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”