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Oil prices: where next? Fundamental importance of the cycle
JOHN KEMP
REUTERS
14 Nov 2017
Oil market fundamentals: the cycle goes on
Oil industry has always been subject to deep and prolonged cycles of boom and
bust and there is no reason to think the future will be any different Cyclical behaviour is the distinguishing characteristic of oil markets and prices and
rooted in the industry’s structure
Low price elasticity of supply and demand
Backward-looking expectations and behaviour
Positive and negative feedback mechanisms
Complex adaptive systems Multiple markets for crude, fuels, refining, services, engineering, construction,
drilling, skilled labour, raw materials etc Each market subject to its own feedback mechanisms, operating at different speeds
and timescales, with constantly changing balances between supply and demand Balancing “the oil market” actually means balancing all these markets
simultaneously Oil market is never really “balanced” or in equilibrium except accidentally and not
for very long
Long boom, wrenching slump, now recovery
Oil market alternates between periods of oversupply and undersupply
Calendar spreads cycle between contango to backwardation
Spot prices and calendar spreads are part of the same cycle
Spot prices and calendar spreads are closely correlated
Rebalancing and recovery: what do we mean? At least five elements
Closer balance between supply & demand (Yes) Normalisation of crude & product stocks (Yes) Forward price curve (Yes) Sustainable flat price (No) Sustainable investment (No)
Market currently shows significant progress on at least three elements
Brent futures prices have been transitioning from deep contango towards
backwardation since January 2015 or January 2016
Brent spot price has been on an upward trend since Jan 2016
Where are we in the cycle? Early to mid expansion
Spot prices have been rising for 21 months (compared with 21 and 26
months after previous slumps to reach first major peak) Calendar spreads have been tightening for 32 months (compared with
21 and 34 months to reach first cyclical peak) Excess oil stocks down -180 million bbl since start of 2017 but still +160
million bbl over 5-year average Five-year average likely to be too low given the growth in oil demand
since 2012 Oil price adjustments are highly non-linear and do not move smoothly
to a new equilibrium value Rebalancing process is accelerating according to OPEC
Oil prices still feel low compared with the very recent past
From longer perspective, prices already close to full-cycle average
Annual oil price is now in line with the average since 1973
Brent calendar spread is already in upper half of historic distribution
Brent calendar spread in 62nd percentile of post-1990 distribution
What next?
Cyclical recovery likely to continue in 2018/19 Spot prices will rise to moderate consumption growth and encourage
faster increases in production Calendar spreads will tighten as crude and products stocks continue to
draw down
Oil demand outlook for 2018/19
Gasoline-led in 2016/17 becoming diesel-led in 2018/19 Diesel demand mostly from industry and freight movements Diesel demand being driven by synchronised global growth Biggest risk comes from the macroeconomy Oil industry expansion still in early/middle stages? U.S. economic expansion in middle/late stage? U.S. expansion will be longest on record by July 2019
World trade volumes growing at fastest rate since 2011
Almost all freight relies on high-powered diesel engines
Biggest threat to oil expansion comes from macroeconomy
U.S. shale production will continue to grow in 2018/19
Shale producers’ costs are pro-cyclical Cost deflation during 2014/2016 slump Breakeven prices remain in dispute Most shale firms not really profitable with WTI < $50 Rig activity follows WTI with lag of around 20 weeks Big surge in drilling between May 2016 and July 2017 Rig count has fallen since August Recent rise in WTI prices should stabilise drilling WTI prices above $60 likely to see acceleration of drilling and output
U.S. oil rig count generally follows WTI with a lag of 16-20 weeks
WTI prices hit a low of $43 per barrel on Jun 23 and have been on rising
trend for last 20 weeks. Rig count set to stabilise and rise again?
Shale firms under pressure to focus on profits as well as production
But hedging currently possibly at almost $57 for calendar 2018
Saudi-led OPEC has accelerated rebalancing process
OPEC/Saudi production cuts have accelerated a rebalancing process
that was already underway Brent prices have doubled from low of $27 in Jan 2016 to $45 at time of
OPEC’s Nov 2016 meeting and now almost $64 OPEC’s formal target is to reduce OECD oil stocks (crude + products)
to five-year average Oil surplus down -180 million bbl between Jan and Sep but still +160
million above five-year average Most of the remaining surplus is concentrated in crude rather than
products Contango has been replaced by backwardation
OPEC will continue to tighten oil market in 2018
What is the price target? OPEC sources have said they want to see $60 price floor in 2018 Real target may be closer to $70 as an annual average for 2018 IMF estimates that $70 needed to balance Saudi government budget Aramco part-privatisation remains scheduled for end of 2018 OPEC is notoriously slow to respond to changes in supply/demand
conditions OPEC allowed prices to overshoot during both the previous recoveries
after 1997/99 and 2008/2009 price slumps
Record bullish positioning by hedge funds creates reversal risk
Hedge funds and other money managers running record or near-
record bullish positions in crude and especially refined fuels Positioning creates downside risk if and when fund managers attempt
to realise some profits after the rally but pull back might be limited Crude and products markets are nonetheless tightening and the
cyclical trend is probably higher in 2018
Hedge funds have amassed a record net long position in the five major
petroleum contracts equivalent to 1,085 million bbl
Hedge funds have amassed record net long position in Brent equivalent
to 543 million barrels
Hedge funds hold almost 11 bullish long positions for every bearish
short position in Brent: imbalance is source of liquidation risk
Conclusions
Cyclical recovery is underway and set to continue in 2018/19 Spot prices will continue trending higher Calendar spreads will continue tightening Crude and products stocks will continue to draw down OPEC will allow the market to tighten too much rather than risk not
tightening enough Shale output will continue to grow as prices rise above $60 Hedge fund positioning poses risk of a sharp correction Biggest risks come from macroeconomic or trade shock
Final warning from Rex Predictions notoriously unreliable, better to focus on coping strategies
Former Exxon Mobil Chief Executive Rex Tillerson (2 March 2016):
“We’ve never been any good at predicting these [price] cycles, neither when
they occur nor their duration. We don’t spend a lot of time even trying.
“How the future is going to look, we take no particular view on it, other
than to recognize that whatever it is today it will be different sometime in
the future, and after that it will be different again.
“In my nearly 41 years [with Exxon], that’s been my experience. I didn’t
learn anything about my ability to foresee that. I learned a lot about how you
deal with it”