Upside is the way to go both front end and back end. Go buy Brent Dec-2020 at $58/bl

SEB - Prognoser på råvaror - CommodityAfter hitting a fresh 2015 high of $64.65/bl last week on the back of spiralling geopolitical risk it is not too surprising that the front month Brent crude is taking a small breather. Yesterday it closed at $63.16/bl while it is pulling back another 0.5% to $62.8/bl this morning. The longer dated contracts like the Brent December 2020 have however continued to gain ground with a close yesterday of $58.13/bl. US inflation is currently running at about 2%. Assume simplistically that this is the inflation rate also the next three years to December 2020. The future Brent Dec-2020 contract is a nominal price. This means that in real terms (adjusting for 2% yearly inflation) the current Brent Dec 2020 is currently priced at $54.7/bl in real terms while it is $58.13/bl in nominal terms.

In other words consumers can still purchase forward the Dec-2020 at less than $55/bl in real terms. The frame work reflection around this is that US shale oil players are not making satisfying returns with a crude oil price of $50/bl. So the general assumption is that they need a higher price than that. What we also have seen since the start of the year and accelerating so over the latest months is that the Brent to WTI price has widened out as increasing production has hit pipeline export constraints in the US from Cushing Oklahoma to the US Gulf. It can be mended but it takes time.

A strong US crude oil production growth to 2020 is both needed and probable. But it requires more than $50/bl for US shale oil players. It is also likely to imply a wide Brent to WTI price spread. At the moment the WTI Dec 2020 contract is trading at only $52/bl. It should at least reflate up to $55/bl on the assumption that the global oil market will need a lot of US shale oil production growth to 2020. Currently the Brent to WTI Dec 2020 crude spread is a full $6/bl. This seems fair in a scenario of strongly increasing US shale oil production.

This kind of base assumption thus places Brent Dec-2020 outlook easily at $60/bl as some kind of floor-price assumption in a scenario where the world will need a solid growth in US shale oil production. Of course if we have a global recession in the run-up to 2020 there is no price floor to talk about and the oil price could obviously deliver below the $60/bl in that case.

However if we assume a Brent 2020 “floor price” of $60/bl then there is no geopolitical risk premium included in that price and there is no cyclical investment upside price spike risk included in that (investment cuts since 2014 leading to structural deficit in 2020. So consumers contemplating purchasing crude oil or oil products on the 2020 horizon should act as Brent Dec 2020 at a nominal price of $58/bl (and real price of $54.7/bl) is still a very, very good offer.

Our expectation is that the Brent Dec 2020 contract will reflate yet higher and into the $60is/bl.

We also expect the Brent to WTI price spread to widen out yet further. In its latest forecast the US EIA predicts US crude oil production to increase 15 kbl/day each week from December to May when it will hit 10 mbl/day. Thus US export pipelines and pipeline infrastructure is going to be under more and more pressure every week all the way to May at least. The WTI crude oil benchmark is priced in-land in Cushing Oklahoma and that price has to scream: “NO MORE” to US shale oil players even if the world needs more of it. The WTI price has to say stop becuse of lack of capacity to get it to market. Inventories there are already brimming full and rising as pipes to the US Gulf are already running full.

So again we have a two wheel crude oil world. Declining crude and product inventories in the world in total and especially the World ex-US-Mid-Continent while at the same time rising inventories in the US Mid-Continent with increasing bottlenecks and transportation issues. Thus a tightening Brent crude market on the one side and a weakening WTI crude market on the other side.

One possible hitch in this argument is however that Permian and Eagle Ford producers may not have to ship their crude oil through Cushing Oklahoma as they are further to the west. Is there enough pipline capacity from Permian and Eagle Ford to get their oil directly to the US Gulf circumventing Cushing? If that is the case then Permian and Eagle Ford producers are actually getting US Gulf crude oil prices for their crude oil which is close to Brent prices. That would mean that those two fields are currently experiencing STRONG price stimulus from US Gulf crude prices and not the WEAK Cushing Oklahoma WTI prices.

Our view on geopolitics is that we are now likely going to experience a long period with a continuous stream of uncomfortable and disturbing news coming out of Saudi Arabia specifically and the Middle East in General. Thus what Mohammed bin Salman set in motion a little more than a week ago is probably only the start of it. In the quite after the Saudi event a week ago the Brent price has eased back. Our expectation is that there is going to be more disturbing geopolitical news items in not too long. Inventories are still declining. OPEC and Russia are likely going to maintain cuts to the end of 2018 but no decision at upcoming OPEC meeting in Vienna on 30th November. Investors continue to flock into front end Brent backwardation positive roll yield and the upside is the way to go for Brent. Both for the front end contract as well as for the longer dated Brent Dec-2020.

Adding in geopolitical risks to the whole mix of declining inventories (ex-US-Mid-Continent), increasing Brent to WTI price spread, increasing Brent backwardation, strong global demand growth, positive Brent roll yield in a zero interest rate world sucking in more speculative long positions, well then seeing the Brent front month sniffing close to the $70/bl seems like the likely price action. Not long ago we said that it was likely to see Brent touching up to $65/bl before Christmas, but then we had no strong geopolitical driver in our assumption besides the Kurdistan issue. Now the central bank of oil, Saudi Arabia, is added to the mix of geopolitical concerns.

So upside is the way to go for the time being. Both for front end Brent and the Dec-2020.

Kind regards

Bjarne Schieldrop
Chief analyst, Commodities
SEB Markets
Merchant Banking

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