasing their number of short contracts (speculation on falling prices). However, in the past months, we also saw hedge funds become increasingly negative compared to the speculative investors.

This stance was not only reflected in increased short positions, but above all in the closing of long positions (speculation on rising prices). Speculative investors did not follow suit. This was partly instrumental in causing the price decline that we saw in the past weeks which, in turn, opens up scope for an upward price movement as soon as the hedge funds become more confident in a price recovery.

US oil production, back in a growth market

US shale oil production has been growing for some time now. The significant rise in the number of drilling installations in the first half of 2016 is now beginning to show in the production figures. In addition, thousands of oil wells have been drilled, but still await completion and have not yet come on stream. These ‘drilled but uncompleted’ oil wells are effectively stocks that can be brought into production fairly rapidly as soon as oil prices climb further. Whether US oil output can rise as strongly as in the 2012-2015 period remains to be seen, however.

Shale oil wells have a steep production decline rate, with 80% of the stocks being exhausted within two years of production starting. Production firms in the US must therefore continuously search for new projects, both to replace old projects and to meet the growing demand for their product. Another constraint is the high financing requirement (with the risk of even higher costs as soon as interest rates really start to rise). Finally, production costs are also edging higher on growing demand for suppliers and staff.

OPEC: the compliance challenge

According to the new IEA monthly report, OPEC compliance with the agreed production cuts significantly decreased in June (from over 90% to 78%). With fewer countries adhering strictly to their commitments, output increased slightly to just above the agreed production ceiling. Even more important is the rising production trend in Nigeria and Libya. Though these countries are exempt from the OPEC agreement – and are therefore free to raise production – the market responded sharply to the higher oil production resulting from the growing stability in these countries. OPEC will no doubt soon send out a robust signal that any extra output from Nigeria and Libya will be offset by other members of the oil cartel. However, in view of the current negative sentiment, it will take a lot more than a verbal signal to convince the market that the existing OPEC agreement is sufficient to re-balance the market.

As noted, whilst US inventories appear to be peaking, the market focus has briefly shifted to oil production growth in the US. However, a new concern is already appearing on the horizon. Though the agreement runs until the end of the first quarter of 2018, OPEC – and Russia acting on behalf of the non-OPEC participants – must already start slowly managing the market’s fears of a sudden end to the output cut at the end of March.

Global demand continues to grow strongly

In its Oil Market Report, the International Energy Agency (IEA) observed that global oil demand was accelerating faster than expected. After picking up by a ‘lacklustre’ 1 mb/d in the first quarter, demand quickened by 1.5 mb/d in the second quarter. Robust growth is also expected for the rest of the year, bringing average annual growth for 2017 to around 1.4 mb/d. For 2018, the IEA expects a comparable development, raising global oil demand to some 99.4 mb/d at year-end 2018.

China accounts for a large share of this increased demand. Chinese economic growth is gradually decelerating as a result of the transition from an industry-driven to a consumer-driven economy. For 2017, we foresee growth of 6.7% (versus 6.8% in 2016). This economic cooling, however, will not yet dampen the growing demand for oil. This is partly because of China’s announced intention to build up strategic oil reserves, but higher energy consumption due to increased prosperity is no doubt also an important factor. We do not expect a break in this trend in the short term.

Whilst emerging countries – notably Asia and the Middle East (seasonal demand) – account for most of the increased oil demand in the second quarter, we also see rising demand in other regions such as the US and Europe. The fact that total demand from the OECD is declining is attributable to lower demand from Oceania.

Market balance appears to be on its way… if not already here

In its press release, the IEA said that the oil oversupply was not yet shrinking. This is remarkable as the global oil supply and demand table in that same IEA report most definitely signals a change. In the second quarter, oil demand rose to 97.4 mb/d while supply amounted to 96.8 mb/d. This means there was an actual shortfall. Clearly, due to the enormous stocks, this will not trigger an immediate turnaround, let alone a market shortage. But it does suggest that, after years of surplus, the supply and demand ratio is slowly starting to tilt.


In addition, there is a second interesting development. If we look at the projected oil demand in the second half of the year, and subtract the expected ‘non-OPEC’ supply, we see that the ‘call-on-OPEC’ will average 33.5 mb/d. This expected and required OPEC production is well above the agreed production ceiling of 32.5 mb/d. If this forecast is accurate, substantial inroads will be made into the existing record stocks, thus reducing the level to within the ‘normal’ five-year average bandwidth. So the market definitely appears to be in the process of re-balancing, provided you look at the bigger picture.

Forward curves, geopolitical risks and investments in the sector

The price-predictive value of the forward curve (series of oil prices for future delivery) is extremely limited. The fact that the forward curve is currently in contango (spot prices lower than prices for future delivery) indicates the presence of considerable short-term stress in the oil market. In other words, oversupply in the market is putting pressure on the spot prices.

One important aspect that is often overlooked is the fact that US oil producers are barely active in the spot market. They mainly use futures to hedge their risks which, in the current market, means they are fixing their selling price above USD 50-55. The low spot price, therefore, is a reflection of the negative market sentiment rather than an indicator of the required oil production costs in the US.

The geopolitical scene is fairly quiet at the moment. The threat of escalating tensions hitting oil production and leading to higher risk premiums is perceived as negligible.  With the EUR/USD exchange rate forecast at 1.15 and 1.20 for, respectively, year-end 2017 and 2018, currency movements will also provide little direction for dollar-denominated commodity prices.

Production growth outside the OPEC and US is limited owing to the low oil price. Investments (capex) remain under strong pressure. Though production costs have decreased (so that less investments are required), we still see output falling in countries where costs are relatively high (e.g. due to the absence of infrastructure).

In the coming years, net extra production in the US could easily run to as much as one million barrels per day (mb/d). And that may be a good thing, considering the rising demand for oil in the coming years. Taking account of the rapid production decline rate of their oil fields, US shale oil producers will need to raise their output by about one and a half mb/d to continue making a significant contribution to global supply growth.

Adjustment of oil price expectation: bigger difference between Brent and WTI…

OPEC policy clearly has a strong bearing on the Brent price, but so do developments in other regions. Accordingly, Brent is not just extremely sensitive to geopolitical risks and production interventions in the Middle East, but also to developments elsewhere such as the North Sea. Brent is slowly but surely acquiring the status of global benchmark for oil, whereas WTI is mainly an indicator of developments in the US. Brent and WTI often move in the same direction. Nevertheless, we think that the expected sustained growth of US production will continue to dampen WTI prices relative to Brent prices for the time being. Our price forecasts thus project a widening differential between Brent and WTI.

In our opinion, market sentiment is too negative at the moment. Once hedge funds acknowledge that the downward risks are receding and US oil inventories fall back within the 5-year bandwidth, there will be room for a price recovery. This will probably be short-lived in the first instance whilst uncertainty around the OPEC policy continues to hang over the market until the end of the first quarter. However, once the price pressure resulting from this uncertainty in the first half of 2018 disappears, we see the price picking up again.

… and a faster price recovery from H2 2018

Due to the natural depletion of oil wells, some 3.5% of the total supply must be annually replaced with new finds in order to keep production at the same level. In addition, more oil will be required year on year to meet the growing demand due to economic expansion. Part of the required additional oil will come from shale oil production in the US. Another part can be absorbed by the OPEC reserve capacity. The remainder must come from the existing stocks and production from non-OPEC oil countries. Whether these countries can meet the accelerating oil demand in the coming few years is open to question. The chances are that in the foreseeable future:

  1. a) increased US oil production will not be sufficient to meet oil demand;
  2. b) global stocks will return to normal levels;
  3. c) extra OPEC production will be necessary to prevent shortages

We expect that the re-balancing of supply and demand in the oil market will lead to a reduction in global oil stocks due to sustained growth in demand. This, combined with the slowly rising costs, e.g. for labour at suppliers, could lead to a higher oil price starting from the second half of 2018.

190717-Energy-Monitor-July.pdf (302 KB)