Analys
OPEC meeting May 25th – Give me a premium!
OPEC members and some non-OPEC producers including Russia are most likely going to decide to maintain current production cuts for another six to nine months. Inventories are likely to draw down towards normal at the end of 2017. It will be supportive for oil prices in H2-17 and would likely lift the front month Brent crude oil contract to $60/b by the end of 2017. The risk is however that US shale oil production is stimulated to grow yet more driving both 2018 and 2019 into strict surplus. It may thus be increasingly difficult to exit the cuts further down the road. It thus poses a downside price risk to 2018 unless some cuts are kept all through 2018 as well as 2019.
“We think that we have everybody on board” said Saudi Arabia’s energy minister Khalid al-Falih (Bloomberg) following a meeting in Vienna on Friday in preparation for the ministerial OPEC meeting on May 25th this week. Both OPEC and some non-OPEC producers were present. He stated that everybody he had talked to viewed a nine months extension of the cuts in H1-17 as a wise decision. Apparently there thus seems to be a unanimous support for an extension of the current cuts. There still seems to be some discussion whether to extend the cuts to Dec 2017 or to Mar 2018.
On November 30th last year individual OPEC members decided to cut production by 1.17 mb/d versus their October production level while a group of non-OPEC producers joined in with a promised cut of 0.6 mb/d. Thus a pledged cut from both OPEC and non-OPEC members of close to 1.8 mb/d. Both OPEC and Russia have delivered on their pledges with OPEC’s production down 1.14 mb/d averaging 32.1 mb/d so far this year while Russia’s production was down 0.3 mb/d in April versus November.
Oil demand will jump seasonally by close to 2% (close to 2 mb/d) from H1-17 to H2-17. Thus production cuts will get a tailwind help by this seasonal jump in demand. If OPEC keeps its production at 32 mb/d in H2-17 we expect global oil inventories to draw down some 350 mb. OECD’s commercial crude and product inventories are today some 300 mb above normal. Some of the draw down may however take place in unspecified non-OECD inventories.
When OPEC decided to cut production last November it did talk about prices. An oil price of $60/b was mentioned many times. That was probably a mistake as it helped to shift forward crude curves higher and helped to stimulate US shale oil rig activation unnecessary.
Now there is no talk about an oil price level. The whole focus is on inventories. When oil inventories are above normal and rising then the crude curves are in deep contango which means a large spot price discount to longer dated crude contracts. Last year the front month Brent crude oil contract had an average discount of $12/b versus the five year contract. Since OPEC mostly sells its oil in the spot market it lost some $150 – 200bn last year solely due to this spot price discount of $12/b. When oil inventories are below normal and the market is tight then the forward curve is instead backwardated with spot prices at a premium to longer dated prices. That is what OPEC desires and long for.
OPEC knows that it cannot control the oil price over time. Especially it cannot place it at an artificially high level over time without having to accept a continuous decline in market share which over time is of course unsustainable. OPEC can however intervene in the market in the short term. The goal now is to draw down oil inventories. To move away from a contango market with a spot price discount which has been the situation since mid-2014 and instead hoping for a backwardated market with a spot price premium over longer dated crude prices. “Give me a premium!” is basically what OPEC is asking.
Over the last year we have learned that when the WTI 18 months forward crude oil contract is below $47.5/b then the number of US shale oil rigs is declining. When it is above it is increasing. This rig count inflection point is of course not cut in stone. It rises with cost inflation and declines with volume productivity growth. Over the last year the oil price has stimulated US shale oil to expand continuously. The number of oil rigs is still rising, but productivity growth has lately halted to zero on the margin while cost inflation has accelerated. The inflection point may thus start to rise if US shale oil production is stimulated to expand yet more in response to a positive price signal following further production cuts.
Three examples of price settings and dynamics in a global oil market with US shale oil on the margin:
1)US shale oil at neutral with normal inventories:
WTI crude 18 month contract = $47.5/b (no expansion or contraction in US oil rig count)
Brent crude 18 month contract = $50.0/b (Brent crude trades at a $2.5/b premium to WTI)
Brent crude 1 month contract = $50.0/b (Brent crude oil curve is flat)
2)US shale oil accelerating in a deficit market with below normal OECD inventories:
WTI crude 18 month contract = $55.0/b (Solid expansion in US oil rig count)
Brent crude 18 month contract = $57.5/b (Brent crude trades at a $2.5/b premium to WTI)
Brent crude 1 month contract = $65.0/b (Brent 1 mth at a $7.5/b premium to the 18 mth)
3)US shale oil is slowing in a surplus oil market with above normal OECD inventories:
WTI crude 18 month contract = $40.0/b (Solid contraction in US oil rig count)
Brent crude 18 month contract = $42.5/b (Brent crude trades at a $2.5/b premium to WTI)
Brent crude 1 month contract = $35.0/b (Brent 1 mth at a $7.5/b discount to the 18 mth)
Thus even if we assume that the US shale oil rig count inflection point is fixed at $47.5/b in the above three different exemplified states it still leaves the Brent crude oil front month contract to range within a large span of ranging from $35/b to $65/b. Then add cost inflation/deflation on top of the expansionary and contractionary phases and the span becomes even larger.
If production cuts are maintained for another six to nine months we expect it to drive OECD inventories down to normal or below by year end 2017. It is also likely to hold oil prices at such a level that it stimulates US shale oil rig activation yet further. The market will thus move towards a state depicted in example two above: A market in deficit due to production cuts with inventories below normal and a crude oil curve in backwardation. That is of course as long as the market is still in deficit.
The big question is what will happen when the cuts end in six to nine months. Rosneft’s CEO, Igor Sechin, has asked the Russian government to draw up a plan for an orderly exit from the ongoing production cuts. He sees a clear risk for a renewed competitive battle and price war if US production growth is not contained and production cuts ends uncontrolled.
It is clear that the likely decision to cut for another six to nine months will stimulate US crude oil production to grow yet more. Our projection is that US crude oil production will grow by 0.52 mb/d y/y in 2017 and by 1.51 mb/d y/y in 2018. However, if the oil price stimulates the US shale oil rig count to grow by 30 rigs/month (its current pace of expansion) from July 2017 to March 2018 then we project that US crude production will grow 2.3 mb/d y/y in 2018 driving the market into strict surplus for both 2018 and 2019 (assuming sufficient labor, materials and services capacities in the US shale oil space).
The risk is thus that if cuts are extended (as now seems likely), then there is likely going to be a need for cuts all through 2018 and 2019. Else the market is likely to shift into surplus, growing inventories, a crude curve which shifts from backwardation to contango again and a price level which needs to move down again in order to send a signal to US shale oil producers to reduce the number of oil rigs in operation again. I.e. the oil market could possibly shift back to phase 3) above again for a while.
If production cuts are extended and OECD inventories are drawn down towards normal by year end we expect the Brent crude oil curve to flip into backwardation by some $5/b versus the 18 month contract. It also seems reasonable to expect the the US rig count inflection point to shift up $5/b from $47.5/b to $52.5/b. Since Brent crude trades at a $2.5/b premium to WTI it places the Brent 18 mth contract at $55/b by year end. Adding a backwardation premium of $5/b to this means that the front month Brent crude oil contract would trade at $60/b by the end of 2017. The head-scratching problem is then that 2018 and 2019 may have shifted into surplus if 30 rigs are added per month from Jul-17 to Mar-18.
Kind regards
Bjarne Schieldrop
Chief analyst, Commodities
SEB Markets
Merchant Banking
Brent touching down to the 200dma. Brent crude traded down for a fifth day yesterday with a decline of 0.4% to USD 70/b. This morning it has traded as low as USD 78.6/b and touched down and tested the 200dma at USD 78.6/b before jumping back up and is currently trading up 0.2% on the day at USD 79.1/b.
The Dubai 1-3mth time-spread is holding up close to recent highs. The 1-3mth time spreads for WTI and Brent crude have eased significantly. The Dubai 1-3mth spread is however holding up close to latest high. Indian refiner Bharat is reported to struggle to get Russian crude for March delivery (Blbrg). The Biden-sanctions are clearly having physical market effects. So, the Dubai 1-3mth time-spread holding on to recent high makes a lot of sense. I.e. it was not just a spike on fears.
US oil inventories may have risen 6 mb last week (API). Actual data later today. The US DOE will release US oil data for last week later today. The US API last night indicated that US crude and product stocks may have risen close to 6 mb last week. This may be weighing on the oil price today.
Brent and WTI 1-3mths time-spreads have fallen back while Dubai is holding up
Brent crude is no longer overbought. Down touching the 200dma before bouncing back up a lilttle.
Analys
Crude oil comment: Deferred contracts still at very favorable levels as latest rally concentrated at front-end
Bouncing up again after hitting the 200dma. Bitter cold winter storm in Texas adding to it. Brent crude continued its pullback yesterday with a decline of 1.1% to USD 79.29/b trading as low as USD 78.45/b during the day dipping below the 200dma line while closing above. This morning it has been testing the downside but is now a little higher at USD 79.6/b. A bitter cold winter storm is hitting Texas to Floriday. It is going to disrupt US nat gas exports and possibly also US oil production and exports. This may be part of the drive higher for oil today. But maybe also just a bounce up after it tested the 200dma yesterday.
Some of the oomph from the Biden-sanctions on Russia has started to defuse with arguments running that these sanctions will only delay exports of Russian crude and products rather than disrupt them. The effects of sanctions historically tend to dissipate over time as the affected party finds ways around them.
Donald criticizing Putin. Biden-sanctions may not be removed so easily. In a surprising comment, Donald Trump has criticized Putin saying that he is ”destroying Russia” and that ”this is no way to run a country”. Thus, Donald Trump coming Putin to the rescue, removing the recent Biden-sanctions and handing him a favorable peace deal with Ukraine, no longer seems so obvious.
Deeper and wider oil sanctions from Trump may lift deferred contracts. Trump may see that he has the stronger position while Putin is caught in a quagmire of a war in Ukraine. Putin in response seems to seek closer relationship with Iran. That may not be the smart move as the US administration is working on a new set of sanctions towards Iranian oil industry. We expect Donald Trump to initiate new sanctions towards Iran and Venezuela in order to make room for higher US oil production and exports. That however will also require a higher oil price to be realized. On the back of the latest comments from Donald Trump one might wonder whether also Russia will end up with harder sanctions from the US and lower Russian exports as a result and not just Iran and Venezuela. Such sanctions could lift deferred prices.
Deferred crude oil prices are close to the 70-line and are still good buys for oil consumers as uplift in prices have mostly taken place at the front-end of the curves. Same for oil products including middle distillates like ICE Gas oil. But deeper and lasting sanctions towards Iran, Venezuela and potentially also Russia could lift deferred prices higher.
The recent rally in the Dubai 1-3 mth time-spread has pulled back a little. But it has not collapsed and is still very, very strong in response to previous buyers of Russian crude turning to the Middle East.
The backwardation in crude is very sharp and front-loaded. The deferred contracts can still be bought at close to the 70-line for Brent crude. The rolling Brent 24mth contract didn’t get all that much lower over the past years except for some brief dips just below USD 70/b
ICE Gasoil rolling forward 12mths and 24mths came as low as USD 640/ton in 2024. Current price is not much higher at USD 662/ton and the year 2027 can be bought at USD 658/ton. Even after the latest rally in the front end of crude and mid-dist curves. Deeper sanctions towards Iran, Russia and Venezuela could potentially lift these higher.
Forward curves for Brent crude swaps and ICE gasoil swaps.
Nat gas front-month getting costlier than Brent crude and fuel oil. Likely shifting some demand away from nat gas to instead oil substitutes.
Brent crude was already ripe for a correction lower. Brent closed down 0.8% yesterday at USD 80.15/b and traded as low as USD 79.42/b intraday. Brent is trading down another 0.4% this morning to USD 79.9/b. It is hard to track and assign exactly what from Donald Trump’s announcements yesterday which was impacting crude oil prices in different ways. But crude oil was already ripe for a correction lower as it recently went into strongly overbought territory. So, Brent would probably have sold off a bit anyhow, even without any announcements from Trump.
Extending the life of US oil and gas. The Brent 5-year contract rose yesterday. For sure he wants to promote and extend the life of US oil and gas. Longer dated Brent prices (5-yr) rose 0.5% yesterday to USD 68.77/b. Maybe in a reflection of that.
Lifting the freeze on LNG exports will be good for US gas producers and global consumers in five years. Trumps lifting of Bidens freeze on LNG exports will is positive for global nat gas consumers which may get lower prices, but negative for US consumers which likely will get higher prices. Best of all is it for US nat gas producers which will get an outlet for their nat gas into the international market. They will produce more and get higher prices both domestically and internationally. But it takes time to build LNG export terminals. So immediate effect on markets and prices. But one thing that is clear is that Donald Trump by this takes the side of rich US nat gas producers and not the average man in the street in the US which will have to pay higher nat gas prices down the road.
Removing restrictions on federal land and see will likely not boost US production. But maybe extend it. Donald Trump will likely remove restrictions on leasing of federal land and waters for the purpose of oil and gas exploration and production. But this process will likely take time and then yet more time before new production appears. It will likely extend the life of the US fossil industry rather than to boost production to higher levels. If that is, if the president coming after Trump doesn’t reverse it again.
Donald to fill US Strategic Reserves to the brim. But they are already filled at maximum rate. Donald Trump wants to refill the US Strategic Petroleum Reserves (SPR) to the brim. Currently standing at 394 mb. With a capacity of around 700 mb it means that another 300 mb can be stored there. But Donald Trump’s order will likely not change anything. Biden was already refilling US SPR at its maximum rate of 3 mb per month. The discharge rate from SPR is probably around 1 mb/d, but the refilling capacity rate is much, much lower. One probably never imagined that refilling quickly would be important. The solution would be to rework the pumping stations going to the SPR facilities.
New sanctions towards Iran and Venezuela in the cards but will likely be part of a total strategic puzzle involving Russia/Ukraine war, Biden-sanctions on Russia and new sanctions on Iran and Venezuela. All balanced to end the Russia/Ukraine war, improve the relationship between Putin and Trump, keep the oil price from rallying while making room for more oil exports of US crude oil into the global market. Though Donald Trump looks set to also want to stay close to Muhammed Bin Salman of Saudi Arabia. So, allowing more oil to flow from both Russia, Saudi Arabia and the US while also keeping the oil price above USD 80/b should make everyone happy including the US oil and gas sector. Though Iran and Venezuela may not be so happy. Trumps key advisers are looking at a big sanctions package to hit Iran’s oil industry which could possibly curb Iranian oil exports by up to 1 mb/d. Donald Trump is also out saying that the US probably will stop buying oil from Venezuela. Though US refineries really do want that type of oil to run their refineries.
Big money and USD 80/b or higher. Donald Trump holding hands with US oil industry, Putin and Muhammed Bin Salman. They all want to produce more if possible. But more importantly they all want an oil price of USD 80/b or higher. Big money and politics will probably talk louder than the average man in the street who want a lower oil price. And when it comes to it, a price of USD 80/b isn’t much to complain about given that the 20-year average nominal Brent crude oil price is USD 77/b, and the inflation adjusted price is USD 102/b.
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