Energy Monitor – Opposing dynamics in oil

by: Hans van Cleef

  • Supply issues due to production disruptions and sanctions while global demand continues to increase
  • OPEC increases production but will it be enough?
  • Oil price forecasts unchanged, but upside risks have increased
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Oil prices still in uptrend, but for how long?

Oil prices are in an uptrend for some time now. The most important drivers are: a) solid growth in global demand, b) the production cut agreement of OPEC and non-OPEC oil producers, c) the US stepping out of the Iran nuclear deal, d) market speculation of higher oil prices, e) unexpected production disruptions and f) the effects of sanctions imposed against oil producers like Venezuela and Iran. Despite all these factors US crude oil production has risen to a record high and this has mitigated some of the above-mentioned effects.

OPEC increased crude oil production…

During the most exciting meeting in a long period of time, OPEC decided to raise crude production on paper by 1 million barrels per day (mb/d). In practice many of these OPEC oil producers are technically not able to increase production. Therefore, the net rise in crude production will be around 600 kb/d. Saudi Arabia, the United Arab Emirates, Kuwait and perhaps a small part by Iraq will account for this rise in production. The non-OPEC producers who participate in the current production cut agreement will not raise production this year.

…but the effect is limited due to production disruptions and sanctions

The risk that the market is heading towards a new period of production shortages is increasing. Besides the fact that there is a lack of investments in new upstream activities, the current production levels in several countries have declined. For example, Libya is confronted with unrests resulting in production disruptions and lower exports from the large harbors. At the start of this year Libyan production was still 1 mb/d. Currently the production is almost halved. Moreover, the production in Venezuela has dropped significantly to 1.4 mb/d, partly due to the economic situation, but also due to the US sanctions. This is now 400 kb/d less than at the end of 2017. Finally, crude oil exports from Iran will be hurt by sanctions imposed by the US. These sanctions will become effective at the end of 2018. If we take into account a net drop of 600 kb/d in Iran, the total amount of production decline will be roughly 1.5 mb/d. Iranian exports may even drop faster than we currently expect. Then production declines will be more serious. This could be the case if countries actually listen to US president Trump who asked consumers not to buy Iranian oil anymore.

At the same time crude production in the US reached a record high (10.9 mb/d). The main question is how long this pace of production growth will continue. We see more upside potential for the Permian basin. However, in other large production areas the low hanging fruit of crude oil production is already in production. On top of that, the ratio at production between gas and oil is shifting towards more gas, and there is a rise in costs (labor, infrastructure and financing). Finally, the maximum capacity of infrastructure has been reached. This could limit growth potential for US crude and crude oil products’ exports. We think that it is likely that the upside potential for US crude production is overestimated.

Trade war forms a threat for oil demand

There is one important mitigating factor for an oil price rally and that is the looming trade war the US and China (if not already the case). The first import levies have been implemented from both sides and, unless some sort of agreement is reached in the coming months, more of these levies will be implemented. The effects of this are already seen in the financial markets. Only this week, the announcement of a new round of US trade tariffs triggered the largest drop in oil prices since Q1 2016 (-/- 6.5%).

If such a trade war actually starts to affect business confidence and global economic growth – and thus impact global oil demand – oil prices will probably decline. Markets will continue to cut back their speculative positions anticipating for further price gains, and investors may even start to speculate on further price declines. In that case, price declines will be more aggressive than the modest profit taking wave we now expect..

Market speculation more important than ever for near-term oil price direction

Market speculation becomes more and more important for setting the direction of oil prices. This becomes clear when we look to the number of outstanding contracts. Ten years ago, the net position (longs minus shorts) was on average almost nil. The current outstanding position equals roughly seven times the global daily physical demand. This means that market speculation currently plays a much greater role in setting – or affecting – the direction in oil prices, especially in the near term. In the longer run, market fundamentals such as supply and demand continue to play an important role for oil price direction.

Oil price forecasts: downside risks at first, followed by further long-term upside risks

The call towards OPEC to produce more oil, as recently done by US president Trump, may find more support if the oil prices remain high for longer. Adversely, the number of warnings that the market is heading towards serious shortage is increasing as well. Trumps’ policy is paradoxically partly the reason behind higher oil prices due to sanctions against Venezuela and Iran as a result of stepping out of the Iran nuclear deal. But also the lack of investments in the sector and unexpected production disruptions add to the support for oil prices. It is remarkable that also after the announcement of OPEC to increase production earlier than expected, oil prices continued to rise. This is another signal that market speculation is an important driver for oil prices. After all, market focus shifted suddenly from production cuts – which triggered a rally from USD 30/bbl to USD 80/bbl – towards fears for a possible shortage of reserve capacity if production is increased. This means that the reserve capacity of (OPEC) is back on investor radar.

During the coming months crude production will drop by 1.5 mb/d (Venezuela, Iran, Libya) due to sanctions and production disruptions, assuming that other OPEC members stick to the original agreements. On the other side, some OPEC members will raise production by net 600 kb/d. This may be complemented by extra US crude production of 200-300 kb/d. Adding this up the market is heading towards new shortages if global demand continues to grow at its current pace. So the risks have increased for higher oil prices in the coming months. Spokespersons of the OPEC indicate that OPEC will increase production if necessary. The question is whether they are technically able, and politically willing to do so.

As indicated above, the risk for higher oil prices in the second half of 2019 and beyond is rising. However, the uncertainty about the US/China trade issues may lead to profit taking on existing long positions. This could trigger downward pressure on oil prices in the near term. Therefore, we keep our forecasts unchanged indicating somewhat lower prices in this quarter, followed by a Brent oil price of USD 75/bbl at the end of this year. We do see further upside potential for oil prices in the first half of 2019 and we keep a close eye on current developments to see if we need to increase our longer term forecasts (> H2 2019) even higher. For more details see the table below.