High risk for repeated attacks. Bearish concerns overstated

For two days in a row the Brent crude oil price has traded quite hard to the downside during intra-day trading before kicking back up again towards the close. A lot of the gains following the attacks on Saudi oil infrastructure almost two weeks ago have now been given back. Brent closed at $60.22/bl on Friday 13 September just before the attacks. Though having given back a lot of its gains (it spiked to $71.95/bl on Monday Sep 16) Brent has struggled to close below the $62/bl line.

What is notable is that following the Brent low close of $56.23/bl on 7 August Brent has been on a gradual trend higher irrespective of the attacks on Saudi Arabia. This matches well with the fact that US crude oil stocks declined by 70 million barrels from early July to early September.

The global oil market now seems to be so accustomed to living in oil affluence since 2014 that not even a damaging attack at the heart of the global oil market is able unnerve the market much with oil prices now just a tiny bit higher than before the attacks. Real action, real physical tightness in the spot market is probably what is needed to pull the market out of its current complacency.

The market is now “bean-counting” how much oil is lost from the attacks. What really matters in our view is the repetition risk for new attacks. In our view this risk is very high but there is hardly any risk premium in the market for this as we can see.

The front-end of the Brent crude oil curve has been in backwardation continuously since early this year signalling a draw-down in crude oil inventories and a tight front-end crude oil market. This tightness has not manifested itself as elevated flat prices as the whole crude oil curve has been pushed down by bearish bearish sentiment for the global oil market balance for next year amid slowing global growth, strong non-OPEC production growth projections for 2020 and doubts over the abilities and willingness of OPEC+ to cut yet deeper if needed.

The global oil market is unlikely to run a 1 m bl/d surplus in 2020 due to IMO-2020 (barring a global recession). We do share some of the markets bearish concerns for next year, but we do not agree with all of them and we do not agree with the conclusion of many oil market balance forecasts for next year being strongly in surplus with need of further cuts by OPEC+ to prevent a strong rise in OECD stocks. And neither do we agree with the view that OPEC+ has its back against the wall and has lost so much oil production volume to booming US shale oil production that it has now basically run out of bullets with little capacity to cut further if needed.

One key element in the global oil market balance next year in our view is the IMO-2020 sulphur bunker oil regulations. We have worked on this issue extensively over the past three years and written numerous reports on the subject. It is of course a hot topic and almost everyone who is writing about oil has nowadays written a report about it. What puzzles us is that as far as we can see no one accounts for the IMO-2020 event in their supply/demand balances for 2020. We have at least not seen any specific IMO-2020 line item in any of the balances we have seen.

As a consequence of the IMO-2020 regulations our base assumption is that a ballpark 1 m bl/d of high sulphur residue / bunker oil will be barred from legal use in global transportation. It will either be burned for heat, power or be stored. Typical HFO 3.5% bunker demand today is 3.5 m bl/d. Legal plus cheating demand in global shipping in 2020 will likely be about 1 m bl/d. Our guestimate is that some 1.5 m bl/d will be converted and transformed in refineries to other compliant products.

So in our view the IMO-2020 effect will put about 1 m bl/d of high sulphur residue /bunker oil on the side-line of the global transportation market. This is a clear and straight forward tightening of the global liquids market. The global transportation market thus needs an additional 1 m bl/d of hydrocarbon liquids from other sources instead. That is the IMO-2020 tightening we expect to see and we cannot identify such an IMO-2020 item in the supply/demand balances anywhere else in the market.

Everybody talks about the adverse impact the IMO-2020 will have on the global oil market, but no one takes account of it in any way in their supply/demand balances. Thus everyone sees a 1 m bl/d surplus for 2020 instead of a balanced market as we do.

OPEC+ has not run out of bullets. The key producers are instead producing close to all-time-high or 5yr averages. A key assumption in the market’s highly bearish concerns for next year is the assumption that “OPEC+ has run out of bullets” with no ability or appetite to cut deeper if needed. “They are cutting and cutting but are not able to get the oil price higher” is the market’s view of OPEC+ currently. It is true that production from the group has fallen sharply but that is primarily due to the sharp involuntary losses from Iran, Venezuela and Mexico. The key players being Russia, Kuwait, Iraq, UAE and Saudi Arabia are however producing either close to all-time-high levels or normal averages. They have hardly given away a single barrel.

Apparently Saudi Arabia has been cutting deep and delivered much deeper cuts than what it has been obliged to according to the agreement at the end of last year. But Saudi Arabia is to a large degree just playing with our minds and views. Saudi Arabia boosted production from 9.9 m bl/d in March 2018 to a monthly high of 11.1 m bl/d in November 2018 and then agreed to cut from that level down to 10.5 m bl/d. As such its production 9.8 m bl/d in August seems like a deep cut and over-compliance. Saudi Arabia’s average production over the past 60 months was 10.15 m bl/d. So Saudi Arabia produced only 0.3 m bl/d below its 5 yr average in August.

Our view is thus that the key players with control over their production have not at all given away much volume to booming US shale oil production and are fully in a position to cut more if needed or if they decide to do so.

High speed to Saudi Aramco IPO = high oil price volatility and elevated risks for renewed attacks. Saudi Aramco is now pushing hard to speed up the Aramco IPO at least for its partial and initial listing in Saudi Arabia. Research teams from the world’s largest financial institutions are now working around the clock to finalize draft assessments by mid-October. An as of yet non-published time-schedule of the IPO has it that Saudi Aramco will announce its IPO-plans on October 20th.

The recent attack on Saudi Arabia’s oil infrastructure is in our view just the last attack in a line of many. The attack has made it very clear that Saudi Arabia’s oil infrastructure is highly vulnerable and that it is very difficult to protect against attacks of the character two weeks ago. The weapons used were probably fairly low cost but had high precision and can be launched from almost anywhere. The attackers have detailed information of Saudi Arabia’s oil infrastructure and obviously also understands where to attack with high precision in order to make maximum damage with relatively small explosives.

It is clear that the market will managed and overcome the latest damages and supply outage in Saudi Arabia and repairs will be done. It will however draw down global inventories further and reduce Saudi spare capacity for several months to come. We do however think that the risk for repetitions of the latest attack is very, very high unless source of the reason for the attack is solved. I.e. the Iran and Yemen issues need to be resolved and defused. As long as those issues are not resolved we expect renewed attacks to take place. Especially so in the run-up to the Saudi Aramco IPO as it will have a negative effect on the listing in our view.

Strengthening cracks on refinery runs, Saudi attack and IMO-2020. US refineries are now reducing runs and crude consumption in the weeks to come until they ramp up again in mid-October. Thus US crude inventories are likely to rise (as we saw in this week’s data release) while product inventories are likely to decline along seasonal trends. This is likely to put strength to oil product cracks. Saudi Arabia has also imported oil products from the global market in order to compensate for domestically reduced refinery runs which also add strength to product cracks. The IMO-2020 switch-over is also moving closer and closer and we expect a very strong transitional Gasoil demand from the global shipping market in Q4-19 and Q1-20 just as we move through the Nordic hemisphere heating season peak. We see significant upside price risk for gasoil cracks in those two quarters. We think it is just a matter of time before much stronger mid-dist cracks kicks in fully in the spot market with a bullish effect rippling down the forward crack curve.

In sum: Bearish risks for 2020 are overstated

Bullishly:

• IMO-2020 will have a tightening effect of about 1 m bl/d
• OPEC+ has not run out of bullets
• High risk for repeated attacks and damages on Saudi Arabia oil infrastructure. Especially in the IPO run-up

Bearishly:

• A global recession if it materializes would have a strong bearish impact on oil prices and market
• A return of supply from Venezuela and/or Iran are clear bearish risks but we hold low probabilities for this

We expect Brent crude to average:

• 2020: $70/bl
• 2021: $70/bl