- OPEC+ disappointed markets with production cut agreement
- The effect of market positioning on volatility is greater than ever before
- Oil price forecasts: recovery expected, but upside potential is limited
The OPEC and its partners will cut oil production by 1.2 million barrels per day (mb/d) compared to October levels starting in January. The actual production cut will be somewhat bigger, as oil production for November was higher. It seems to have been quite a challenge to agree on this lower oil production. Therefore, the market reaction was muted. This production cut agreement was necessary in order to balance the market. Several large oil producers have produced more oil than expected recently and in some countries oil production even reached record high levels. Especially the oil production of the three largest oil producers have reached new record highs: Russia, the US and Saudi Arabia. Due to the limited growth in the US export capacity, inventories rose to above the 5-year average. This led to investor expectations of oversupply. US inventory data are released on a weekly basis and so they only indicator to follow for the trend in inventories. However, US inventories only show a small part of the complete complex puzzle. The US sanctions against Iran proved less stringent than was feared – and anticipated by the market – after president Trump gave eight waivers to consumers of Iranian oil. So the extra oil production from Saudi Arabia and Russia to compensate for lower oil production from Iran was too high.
Investors had expected a significant production cut ahead of the OPEC meeting. They were not only disappointed with the agreed amount, but also by the way the agreement was reached. Especially the lack of decisiveness by Saudi Arabia indicated that it was a complex exercise to weigh all the interests of the different stakeholders. As a result, the positioned of Saudi Arabia seems to have weakened and eventually benefits other major oil producers like Russia and the US. Oil prices hardly recovered after this agreement and continues to trade close to USD 60/bbl (Brent) and USD 51/bbl (WTI).
Market positioning leads to more and more volatility
Oil markets are – like most financial markets – more and more driven by expectations for supply and demand. As the outstanding number of contracts speculating on oil prices continue to grow, the sensitivity of oil prices to changing market expectations regarding possible future supply and demand towards increases. Although from a fundamental point of view not a lot has changed, since early October, oil prices have dropped by USD 25/bbl because a change in market perception. For example, fears that a trade war between the US and China will have a negative effect on future oil demand have increased. On top of that, the announced US sanctions against Iran proved to be less strong than anticipated. As a result, investor’ long positions (speculating on price gains) were cut massively in a short period of time to relatively neutral levels. This has resulted in a considerable slide in oil prices. Facts are that:
- growth of global oil demand did not change significantly, and
- oil production in Iran decreased.
As these facts were already anticipated and priced in priced, concerns about a change in supply and demand kicked in. Higher volatility seems to be the new standard as fears and hopes are seen as more important short-term drivers than supply and demand.
Supply and demand in 2019
The OPEC+ production cut agreement should lead to a balance between supply and demand at the start of 2019. Nevertheless, this balance is very fragile. OPEC expects global demand for oil to grow by 1.3 mb/d in 2019. The International Energy Agency (IEA) expects a rise in demand of 1.4 mb/d. We even expect global demand to growth by even more (+1.6 mb/d) because global economic growth, and consumption may increase at a faster pace supported by the current low oil prices. This growth in oil demand will be mainly met by the rise in US crude production. The Energy information Administration (EIA) expects an average increase of US crude production of 1.2 mb/d in 2019 to 12.1 mb/d (versus 10.9 mb/d in 2018). This is comparable with the production cut of OPEC+. Due to the ongoing growth of US crude production the room for growth of OPEC crude may be limited according to the EIA.
An important aspect is whether the US is able to increase its exports. At the moment there is only limited room for a rise of US crude exports as the infrastructure to transport oil from the wells towards the coast runs around maximum capacity. Extra capacity is being built at this moment. And although market expectations were indicating that this capacity would become available at the end of 2019, it seems that this could be available already earlier. So, probably during the second half of 2019 oil exports from the US could already increase. As a result, the difference between Brent and WTI may decrease (WTI somewhat higher) as US inventories could decrease due to this rise in exports. Until then, higher crude production in the US will mainly lead to higher inventories. Higher inventories will probably cap the upside potential of WTI as investors are sensitive to these weekly inventory data from the US.
OPEC also expects that non-OPEC production – especially in the US – will continue to increase in 2019. As a result, a continuation of the OPEC+ production cut agreement may be needed in the course of 2019. Nevertheless, this will depend on several factors. Especially the production in and export from countries like Venezuela and Libya is, and will remain, uncertain. However, if this production/export is able to recover to normal levels, and the US crude production will indeed continue to increase as expected, OPEC and its partners may have to act again and to extent the production cut agreement in June. The first signals may be given in April during the evaluation of the current production cut. Market speculation regarding a possible renewal of the production cut agreement could continue to dominate market sentiment during the first half of 2019.
Downward revision of oil price forecasts
We have adjusted oil price forecasts downwards but we still expect a modest recovery in oil prices from current levels within a trading range. The recent steep drop in oil prices created a new reality in which oil prices have less upside potential than expected a few months ago.
This is because supply and demand should be pretty much in balance after the production cut agreement of OPEC+ will go into force at the start of 2019. Although the market volatility can increase based on unforeseen (geopolitical) circumstances, we expect that the markets will aim for a sort of equilibrium price. For 2019, we expect that this equilibrium price for Brent will be around USD 70/bbl, within a trading range of USD 60-80/bbl. For WTI we expect a trading range of USD 50-70/bbl, with an average of USD 60/bbl.
As indicated the balance between supply and demand is fragile. Due to the fast increase in production, especially by Saudi Arabia, the reserve capacity – or the room to act in case of unexpected production disruptions – has dropped significantly. If for some reason we would see unexpected production disruptions it would become harder to temporarily increase production. This can provide strong support to oil prices in the future. Nevertheless, the expected growth in demand for oil in 2019 will be mainly balanced by the increase of US crude production. As a result, there will be still some room left for OPEC+ to act in case of unexpected production disruptions.
A second argument is found in market positioning. Now the market has brought back its number of outstanding long positions to neutral, and hardly increased the short positions. So there is room for higher prices if the market would start to anticipate possible shortages in the market. This fear can for instance be triggered by a fresh drop in investments in the sector. These investments (capex) in the exploration of the oil production fields finally started to recovery somewhat after the strong price decline in 2014. However, the recent drop in oil prices may make investors cautious again.
A third reason for higher oil prices is a possible faster than expected drop of the US dollar. In our base case scenario, we expect EUR/USD to rise to 1.25 at the end of 2019. In general a lower dollar coincides in often with higher commodity prices including oil prices.
The expected trading ranges will be characterized by a floor which is mainly based on technical factors and geopolitical considerations. If the price drops below this floor it could result in production disruption as several projects will produce at a loss. Besides that, OPEC aims for higher prices as many oil producing countries need a higher oil price to balance their fiscal budgets. The upside of the trading range is protected by geopolitical and economic factors. A structural higher oil price will lead to comments by net importing countries. The US is a clear and recent example where president Trump opposes a high oil price which affects the economy via high gasoline prices. The US is still a net importer of oil, although recently it became a net exporter of oil plus refined petroleum products. Having said that, Trump does have a nice instrument to actively steer the direction of oil prices: Iran sanctions. By tightening or loosening these sanctions, he can give directions to market expectations about future Iran oil supply.